Sweat equity taxation

[Matyas Sustik]

I hoped some experinced members could point me to the right resources on the following situation.

Assume you syndicate a deal and as part compensation for putting the deal deal together, for finding the right property etc. you are granted a 10% equity interest in the partnership that is formed for the venture. Again, you do not put cash in like the passive investors. For example, assume that 50 passive investors contribute 50k each and using these funds the partnership purchases an apartment complex. But the passive investors only gain 90%/50 = 1.8% ownership each, while you gain 10% ownership without outlaying any cash.

Is this considered to be a taxable event? I heard arguments that this is something called sweat equity and that the IRS will tax it as ordinary income. Basically, the 10% grant represents a 250k value of the total 2.5M of the partnership assets. I also know that when a company grants stock to employees (say on a vesting schedule) then income tax is deducted when the stock is vested. The value of the stock at vesting is considered ordinary income.

So the questions:

1. Is there a large tax bill due for this grant in the year of forming the partnership?

2. What are the implications for the partnership tax return? Does the partnership itself have to pay some tax (like when it pays wages to someone, there could be social security taxes etc.)

3. The other investors get diluted on day one and essentially pay for the 10% ownership given away. Now, is that an expense for these partners that they can deduct and get some tax benefits?

Thanks for anyone reading this and considering helping me out.

[Eric Williams]

Quote from @Matyas Sustik:

I hoped some experinced members could point me to the right resources on the following situation.

Assume you syndicate a deal and as part compensation for putting the deal deal together, for finding the right property etc. you are granted a 10% equity interest in the partnership that is formed for the venture. Again, you do not put cash in like the passive investors. For example, assume that 50 passive investors contribute 50k each and using these funds the partnership purchases an apartment complex. But the passive investors only gain 90%/50 = 1.8% ownership each, while you gain 10% ownership without outlaying any cash.

Is this considered to be a taxable event? I heard arguments that this is something called sweat equity and that the IRS will tax it as ordinary income. Basically, the 10% grant represents a 250k value of the total 2.5M of the partnership assets. I also know that when a company grants stock to employees (say on a vesting schedule) then income tax is deducted when the stock is vested. The value of the stock at vesting is considered ordinary income.

So the questions:

1. Is there a large tax bill due for this grant in the year of forming the partnership?

2. What are the implications for the partnership tax return? Does the partnership itself have to pay some tax (like when it pays wages to someone, there could be social security taxes etc.)

3. The other investors get diluted on day one and essentially pay for the 10% ownership given away. Now, is that an expense for these partners that they can deduct and get some tax benefits?

Thanks for anyone reading this and considering helping me out.

I want to hear if other CPAs are aware of an exception but my initial conclusion would be this is a taxable transaction since 721 allows for nontaxable exchanges for property.

There is a difference in treatment of receipts of a profits interest and a capital interest.

(a)General rule

No gain or loss shall be recognized to a partnership or to any of its partners in the case of a contribution of property to the partnership in exchange for an interest in the partnership.

Profits interests and capital interests are defined in Rev Proc 97-23.

"Rev. Proc. 93-27 provides that (except as otherwise provided in section 4.02 of the revenue procedure), if a person receives a profits interest for the provision of services to or for the benefit of a partnership in a partner capacity or in anticipation of being a partner, the Internal Revenue Service will not treat the receipt of the interest as a taxable event for the partner or the partnership."

"section 2.02 of Rev. Proc. 93-27 defines a profits interest as a partnership interest other than a capital interest. Section 2.01 of Rev. Proc. 93-27 defines a capital interest as an interest that would give the holder a share of the proceeds if the partnerships assets were sold at fair market value and  then the proceeds were distributed in a complete liquidation of the partnership"

There may be ways to restructure for more favorable consequences but you would have talk to someone closer to the matter and with that particular skillset.