[Federal Register Volume 70, Number 99 (Tuesday, May 24, 2005)]
[Proposed Rules]
[Pages 29675-29683]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 05-10164]


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DEPARTMENT OF THE TREASURY

Internal Revenue Service

26 CFR Part 1

[REG-105346-03]
RIN 1545-BB92


Partnership Equity for Services

AGENCY: Internal Revenue Service (IRS), Treasury.

ACTION: Partial withdrawal of notice of proposed rulemaking, notice of 
proposed rulemaking, and notice of public hearing.

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SUMMARY: This document withdraws the remaining portion of the notice of 
proposed rulemaking published in the Federal Register on June 3, 1971 
(36 FR 10787) and contains proposed regulations relating to the tax 
treatment of certain transfers of partnership equity in connection with 
the performance of services. The proposed regulations provide that the 
transfer of a partnership interest in connection with the performance 
of services is subject to section 83 of the Internal Revenue Code 
(Code) and provide rules for coordinating section 83 with partnership 
taxation principles. The proposed regulations also provide that no gain 
or loss is recognized by a partnership on the transfer or vesting of an 
interest in the transferring partnership in connection with the 
performance of services for the transferring partnership. This document 
also provides a notice of public hearing on these proposed regulations.

DATES: Written or electronic comments must be received by August 22, 
2005. Outlines of topics to be discussed at the public hearing 
scheduled for October 5, 2005, at 10 a.m. must be received by September 
14, 2005.

ADDRESSES: Send submissions to: CC:PA:LPD:PR (REG-105346-03), room 
5203, Internal Revenue Service, P.O. Box 7604, Ben Franklin Station, 
Washington, DC 20044. Submissions may be hand-delivered Monday through 
Friday between the hours of 8 a.m. and 4 p.m. to CC:PA:LPD:PR (REG-
105346-03), Courier's Desk, Internal Revenue Service, 1111 Constitution 
Avenue, NW., Washington, DC, or sent electronically, via the IRS 
Internet site at http://www.irs.gov/regs or via the Federal eRulemaking 
Portal at http://www.regulations.gov (IRS REG-105346-03).

FOR FURTHER INFORMATION CONTACT: Concerning the section 83 regulations, 
Stephen Tackney at (202) 622-6030; concerning the subchapter K 
regulations, Audrey Ellis or Demetri Yatrakis at (202) 622-3060; 
concerning submissions, the hearing, and/or to be placed on the 
building access list to attend the hearing, Robin Jones, (202) 622-7180 
(not toll free numbers).

SUPPLEMENTARY INFORMATION:

Paperwork Reduction Act

    The collection of information contained in this notice of proposed 
rulemaking has been submitted to the Office of Management and Budget 
for review in accordance with the Paperwork Reduction Act of 1995 (44 
U.S.C. 3507(d)). Comments on the collection of information should be 
sent to the Office of Management and Budget, Attn: Desk Officer for the 
Department of the Treasury, Office of Information and Regulatory 
Affairs, Washington, DC 20503, with copies to the Internal Revenue 
Service, Attn: IRS Reports Clearance Officer, SE:W:CAR:MP:T:T:SP, 
Washington, DC 20224. Comments on the collection of information should 
be received by July 25, 2005. Comments are specifically requested 
concerning:
    Whether the proposed collection of information is necessary for the 
proper performance of the functions of the IRS, including whether the 
information will have practical utility;
    The accuracy of the estimated burden associated with the proposed 
collection of information (see below);
    How the quality, utility, and clarity of the information to be 
collected may be enhanced;
    How the burden of complying with the proposed collection of 
information may be minimized, including through the application of 
automated collection techniques or other forms of information 
technology; and
    Estimates of capital or start-up costs and costs of operation, 
maintenance, and purchase of services to provide information.
    The following collections of information in this proposed 
regulation are in Sec.  1.83-3(l):
    (1) Requirement that electing partnerships submit an election with 
the partnership tax return.
    (2) Requirement that certain partners submit a document to the 
partnership;
    (3) Requirement that such documents be retained; and
    (4) Requirement that partnerships submit a termination document 
with the partnership tax return as one method of terminating the 
election.
    These collections of information are required by the IRS to 
determine whether the amount of tax has been calculated correctly. The 
respondents are partnerships and partners or other service providers.
    The estimated total annual reporting and/or recordkeeping burden is 
112,500 hours.
    The estimated annual burden per respondent/recordkeeper varies from 
.10 hours to 10 hours, depending on individual circumstances, with an 
estimated average of 1 hour for partnerships and .25 hour for a partner 
or service provider. The estimated number of respondents and/or 
recordkeepers is 100,000 partnerships and 50,000 partners or other 
service providers.
    The estimated annual frequency of responses (used for reporting 
requirements only) is on occasion.
    An agency may not conduct or sponsor, and a person is not required 
to respond to, a collection of information unless it displays a valid 
control number assigned by the Office of Management and Budget.
    Books or records relating to a collection of information must be 
retained as long as their contents may become material in the 
administration of any internal revenue law. Generally, tax returns and 
tax return information are confidential as required by 26 U.S.C. 6103.

