The Tax Court held in Crescent Holdings LLC et al. v. Commissioner,141 T.C. No. 15 (Dec. 2, 2013) that an individual who was issued an unvested partnership interest received a capital interest in a partnership in exchange for the performance of services instead of a profits interest. The court also held that the undistributed profit or loss attributable to that interest should be recognized in the income of the transferor, rather than the individual.

Crescent Holdings involved Arthur Fields, an executive of Crescent Resources LLC, a company wholly owned by Duke Ventures, LLC, a subsidiary of Duke Energy Corp. Fields was issued a 2% membership interest in a new LLC, Crescent Holdings, when Duke Ventures entered into a partnership with a Morgan Stanley entity. The interest received by Fields entitled him to 2% of the value of the assets in Crescent Holdings after a priority distribution for members who made a priority capital contribution. Fields paid no amount for his 2% membership interest. Additionally, Fields entered into a new employment agreement with Crescent Resources, but did not make an election under Section 83(b). Concurrent with the formation of Crescent Holdings, Fields entered into a new employment agreement with Crescent Resources.

In 2006 and 2007, Crescent Holdings issued a Schedule K-1 to Fields reflecting allocations to him of income in both years. Though Fields believed he was not a partner in Holdings, he nonetheless reported those allocated amounts on his own income tax return. He never received a distribution from Holdings, but later, after discussions with the management of Duke Ventures, Crescent Resources paid Fields an amount to cover the tax he paid on the income allocations for the 2006 and 2007 taxable years and estimated taxes for the 2008 taxable year.

Ultimately, the IRS issued a final partnership administrative adjustment (FPAA) with regard to Holdings for 2007 and 2008, asserting increased ordinary income overall and that Fields should be treated as a part of Holdings for purposes of allocating partnership items.

The Tax Court concluded that the 2% interest received by Fields was a partnership capital interest, not a partnership profits interest. The court explained that if Holdings had liquidated on the date of formation, Fields would have received a share of the proceeds, given that no priority capital contribution had been made that would have entitled another member to a priority distribution. The court specifically stated that Rev. Proc. 93-27 and Rev. Proc. 2001-43 were not applicable.

The court held further that Section 83 applies to a nonvested partnership capital interest transferred in exchange for the performance of services. Interestingly, the court stated that since it found that Field's interest was a capital interest, it did not need to decide whether Section 83 applies to partnership profits interests.

Finally, the court held that under Treas. Reg. Section 1.83-1(a)(1), the undistributed partnership income allocations attributable to the nonvested 2% partnership capital interest should be recognized in the income of the transferor. The court had noted this to be an issue of first impression. Crescent Holdings was the transferor of the 2% partnership capital interest. Thus, according to the court, the undistributed partnership allocations attributable to the 2% capital interest were allocable to the partners holding the remaining interest in Holdings.

Notably, the court made clear that the entire interest received by Fields was a capital interest and thus made no attempt to treat any part of his interest as a profits interest. Given that the membership interest he received was in the same class as that of the other partners in terms of distribution rights, it would have been difficult to argue a bifurcation of the capital interest from a profits interest.

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