Water, Water Everywhere, Nor Any Drop to Drink[i]

At the beginning of every week, after posting that week’s article, I start to think about a topic for the next post. There are times when I struggle to find something that may be appealing in and of itself, or that may, perhaps, provide a vehicle through which a broader “tax lesson” may be conveyed.

Recent IRS pronouncements are usually the best place to search. They come in many different varieties, from revenue rulings to letter rulings, from revenue procedures to notices, from proposed regulations to final regulations.[ii] Then there are decisions of the Tax Court and of the Federal Courts of Appeals. Finally, there may be proposed legislation, as well as recently enacted statutes.[iii]

The tax practitioner has to keep abreast of as many of the foregoing developments as is humanly possible. Given the sheer volume of material, one may wonder, “How can there ever be a shortage of interesting” – dare I say, fascinating – “things to write about?” You’d be surprised.[iv]

Sometimes, during a moment of inspirational lapse, Fortuna[v] will intercede and another tax professional will contact me for a proverbial “gut check” on an issue that turns out to be pretty interesting. That’s what happened at the end of last week when a friend of mine called with the following question:[vi]

Will the holder of a profits interest[vii] in a partnership that owns stock in a qualifying small business corporation be entitled to exclude their share of the gain from the partnership’s sale of such stock?

Hmm. Before considering this inquiry, let’s review the basic tax treatment for a profits interest in a partnership and for stock in a small business corporation.

The Carried Interest

A carried, or profits, interest in a partnership is issued to a service provider in respect of services rendered or to be rendered to the partnership.

In general, the profits interest entitles the holder to a share[viii] of future profits from the partnership and to a share of the appreciation in value[ix] of the partnership occurring after the issuance of the interest to the service partner. It does not provide a current right to share in the proceeds upon the liquidation of the partnership immediately after the issuance of the interest; thus, the profits interest has no liquidation value at that time.[x]

In 1993, the IRS issued guidance that it generally would not treat the receipt of a partnership profits interest for services as a taxable event either for the issuing partnership or for the recipient service partner.[xi] However, this treatment would not apply if: (1) the profits interest relates to a substantially certain and predictable stream of income from partnership assets; (2) within two years of receipt, the partner disposes of the profits interest; or (3) the profits interest is a limited partnership interest in a publicly traded partnership.

More recent guidance clarified that this treatment applies with respect to a substantially unvested profits interest,[xii] provided the service partner takes into income their distributive share of partnership income, and the partnership does not deduct any amount, either on grant or on vesting of the profits interest.[xiii]

By contrast, a partnership capital interest received for services is includable in the recipient partner’s income under generally applicable rules relating to the receipt of property for the performance of services.[xiv] A partnership capital interest for this purpose is an interest that would entitle the recipient partner to a share of the proceeds if, immediately after the issuance of the interest, the partnership’s assets were sold at fair market value and the proceeds were distributed in liquidation.[xv]

Regardless of the nature of the interest issued to the service-providing partner, the partnership is not, itself, subject to Federal income tax.[xvi] Instead, its items of income, gain, deduction or loss of the partnership retain their character and flow through to the partners, who must include such items on their tax returns (whether or not actually distributed) as if the items were realized directly by the partners.[xvii] Thus, for example, long-term capital gain realized by the partnership on a sale of property is treated as long-term capital gain in the hands of the partners.

Qualified Small Business Stock

A non-corporate taxpayer who holds “qualified small business stock” for more than five years may exclude from their gross income the gain realized by the taxpayer from their disposition of such stock (“eligible gain”).[xviii]

The excluded gain will not be subject to either the income tax or the surtax on net investment income; nor will the excluded gain be added back as a preference item for purposes of determining the taxpayer’s alternative minimum taxable income.

That being said, the amount of gain from the disposition of stock of a qualified corporation that is eligible for this exclusion cannot exceed the greater of:

  1. $10 million, reduced by the aggregate amount of eligible gain excluded from gross income by the taxpayer in prior taxable years and attributable to the disposition of stock issued by such corporation, or
  2. Ten (10) times the aggregate adjusted bases of qualified small business stock issued by such corporation and disposed of by the taxpayer during the taxable year (the “$10 million/10 times basis” limitation rule).[xix]

This limitation notwithstanding, where the provision applies, a qualifying taxpayer may exclude a significant amount of gain from their gross income.[xx]

In order for a non-corporate taxpayer’s gains from the disposition of their shares in a corporation to qualify for the exclusion, the shares in the corporation had to have been acquired after December 31, 1992.

What’s more, with limited exceptions, the shares must have been acquired directly from the corporation – an original issuance – in exchange for money or other property, or as compensation for services provided to the corporation.

If property, other than money, is transferred to a corporation in exchange for its stock, the basis of the stock received is treated as not less than the fair market value of the property exchanged.[xxi] Thus, only gains that accrue after the original issuance of the shares are eligible for the exclusion.

