Section 83(b), Section 409A, Section 457A And Subchapter K

1. INTRODUCTION

   On May 24, 2005, the Treasury Department ("Treasury") published proposed treasury regulations (the "proposed regulations") and a proposed revenue procedure (the "proposed revenue procedure") governing the issuance and vesting of capital and profits partnership interests issued in connection with the performance of services (such interests, "compensatory partnership interests").1 As discussed below, the proposed regulations represent a significant change in the government's approach to the taxation of compensatory partnership interests.2

   The proposed regulations would alter the basis for taxing compensatory partnership interests (or not), while attempting to preserve the tax consequences under the current rules. Achieving this goal may depend in large part on whether final regulations expand the scope of the liquidation value safe harbor and reduce the procedural hurdles associated with its use. Treasury has postponed work on finalizing the proposed regulations while Congress considers proposed carried interest legislation.3

   Very generally, section 409A4 limits the ability of taxpayers to defer compensation under nonqualified deferred compensation plans by imposing stringent deferral election and distribution requirements, and section 457A effectively precludes service providers of "nonqualified entities" from deferring compensation by taxing such amounts when they cease to be subject to a substantial risk of forfeiture. Treasury and the Internal Revenue Service ("IRS") have issued only very limited guidance applying these Code sections to partnership and LLC interests.

2. SECTION 83 GOVERNS COMPENSATORY PARTNERSHIP INTERESTS

   Section 83 generally applies to service-related transfers of property, and courts have held that a partnership capital interest is property for this purpose.5 Resolving a long history of case law questioning the status of profits interests as property for section 83 purposes,6 the proposed regulations provide that section 83 governs the tax consequences of both capital and profits interests issued for services.7 Although the proposed regulations apply section 83 to both capital and profits interests, they do not govern a bare right to receive allocations and distributions from a partnership described in section 707(a)(2)(A), because such a right does not constitute a partnership interest.8 The preamble to the proposed regulations explains that Congress has directed that, consistent with its substance, such an arrangement is properly treated as a disguised payment of compensation to the service provider.9 Excepting section 707(a)(2)(A) payments from the section 83 regime adopted by the proposed regulations creates considerable uncertainty regarding the type of payments the proposed regulations would govern. Section 707(a) provides that a transaction between a partner and its partnership other than in his or her capacity as a partner will be treated as occurring between the partnership and a party who is not a partner. Although section 707(a)(2) authorizes Treasury to promulgate regulations to determine when allocations and distributions should be treated as such payments to a partner not acting in such capacity, Treasury has not issued such regulations.10

   Thus, the description in the 1984 Committee Report to section 707 of the factors to be considered in promulgating regulations still represents the only guidance on the scope of section 707(a)(2)(A).11 Entrepreneurial risk appears to be the determining factor as to when and under what circumstances a service provider's interest should be treated as a partnership interest (and so subject to the proposed regulations). The proposed regulations include significant section 83-related amendments to subchapter K regulations, including changes to (i) conform the subchapter K rules to the section 83 timing rules; (ii) revise the section 704(b) regulations to take into account the fact that potentially transitory allocations with respect to an unvested interest may be forfeited; and (iii) revise the section 721 regulations to provide that a partnership generally does not recognize gain or loss on the transfer of a compensatory partnership interest...