By John G. Hodnette

Pursuant to Rev. Proc. 2001-43, recipients of unvested profits interests are treated as partners on the date of grant regardless of whether they make Section 83(b) elections. Therefore, when the profits interest later vests, there is no additional income provided the parties meet the requirements of Rev. Proc. 2001-43 and Rev. Proc. 93-27. Since the owners of profits interests are treated as partners, they can be allocated income and loss prior to vesting despite the ultimate substantiality of such allocations under the Section 704(b) regulations being unclear at the time of the allocation. That creates a potential problem: What happens if the profits interest is forfeited after such allocations? That is a common occurrence, as employers often require forfeiture of unvested profits interests upon the partner’s leaving the employment of the partnership.

Rev. Proc. 2001-43 does not address forfeiture. The forfeiture of a partnership interest could be taxable to the remaining partners if they are treated as receiving a share of partnership assets from the forfeiting partner under an aggregate theory of partnership. See Treas. Reg. § 1.721-2(e) (authorizing treatment of partnerships as an aggregate of its partners where appropriate). However, the taxation of capital shifts is unsettled.

In 2005, Treasury issued proposed regulations under Section 704(b) to clarify the treatment of the forfeiture of unvested profits interests. Under the proposed regulations, a capital shift that occurs upon forfeiture is taxable to the other partners only to the extent taxable income was previously allocated to the forfeiting partner. The proposed regulations would require allocations of loss to the forfeiting partner in the year of forfeiture equal to the excess of prior non-taxed distributions over the amount paid for such interest (typically zero) minus the cumulative net income allocated to the forfeiting partner during prior years. Prop. Reg. § 1.704-1(b)(4)(xii)(c).  These special allocations work to undo the prior tax treatment of the profits interest holder with offsetting allocations. Similarly, offsetting allocations to the remaining partners are required by the proposed regulations, usually income allocations that offset loss allocations made to the forfeiting partner. Thus, the proposed regulations sometimes treat the forfeiture of a nonvested profits interest as a taxable event for the remaining partners. Although the proposed regulations have not been finalized, many operating agreements incorporate their rules to resolve the treatment of a forfeiture of a nonvested profits interest.

John G. Hodnette is an attorney with Fox Rothschild, LLP in Charlotte.