Background

    Partnerships issue a variety of instruments in connection with the 
performance of services. These instruments include interests in 
partnership capital, interests in partnership profits, and options to 
acquire such interests (collectively, partnership equity). On June 5, 
2000, the Treasury Department and the IRS issued Notice 2000-29 (2000-1 
C.B. 1241), inviting public comment on the Federal income tax treatment 
of the exercise of an option to acquire a partnership interest, the 
exchange of convertible debt for a partnership interest, and the 
exchange of a preferred

[[Page 29676]]

interest in a partnership for a common interest in that partnership. On 
January 22, 2003, the Treasury Department and the IRS published in the 
Federal Register (REG-103580-02) (68 FR 2930), proposed regulations 
regarding the Federal income tax consequences of noncompensatory 
partnership options, convertible equity, and convertible debt. In the 
preamble to those proposed regulations, the Treasury Department and the 
IRS requested comments on the proposed amendment to Sec.  1.721-1(b)(1) 
that was published in the Federal Register on June 3, 1971 (36 FR 
10787), and on the Federal income tax consequences of the issuance of 
partnership capital interests in connection with the performance of 
services and options to acquire such interests. In response to the 
comments received, the Treasury Department and the IRS are withdrawing 
the proposed amendment to Sec.  1.721-1(b)(1) and issuing these 
proposed regulations, which prescribe rules on the application of 
section 83 to partnership interests and the Federal income tax 
consequences associated with the transfer, vesting, and forfeiture of 
partnership interests transferred in connection with the performance of 
services.

