Value of Business Interest Transferred to Service Provider

 

Giving employees or other service providers an ownership interest in a business is a way to incentivize the workers to render top performance while conserving cash.  But determining what type of ownership interest to give the worker and knowing the tax consequences can be somewhat complex.  The tax issues can be even more difficult if the business is operated in the form of a partnership or LLC treated as a partnership.

Under Revenue Procedures 93-27 and 2001-43, the grant of a profits interest in a partnership in exchange for services is NOT generally a taxable event IF the person receives that interest as a partner or in anticipation of becoming one, and neither the partnership nor the other partners deduct any amount related to grant or vesting of such interest.

To the contrary, under IRC  section 83, the grant of a capital interest in a partnership in exchange for services is taxable to the service provider (and deductible by the partnership) at the time of grant UNLESS subject to substantial risk of forfeiture.  If the capital interest is subject to substantial risk of forfeiture at time of grant, the capital interest becomes taxable to the service provider (and deductible by the partnership) as such forfeiture provisions lapse.

Once it has been determined that the interest transferred to the service provider was a capital interest, and that the grant or vesting of the interest is a taxable event, the next step is to determine the value of the transferred interest.

There are multiple ways to determine the value of a capital interest received for services.  Support exists for any one of several different valuation approaches.

The best indicator of value of a capital interest is often a recent sale.  So if a partner recently bought a 10% interest for $15,000, the value of a 10% interest given to a service provider in exchange for services would be $15,000.  But often there have not been recent comparable sales of similar interests.   So other valuation approaches and methodologies often must be considered.

One valuation approach is to calculate the value of the capital interest being transferred to the service provider by reference to the amount of existing capital being transferred.  Under this approach, if other partners previously contributed $100,000 cash to a partnership and then gave a service provider a 20% capital interest in exchange for services, that capital interest would have a value of $20,000.

Another approach is to calculate the value of the capital interest by reference to the amount the other partners are willing to give up in exchange for such services.  For example, if the other partners are willing to contribute $100,000 in exchange for only 90% of the partnership interests, then a 10% interest given to a service provider must be worth $11,111 ($100,000 / 90% * 10%).  The IRS has used this approach in some cases.

Another approach is to calculate the value of the capital interest by reference to the amount the service provider charges third parties for similar services.  So if the service provider normally charges $25,000 for the services being provided to the partnership in exchange for a 10% interest, the 10% interest would be treated as having a value of $25,000.

Another approach would examine the value of the transferred interest before and after the services were provided, and then increase the value of the transferred interest proportionately based on the value of the services provided.  Under this approach, if the  partnership was worth $100,000 before the services were provided, and 125,000 after the services were provided, then the 10% interest transferred to the service provider would be valued at $12,500 ($25,000 + $100,000 = 125,000 * 10%).

A variation on all of the approaches involves adjusting the value of the capital interest (however determined) to reflect such factors as lack of marketability, lack of liquidity of investment, lack of control, likelihood of taxation on “phantom” income, likelihood of realization of taxable gain on appreciated assets, and other valuation factors.

Giving employees or other service providers a minority interest in a business is a way to incentivize the workers to render top performance while conserving cash.  But determining what type of interest to give the worker and knowing the tax consequences can be somewhat complex.  Please give me a call or email if you have questions about anything you read here.  937-223-1130 or Jsenney@pselaw.com.

AND ONE MORE THING.    In a unanimous decision (with one justice not participating), the US Supreme Court, reversing the Sixth Circuit Court of Appeals, has held that severance payments that were made to involuntarily terminated employees, and that were not tied to the receipt of State unemployment insurance, are subject to tax under the Federal Insurance Contributions Act (social security taxes). The Court concluded that the severance payments at issue fell within the law’s broad definition of “wages” for social security tax purposes.   To discuss further, please contact me by phone or email at 937-223-1130 or Jsenney@pselaw.com.

AUTHOR: Jeff Senney
jsenney@pselaw.com