On December 2, 2013, the United States Tax Court issued an opinion in Crescent Holdings, LLC v. Commissioner, 141 T.C. No.15. This opinion affects individuals who receive a non-vested capital interest in a partnership. In what it states was an issue of first impression, the Tax Court held that income of the partnership that was allocated to a non-vested partner was not properly allocated. The wrongfully allocated income was re-allocated to the other partners.

CEO held an interest in Crescent Holdings which was to vest at a future date.  For the tax years at issue, 2006 and 2007, Crescent Holdings issued to CEO Schedule K-1s allocating to him ordinary business income in the amounts of $423,611 and $3,608,218, respectively.  CEO reported this income on his tax return; however, he received no distributions from Crescent Holdings in either year. CEO resigned three months before his interest vested and Crescent Holdings filed for bankruptcy shortly thereafter. The IRS issued a notice of final partnership adjustment and treated CEO as a partner.  The partners and CEO both filed petitions. CEO asserted that he should not have been allocated income nor treated as a partner. Conversely, because it reduced their income, the partners emphasized that CEO should be allocated income and treated as a partner.

The Tax Court analyzed whether the CEO held a profits interest or capital interest.  A capital interest is an interest that gives its holder a share of the proceeds if the partnership’s assets were sold at fair market value and the proceeds distributed in complete liquidation of the partnership.  A profits interest is defined as an interest that is not a capital interest. The court noted that a recipient of a non-vested profits interest could be recognized as a partner and allocated items of income.  After examining CEO’s agreement the Tax Court concluded that CEO’s interest was a capital interest because CEO was entitled to receive a distribution upon liquidation.

Under the income tax rules of Code section 83, a person who receives property in connection with the performance of services must recognize income. The amount included in income is the fair market value of the property received less the amount paid, if any. A taxpayer has two options, however, if the property received is both non-transferable and subject to a substantial risk of forfeiture.  First, if the taxpayer does nothing, the fair market value of the property would be included in income only as and when it becomes vested. Second, a taxpayer can make an “83(b) election” to include the property in income at the current value.

The Tax Court ruled that a partnership capital interest is property for purposes of Code section 83.  Thus, CEO could have made an 83(b) election for the capital interest received. CEO, however, did not make an 83(b) election, and the property remained not vested. Regulations accompanying section 83 provide that the transferor, in this case Crescent Holdings, shall be regarded as the owner of the property until the property becomes substantially vested. Because CEO’s capital interest was not vested, the Tax Court held that the IRS could not include CEO as a partner in its notice of final partnership adjustment nor allocate any income to CEO.

Although not directly discussed in Crescent Holdings, it can be extrapolated from the Tax Court’s decision that if a partner’s capital or profits interest vests incrementally, partnership income should be allocated to the interest only to the extent then vested. The vested portion would be transferable and not subject to a substantial risk of forfeiture. Therefore, the partnership income allocated to CEO in 2006 and 2007 should have been allocated to Crescent Holding’s vested partners. That said, partnership income should be allocated to a partner’s interest if the partner has made an 83(b) election whether or not the interest has vested.