Explanation of Provisions

1. Application of Section 83 to Partnership Interests

    Section 83 generally applies to a transfer of property by one 
person to another in connection with the performance of services. The 
courts have held that a partnership capital interest is property for 
this purpose. See Schulman v. Commissioner, 93 T.C. 623 (1989) (section 
83 governs the issuance of an option to acquire a partnership interest 
as compensation for services provided as an employee); Kenroy, Inc. v. 
Commissioner, T.C. Memo 1984-232. Therefore, the proposed regulations 
provide that a partnership interest is property within the meaning of 
section 83, and that the transfer of a partnership interest in 
connection with the performance of services is subject to section 83.
    The proposed regulations apply section 83 to all partnership 
interests, without distinguishing between partnership capital interests 
and partnership profits interests. Although the application of section 
83 to partnership profits interests has been the subject of 
controversy, see, e.g., Campbell v. Commissioner, T.C. Memo 1990-162, 
aff'd in part and rev'd in part, 943 F.2d 815 (8th Cir. 1991), n. 7; 
St. John v. U.S., 84-1 USTC 9158 (C.D. Ill. 1983), the Treasury 
Department and the IRS do not believe that there is a substantial basis 
for distinguishing among partnership interests for purposes of section 
83. All partnership interests constitute personal property under state 
law and give the holder the right to share in future earnings from 
partnership capital and labor. Moreover, some commentators have 
suggested that the same tax rules should apply to both partnership 
profits interests and partnership capital interests. These commentators 
have suggested that taxpayers may exploit any differences in the tax 
treatment of partnership profits interests and partnership capital 
interests. The Treasury Department and the IRS agree with these 
comments. Therefore, all of the rules in these proposed regulations and 
the accompanying proposed revenue procedure (described below) apply 
equally to partnership capital interests and partnership profits 
interests. However, a right to receive allocations and distributions 
from a partnership that is described in section 707(a)(2)(A) is not a 
partnership interest. In section 707(a)(2)(A), Congress directed that 
such an arrangement should be characterized according to its substance, 
that is, as a disguised payment of compensation to the service 
provider. See S. Rep. No. 98-169, 98 Cong. 2d Sess., at 226 (1984).
    Section 83(b) allows a person who receives substantially nonvested 
property in connection with the performance of services to elect to 
include in gross income the difference between: (A) The fair market 
value of the property at the time of transfer (determined without 
regard to a restriction other than a restriction which by its terms 
will never lapse); and (B) the amount paid for such property. Under 
section 83(b)(2), the election under section 83(b) must be made within 
30 days of the date of the transfer of the property to the service 
provider.
    Consistent with the principles of section 83, the proposed 
regulations provide that, if a partnership interest is transferred in 
connection with the performance of services, and if an election under 
section 83(b) is not made, then the holder of the partnership interest 
is not treated as a partner until the interest becomes substantially 
vested. If a section 83(b) election is made with respect to such an 
interest, the service provider will be treated as a partner for 
purposes of Subtitle A of the Code. These rules are similar to the 
current rules pertaining to substantially nonvested stock in a 
subchapter S corporation. See Sec.  1.1361-1(b)(3) (upon an election 
under section 83(b), the service provider becomes a shareholder for 
purposes of subchapter S).
    These principles differ from Rev. Proc. 2001-43. Under that revenue 
procedure, if a partnership profits interest is transferred in 
connection with the performance of services, then the holder of the 
partnership interest may be treated as a partner even if no section 
83(b) election is made, provided that certain conditions are met.
    Certain changes to the regulations under both subchapter K and 
section 83 are needed to coordinate the principles of subchapter K with 
the principles of section 83. Among the changes that are proposed in 
these regulations are: (1) Conforming the subchapter K rules to the 
section 83 timing rules; (2) revising the section 704(b) regulations to 
take into account the fact that allocations with respect to an unvested 
interest may be forfeited; and (3) providing that a partnership 
generally recognizes no gain or loss on the transfer of an interest in 
the partnership in connection with the performance of services for that 
partnership. In addition, Rev. Procs. 93-27 (1993-2 C.B. 343), and 
2001-43 (2001-2 C.B. 191), which generally provide for nonrecognition 
by both the partnership and the service provider on the transfer of a 
profits interest in the partnership for services performed for that 
partnership, must be modified to be consistent with these proposed 
regulations. Accordingly, in conjunction with these proposed 
regulations, the IRS is issuing Notice 2005-43 (2005-24 I.R.B.). That 
Notice contains a proposed revenue procedure that, when finalized, will 
obsolete Rev. Procs. 93-27 and 2001-43. The Treasury Department and the 
IRS intend for these proposed regulations and the proposed revenue 
procedure to become effective at the same time. The proposed amendments 
to the regulations under section 83 and subchapter K, as well as the 
Notice, are described in further detail below.
    The proposed revenue procedure and certain parts of the proposed 
regulations (as described below) only apply to a transfer by a 
partnership of an interest in that partnership in connection with the 
performance of services for that partnership (compensatory partnership 
interests). The Treasury Department and the IRS request comments on the 
income tax consequences of transactions involving related persons, such 
as, for example, the transfer of an interest in a lower-tier 
partnership in exchange for services provided to the upper-tier 
partnership.

