Grant equity to a new member in Partnerships

[Yaodi]

I have been offered to join my friend's company, which now reports as a single-member LLC. He'd grant me 10% equity of the company and convert it to Partnerships. The company owns some portfolio investments so the equity apprently is worth something. Is there any tax liability for me on this equity grant transaction? 

[tagteam]

I'll page @Rick19744 for input, but your contribution should be tax-free.

[Yaodi]

My understanding is Profits Interest is not a taxable event, but Capital interest is, which is what I have granted. But I'm struck to see a big tax liability it'll incur for me in that case. 

Source: https://www.irs.gov/publications/p541#en_US_202203_publink[phone number removed]

[Rick19744]

It's not clear from the facts exactly how your equity interest is being acquired:

• When you say "grant" what exactly does this mean?
  • Are you purchasing a 10% interest?
  • Are you being "given" a 10% interest?
    • If "yes" is this for services rendered?
• In addition to the above, you need to look at Revenue Ruling 99-5 which provides commentary on two different situations.
• Additionally, there could be the need for a Section 754 election
• There could be a need for a Section 704(c) allocation
• Unfortunately, partnership tax gets complicated very quickly, as a result, you should consider meeting with a tax professional to get started down the right path and so all parties understand the tax consequences.
  • You will need an operating agreement
  • You will need to maintain outside tax basis worksheets
  • Based on the limited facts, the LLC may have special allocation(s) as a result of Section 754 or 704(c)

[Rick19744]

I see we were responding at the same time.

Please respond to my questions.

[Yaodi]

Thank you for laying out the factors to consider! To clarify, the equity was given as compensations for service rendered, so no capital was contributed to "purchase" the equity. So I don't think Revenue Ruling 99-5 is relavent in this case. 

I need to research on Section 754 election and Section 704(c) allocation. If I simplify how this equity should be reflected on my tax forms, is it going to be reported as "Guaranteed payment to partners" on K-1s? This isn't a payment in cash form, so I wonder how I shall make sure the equity % is shown on the tax forms, which will be my tax basis for furture capital gain calculation if I were to sell the interests. 

[PatriciaV]

Receiving a Partnership interest in exchange for services rendered is not a taxable event. You have a new investment with an initial basis equal to the value of the services you provided.

Unless the Partnership Agreement provides for guaranteed payments to the partners and you actually receive such payment, there would be no such payments reported on the Schedule K-1 you receive from the partnership.

Champ Rick19744 is correct - Partnership taxes can be complicated. Engaging an experienced tax professional and/or legal advisor may save you many issues in the future.

TurboTax Business now offers both Assisted and Full Service options to help you prepare a Partnership tax return.

[Yaodi]

Based on what I read here, in paragraph "Contribution of Services", only profits interest receipt is not a taxable event, however capital interest is. Is that what you were referring to? 

[PatriciaV]

Yes, you are correct. According to IRS Pub 541 Partnerships, Contribution of Services:
   "The fair market value of services rendered in exchange for a capital interest in a
partnership is taxable to the partner as a guaranteed payment..."

   "The receipt of a profits interest for providing services to a partnership in a partner capacity is not taxable to the partner..." [some exceptions apply]

If you anticipate receiving a capital interest in the partnership, the potential tax consequences may influence your decision. The value of the contributed services would be reported on Schedule K-1 as Guaranteed Payments, which are subject to both ordinary income and self-employment taxes (IRS FAQ Entities 1).