The issuing corporation must be a qualified small business as of the date of issuance of the stock to the taxpayer and during substantially all of the period that the taxpayer holds the stock.

In general, a “qualified small business” is a domestic C corporation that satisfies an “active business” requirement, and that does not own: (i) real property the value of which exceeds 10-percent of the value of its total assets, unless the real property is used in the active conduct of a “qualified trade or business,” or (ii) portfolio stock or securities (i.e., not from subsidiaries) the value of which exceeds 10-percent of its total assets in excess of liabilities.[xxii]

What’s more, at least 80-percent of the corporation’s assets,[xxiii] including intangible assets, must be used by the corporation in the active conduct of one or more qualified trades or businesses.[xxiv]

Assets that are held to meet reasonable working capital needs of the corporation, or that are held for investment and are reasonably expected to be used within two years to finance future research and experimentation, are treated as used in the active conduct of a trade or business.

A “qualified trade or business” is any trade or business, other than those involving the performance of services in the fields of health, law, engineering, architecture, accounting, actuarial science, performing arts, consulting, athletics, financial services, brokerage services, or any other trade or business where the principal asset of the trade or business is the reputation or skill of one or more of its employees.[xxv]

As of the date of issuance of the taxpayer’s stock, the excess of (i) the corporation’s gross assets (i.e., the sum of the cash and the aggregate adjusted bases of other property held by the corporation), without subtracting the corporation’s short-term indebtedness, over (ii) the aggregate amount of indebtedness of the corporation that does not have an original maturity date of more than one year, cannot exceed $50 million.[xxvi]

If a corporation satisfies the gross assets test as of the date of issuance, but subsequently exceeds the $50 million threshold, stock that otherwise constitutes qualified small business stock would not lose that characterization solely as a result of that subsequent event, but the corporation can never again issue stock that would qualify for the exclusion.

Where the foregoing requirements are satisfied, the exclusion rule will apply to the non-corporate taxpayer’s disposition of stock in the qualified small business.

Obviously, this covers a sale by the shareholders of all of the issued and outstanding shares of the corporation, subject to the limitations described above. It should also cover the liquidation of a C corporation and its stock following the sale of its assets to a third party; in that case, the double taxation that normally accompanies the sale of assets by a C corporation may be substantially reduced.

Partnership as Shareholder of Qualified Small Business

A non-corporate partner’s allocable share of the gain from a partnership’s disposition of qualified small business stock is eligible for the exclusion, provided that (i) all the eligibility requirements with respect to qualified small business stock are met, (ii) the stock was held by the partnership for more than five years, and (iii) the partner held their partnership interest on the date the partnership acquired the stock from the corporation and at all times thereafter before the partnership’s disposition of the stock.[xxvii]

The amount of gain allocated to a partner – from a partnership’s disposition of stock in a qualified small business – that may be excluded from gross income may be limited by the “$10 million/10 times basis” limitation rule. Each partner applies this rule separately to their share of the partnership’s gain, using their proportionate share of the partnership’s adjusted basis for the stock disposed of.[xxviii]

In addition, a partner cannot exclude any gain allocated to them from the partnership based on their current percentage interest in the partnership to the extent the amount of such gain exceeds the amount that would have been allocated to them based on their percentage interest in the partnership at the time the partnership acquired the stock.[xxix] In other words, a partner can’t increase their share of the excludible gain after the original issuance of the stock.

Partnership Carried Interest

How, then, does the exclusion of gain from a partnership’s sale of stock in a qualified small business apply to a partner who holds a profits interest in a partnership when the partnership disposes of such stock?[xxx]

Well, it is clear that the profits interest will have to have been issued to the service partner prior to the partnership’s acquisition of stock in the corporation if any portion of the partnership’s subsequent gain from the sale of such stock is to be allocated to the profits interest holder.[xxxi]

It is also clear that the profits interest holder will have to apply the “$10 million/10 times basis” limitation rule to their allocable share of the partnership’s gain from the disposition of its shares in the qualified small business.

What is not entirely clear is how the holder’s percentage interest in the partnership’s assets or capital is determined for this purpose. After all, the holder of the profits interest participates only in the appreciation in value of the partnership – i.e., in the gain that accrues after the issuance of the profits interest; they do not begin to share in such gain until those who were “capital partners” as of the date the profits interest was issued are allocated an amount equal to the gain that was inherent in the partnership as of such date.

Does it matter, then, whether this “threshold gain” has already been allocated to the other partners by the time the stock in the qualified small business has been issued to the partnership by the corporation? It may.

Specifically, it is possible that the profits interest holder will be treated as having a capital interest percentage of zero at the time the stock is issued to the partnership if the above threshold allocation of gain has not yet been completed. Recall also that a partner cannot increase their share of the excludible gain from the sale of such stock after the original issuance of the stock. Thus, it is possible no part of the gain allocated to the interest holder will be excludible.

