Corp. & Part. Tax - Problem 4

Problem Set 4

In each case, assume that X is a business entity being formed by three equal owners, R, S and T. In the formation transaction, each owner receives his or her one-third ownership share -- stock, partnership interests or LLC interests, as the case may be. Like stock, the partnership and LLC interests entitle each owner to a share of the capital of X as well as a share of its profits.

What are the tax consequences to X, R, S and T of each of the following fact patterns? For R, S and T, consider the basis of their ownership interests as well as the amount, character and timing of any income they have. In addition, consider the basis to X of any property it receives. In each case, address each of the following scenarios:

Scenario A. X is a C corporation (or an "association").

Scenario B. X is an S corporation.

Scenario C. X is a partnership, or an LLC taxed as a partnership. Under the partnership agreement or LLC operating agreement, all items of income, deduction, loss and credit are allocated equally among R, S and T.

Problem 4.1. R contributes $10,000 cash; S contributes Blackacre, with a basis to S of $3,500 and a fair market value of $10,000; T contributes $10,000 cash. S is not a real estate dealer.

Problem 4.2. Same as Problem 4.1, except that T contributes $10,000 of future services.

Problem 4.3. Same as Problem 4.1, except that, about a year after the formation of X, X sells Blackacre to Y for $12,500. The sale was not planned or contemplated prior to the organization of X.

Problem 4.4. Same as Problem 4.1, except that T contributes Whiteacre, with a basis to T of $8,000 and a fair market value of $25,000; Whiteacre is encumbered by a mortgage securing a recourse loan with an outstanding principal balance of $15,000. X assumes the mortgage. In Scenario C, assume that X is a general partnership.

Problem 4.5. Same as Problem 4.4, except that the fair market value of Whiteacre is $19,000, and the balance on the mortgage is $9,000.

Suggested Study for Problem Set 4

Scenario A (C corporations): I.R.C. §§ 351, 357, 358, 362, 1032, 83.

Scenario B (S corporations): Same Code sections as Scenario A, plus I.R.C. §§ 1366, 1367.

Scenario C (partnerships): I.R.C. §§ 721, 722, 723, 752, 731, 704(c); Treas. Regs. §§ 1.752-2(a), (b); Rev. Proc. 93-27, reproduced below.

Rev. Proc. 93-27
1993-2 C.B. 343

26 CFR 601.201: Rulings and determination letters.
(Also Part I, Sections 61, 83, 721; 1.721-1.)

SECTION 1. PURPOSE

This revenue procedure provides guidance on the treatment of the receipt of a partnership profits interest for services provided to or for the benefit of the partnership.

SEC. 2. DEFINITIONS

The following definitions apply for purposes of this revenue procedure.

.01 A capital interest is an interest that would give the holder a share of the proceeds if the partnership's assets were sold at fair market value and then the proceeds were distributed in a complete liquidation of the partnership. This determination generally is made at the time of receipt of the partnership interest.

.02 A profits interest is a partnership interest other than a capital interest.

SEC. 3. BACKGROUND

Under section 1.721-1(b)(1) of the Income Tax Regulations, the receipt of a partnership capital interest for services provided to or for the benefit of the partnership is taxable as compensation. On the other hand, the issue of whether the receipt of a partnership profits interest for services is taxable has been the subject of litigation. Most recently, in Campbell v. Commissioner, 943 F.2d 815 (8th Cir. 1991), the Eighth Circuit in dictum suggested that the taxpayer's receipt of a partnership profits interest received for services was not taxable, but decided the case on valuation. Other courts have determined that in certain circumstances the receipt of a partnership profits interest for services is a taxable event under section 83 of the Internal Revenue Code. See, e.g., Campbell v. Commissioner, T.C.M. 1990-236, rev'd, 943 F.2d 815 (8th Cir. 1991); St. John v. United States, No. 82-1134 (C.D. Ill. Nov. 16, 1983). The courts have also found that typically the profits interest received has speculative or no determinable value at the time of receipt. See Campbell, 943 F.2d at 823; St. John. In Diamond v. Commissioner, 56 T.C. 530 (1971), aff'd, 492 F.2d 286 (7th Cir. 1974), however, the court assumed that the interest received by the taxpayer was a partnership profits interest and found the value of the interest was readily determinable. In that case, the interest was sold soon after receipt.

SEC. 4. APPLICATION

.01 Other than as provided below, if a person receives a profits interest for the provision of services to or for the benefit of a partnership in a partner capacity or in anticipation of being a partner, the Internal Revenue Service will not treat the receipt of such an interest as a taxable event for the partner or the partnership.

.02 This revenue procedure does not apply:

(1) If the profits interest relates to a substantially certain and predictable stream of income from partnership assets, such as income from high-quality debt securities or a high-quality net lease;

(2) If within two years of receipt, the partner disposes of the profits interest; or

(3) If the profits interest is a limited partnership interest in a "publicly traded partnership" within the meaning of section 7704(b) of the Internal Revenue Code.

* * * * *

Study Guide Reading

For those using the Black Letter study guide (optional), this material is covered in Chapter IV (pages 115-145) and Chapter XVI (pages 417-436).

Created by: bojack@lclark.edu
Update: 10 Jan 08
Expires: 31 Aug 08

Rev. Proc. 93-27 1993-2 C.B. 343

Rev. Proc. 93-27
1993-2 C.B. 343