Note: The following is an excerpt from the introduction to the article as published in The Tax Lawyer. Author citations have been omitted for brevity. Tax Section members may read the article in its entirety in Adobe Acrobat format.
The Proper Tax Treatment of the Transfer of a Compensatory Partnership Interest
If a person receives property as payment for services, whether for past or future services, the receipt typically constitutes gross income to the recipient. If a person performs services for a partnership or agrees to perform future services, and if the person receives a partnership interest as compensation for the past or future services, one might expect that receipt to cause the new partner to recognize gross income in an amount equal to the fair market value of the partnership interest. After all, if a corporation compensated someone for services rendered or to be rendered by transferring the corporation’s own stock to that person, the receipt of the stock would be included in the recipient’s gross income. One might question whether there is any reason to treat a partnership interest differently. In fact, the actual tax treatment of the receipt of partnership interests has had a checkered history, and there are valid reasons for excluding those interests from income in certain circumstances.
This Article does not address the question of how the profits interest of a manager of a private equity fund should be taxed. Rather, the focus of this Article is on the more general question of how the receipt of a compensatory partnership interest should be taxed. However, the analysis and conclusions of this Article are relevant to the resolution of the questions concerning the taxation of a manager of a private equity fund.
Partnership interests can be divided into two broad categories: a partnership capital interest and a partnership profits interest. Part II of this Article sets forth the history of the tax treatment of the receipt for services of those two types of partnership interests. The Article will first define those two terms and the categories they represent. Part III of this Article considers the question of what treatment should be applied to the transfer of a compensatory partnership interest. In that connection, the Article describes circumstances in which there is a principled reason not to tax the recipient of a compensatory partnership profits interest. Part III also discusses the manner in which a taxable compensatory partnership interest, whether a capital interest or a profits interest, should be valued. Part IV discusses the question of whether a taxable transfer of a compensatory partnership capital interest causes a constructive sale of part of the partnership’s assets. Part V sets forth the Article’s conclusions.
*Paul G. Kauper Professor, University of Michigan Law School.