In contrast, if the threshold gain has already been allocated to the other partners prior to the partnership’s acquisition of the qualified small business stock, then the holder of the profits interest will be treated as having an interest in the partnership’s capital gains at that time, which may enable them to exclude from their gross income at least a portion of the gain from the sale of such stock.

Both positions have their merits, but it is not for us to decide. “Washington, are you listening?”


[i] From The Rime of the Ancient Mariner, by Samuel Taylor Coleridge.

[ii] And let’s not forget GCMs, CCAs, FSAs, etc.

[iii] Witness the amount of material provided by the Tax Cuts and Job Act (P.L. 115-97; the Act).

[iv] Or maybe it’s just me.

[v] The Roman goddess of fortune or luck.

[vi] Thanks Pat.

[vii] Also known as a carried interest or a “promote” interest. This endnote was not part of Pat’s question.

[viii] Based upon a stated percentage.

[ix] The partners will usually determine the value of the partnership as of the grant date so as to establish the base or starting point from which to measure any appreciation in value of the partnership.

[x] The partner starts off with a zero capital account, which is why the issuance of the profits interest is not treated as a taxable event to the recipient partner where the interest is vested in the partner.

In the case of an unvested interest, most tax practitioners will advise the recipient service partner of a profits interest to make an election under IRC Sec. 83(b) so as to cut off the compensatory element as of the grant date, when the interest has zero value.

In addition, and consistent with the foregoing approach, they will advise that the partnership adjust the partners’ capital accounts to ensure that no part of the partnership’s value may be distributed to the holder of the profits interest. A “reverse 704(c)” allocation.

[xi] Rev. Proc. 93-27.

[xii] Within the meaning of IRC Sec. 83.

[xiii] Rev. Proc. 2001-43.

See also the “safe harbor” under the proposed regulations under IRC Sec. 83: Prop. Reg. Sec. 1.83-3(l), which would treat the fair market value of a carried interest as being equal to its liquidation value; REG-105346-03; and Notice 2005-43.

[xiv] IRC Sec. 83.

[xv] In other words, the partner starts off with a positive capital account.

[xvi] IRC Sec. 701.

[xvii] IRC Sec. 702.

[xviii] IRC Sec. 1202. See also https://www.taxlawforchb.com/2019/05/is-timing-everything-only-time-will-tell-small-business-stock-and-the-reduced-corporate-tax-rate. (Yes, shameless self-promotion.)

[xix] IRC Sec. 1202(b).

[xx] Moreover, any amount of gain in excess of the limitation would still qualify for the favorable federal capital gain tax rate, though it will be subject to the surtax.

[xxi] IRC Sec. 1202(d)(2)(B).

[xxii] IRC Sec. 1202(c).

[xxiii] By value.

[xxiv] IRC Sec. 1202(e).

[xxv] The term also excludes any banking, insurance, leasing, financing, investing, or similar business, any farming business, any business involving the production or extraction of products of a character for which depletion is allowable, or any business of operating a hotel, motel, restaurant or similar business.

[xxvi] For this purpose, amounts received in the issuance of stock are taken into account.

In the case of a corporation that owns at least 50-percent of the vote or value of a subsidiary, the parent corporation is deemed to own its ratable share of the subsidiary’s assets and to be liable for its ratable share of the subsidiary’s indebtedness, for purposes of the qualified corporation, active business, and gross assets tests.

[xxvii] IRC Sec. 1202(g).

Gain from the partnership’s sale or exchange of qualified small business (QSB) stock that is eligible for the section 1202 exclusion is reported on Line 11 of the Sch. K-1 issued to the partners. Each partner will determine if they qualify for the exclusion. A statement should be attached to Schedule K-1 that reports (a) the name of the corporation that issued the QSB stock, (b) the partner’s share of the partnership’s adjusted basis and sales price of the QSB stock, and (c) the dates the QSB stock was bought and sold.

[xxviii] IRC Sec. 1202(g)(1)(B).

[xxix] IRC Sec. 1202(g)(3).

[xxx] This is different from the question of whether the holder of a profits interest – who did not incur a tax liability on the receipt of their interest, and who made no capital contribution to the partnership that may have found its way as a capital contribution to the corporation – should benefit from the exclusion rule of IRC Sec. 1202.

[xxxi] Because of the requirement under IRC Sec. 1202(g) that the partnership must have held stock in the qualified corporation for more than five years, plus the requirement that the partner (including the holder or a profits interest) must have held their partnership interest on the date the partnership acquired the stock from the corporation and at all times thereafter before the partnership’s disposition of the stock, there is no need to discuss the three-year holding for profits interests introduced by the Act as new IRC Sec. 1061.