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August 2014

Employees, Earned Ownership, and Effective Tax Planning: Evaluating Section 83(b) Elections

By Ryan Bartholomee, CPA

With the battle for talent in Texas due in large part to the thriving oil and gas industry and supporting industries, employers have to be creative in how they attract, retain and motivate experienced talent. Some employers may consider providing ownership opportunities in an affiliated entity to key employees in exchange for services contributed. In the case of an LLC taxed as a partnership, a profits interest could be provided in which the employees could share in the future profits and appreciation in value of the LLC going forward after the interest was granted (if fully vested). In general, receiving a profits interest is not a taxable event (see Rev. Proc. 93-27, clarified by Rev. Proc. 2001-43 for additional information regarding exceptions). Making an IRC section 83(b) election (discussed further below) after receiving a profits interest may still be recommended despite these safe harbor rules so as to protect against the violation that would occur from disposing of the profits interest within two years of receipt.

In contrast to a profits interest, a capital interest entitles the member to receive the proportionate share of the net proceeds of a complete liquidation of the LLC as of the grant date (if fully vested). If a capital interest is earned by the employee and a vesting period is applied, then an IRC section 83(b) election might be worth considering. This election has to be made within 30 days of receiving the capital interest even though the vesting has not yet occurred. It allows the member of the LLC to pay tax on the full fair market value of the membership interest as if it was entirely vested at this time. This is beneficial if the LLC’s assets (such as undeveloped leasehold costs) have a significantly lower value at that time than they are expected to have in the future after assets are developed.

For example, if a membership interest (a capital interest in this case) of 1 percent was granted with a five-year vesting period to an employee, the employee could make a section 83(b) election within 30 days. Let’s say the capital interest had a value of $100,000 (with assets made up largely of leasehold costs associated with undeveloped leases) after discounts for lack of marketability and lack of control. The employee would need to pay ordinary income taxes on the $100,000. If, after five years, the 1 percent capital interest was worth $500,000, then the employee would have paid taxes on $100,000 in order to eventually receive an asset worth $500,000. There are obviously significant assumptions and risks to consider when evaluating this election. Remember that time is of the essence in making an 83(b) election. The 30 days passes quickly. Consistent communication with your clients and knowledge of their plans early on could help these members make wise tax-planning decisions. This could ultimately prevent the LLC in this example from having to distribute too much cash to its members for tax purposes during a phase when capital for asset development is critical.

For definitions and a comparison of capital interests versus profits interests, please see the following link on the IRS website: http://www.irs.gov/publications/p541/ar02.html.


EXCEPTION TO SECTION 731(C) FOR AN INVESTMENT PARTNERSHIP

By Miguel Reyna, CPA

Normally, we all treat stock distributions as taxable in the year received. However, my firm recently met with a client in a situation where the taxation of the stock distribution was deferred to the next year. This is a technical example that is not seen every day, but it is an interesting example that CPAs may find handy.

Facts

The taxpayer received a 2012 Schedule K-1 from an LLC taxed as a partnership. This Schedule K-1 reported $1 on lines 6a ordinary dividends and 6b qualified dividends. Line 19A distributions indicated $1 in cash distributions. Line 19C distributions indicated $223,395 in other property distributions.

The partner footnotes included:

"A distribution of the above number of shares of ABC company stock distributed to you in liquidation of your interest in XYZ, LLC. Please see the accompanying letter for additional information on determining your tax basis and holding period in the aforementioned shares.”

The accompanying letter states:

"It appears that the member owned only Class B Units in XYZ, LLC and as such, the member should have zero tax basis in these units as these units represent profits interests issued for services for which IRC Sec. 83(b) elections were made at issuance. As such, it would appear that the member should receive zero tax basis in the distributed shares of ABC.

Under IRC Sec. 735, the member's holding period for the distributed shares of ABC is deemed to begin on Jan. 18, 2007, which is the same date that XYZ, LLC's holding period began. This date should be used as your acquisition date for the distributed shares of ABC for purposes of determining your holding period irrespective of the date(s) you were issued units in XYZ, LLC.”

Research

Generally, under IRC section 731 (c), a marketable security like the described stock distribution on the taxpayer's Schedule K-1 is taxed in that year. A significant exception to section 731(c) is the exception for "investment partnerships." Section 731(c) does not apply to the distribution of marketable securities by an investment partnership to an "eligible partner." A partnership qualifies as an investment partnership if it has never engaged in a trade or business and substantially all of its assets have always consisted of certain specified assets, including money, stock, bonds, notes, plus some other very specific assets.

Conclusion

XYZ, LLC is deemed to be a qualifying investment partnership and has met the exception to IRC section 731(c). This allows the taxpayer receiving the distribution of shares to not pay taxes when received in 2012, but in the year when they are sold. The taxpayer was then able to wait until the share’s fair market value increased in 2013 before selling the shares at a higher profit than if the shares were sold in 2012.

This sale qualifies for long-term capital gain treatment.


Bitcoin: A Primer for CPAs

In the U.S., bitcoin has become a regulatory hot potato, attracting the attention of a number of federal agencies trying to figure out their particular level of responsibility. The accounting profession needs to watch how the regulatory activity develops going forward. See article from Today’s CPA. TSCPA’s Federal Tax Policy Committee is considering drafting comments to IRS Notice 2014-21 on the treatment of virtual currency. Today's CPA article


TSCPA Asks Lawmakers to Preserve the Use of Cash Basis Method of Accounting

The Texas Society of CPAs asked our members of the House of Representatives to sign a bipartisan letter by Congressmen Brad Schneider (D-IL), Blaine Luetkemeyer (R-MO), Mike Quigley (D-IL), and Richard Hudson (R-NC) opposing the cash accounting changes originally proposed in Chairman Dave Camp’s Tax Reform Act of 2014. The letter is addressed to the House leadership and urges that they preserve the cash method for partnerships, pass-through entities, personal service companies, farmers and ranchers. TSCPA’s federal key persons also contacted their legislators to encourage support for this important issue.

https://www.tscpa.org/eweb/pdf/GovtAffairs/2014/TSCPAltrCashBasis0714.pdf