2. Timing of Partnership's Deduction

    Except as otherwise provided in Sec.  1.83-6(a)(3), if property is 
transferred

[[Page 29677]]

in connection with the performance of services, then the service 
recipient's deduction, if any, is allowed only for the taxable year of 
that person in which or with which ends the taxable year of the service 
provider in which the amount is included as compensation. See section 
83(h). In contrast, under section 706(a) and Sec.  1.707-1(c), 
guaranteed payments described in section 707(c) are included in the 
partner's income in the partner's taxable year within or with which 
ends the partnership's taxable year in which the partnership deducted 
the payments. Under Sec.  1.721-1(b)(2) of the current regulations, an 
interest in partnership capital issued by the partnership as 
compensation for services rendered to the partnership is treated as a 
guaranteed payment under section 707(c). Some commentators suggested 
that the proposed regulations should resolve the potential conflict 
between the timing rules of section 83 and the timing rules of section 
707(c).
    Under the proposed regulations, partnership interests issued to 
partners for services rendered to the partnership are treated as 
guaranteed payments. Also, the proposed regulations provide that the 
section 83 timing rules override the timing rules of section 706(a) and 
Sec.  1.707-1(c) to the extent they are inconsistent. Accordingly, if a 
partnership transfers property to a partner in connection with the 
performance of services, the timing and the amount of the related 
income inclusion and deduction is determined by section 83 and the 
regulations thereunder.
    In drafting these regulations, the Treasury Department and the IRS 
considered alternative approaches for resolving the timing 
inconsistency between section 83 and section 707(c). One alternative 
approach considered was to provide that the transfer of property in 
connection with the performance of services is not treated as a 
guaranteed payment within the meaning of section 707(c). This approach 
was not adopted in the proposed regulations due to, among other things, 
concern that such a characterization of these transfers could have 
unintended consequences on the application of provisions of the Code 
outside of subchapter K that refer to guaranteed payments. The Treasury 
Department and the IRS request comments on alternative approaches for 
resolving the timing inconsistency between section 83 and section 
707(c).

3. Allocation of Partnership's Deduction

    The proposed regulations provide guidance regarding the allocation 
of the partnership's deduction for the transfer of property in 
connection with the performance of services. Some commentators 
suggested that the proposed regulations require that the partnership's 
deduction be allocated among the partners in accordance with their 
interests in the partnership prior to the transfer.
    Section 706(d)(1) provides generally that, if, during any taxable 
year of a partnership, there is a change in any partner's interest in 
the partnership, each partner's distributive share of any item of 
income, gain, loss, deduction, or credit of the partnership for such 
taxable year shall be determined by the use of any method prescribed by 
regulations which takes into account the varying interests of the 
partners in the partnership during the taxable year. Regulations have 
not yet been issued describing the rules for taking into account the 
varying interests of the partners in the partnership during a taxable 
year. Section 1.706-1(c)(2)(ii) provides that, in the case of a sale, 
exchange, or liquidation of a partner's entire interest in a 
partnership, the partner's share of partnership items for the taxable 
year may be determined by either: (1) Closing the partnership's books 
as of the date of the transfer (closing of the books method); or (2) 
allocating to the departing partner that partner's pro rata part of 
partnership items that the partner would have included in the partner's 
taxable income had the partner remained a partner until the end of the 
partnership taxable year (proration method). The Treasury Department 
and the IRS believe that section 706(d)(1) adequately ensures that 
partnership deductions that are attributable to the portion of the 
partnership's taxable year prior to a new partner's entry into the 
partnership are allocated to the historic partners.
    Section 706(d)(2), however, places additional limits on how 
partnerships may allocate these deductions. Under section 706(d)(2)(B), 
payments for services by a partnership using the cash receipts and 
disbursements method of accounting are allocable cash basis items. 
Under section 706(d)(2)(A), if during any taxable year of a partnership 
there is a change in any partner's interest in the partnership, then 
(except to the extent provided in regulations) each partner's 
distributive share of any allocable cash basis item must be determined 
under the proration method. To allow partnerships to allocate 
deductions with respect to property transferred in connection with the 
performance of services under a closing of the books method, the 
proposed regulations provide that section 706(d)(2)(A) does not apply 
to such a transfer.

4. Accounting for Compensatory Partnership Interests

A. Transfer of Compensatory Partnership Interest
    Under the proposed regulations, the service provider's capital 
account is increased by the amount the service provider takes into 
income under section 83 as a result of receiving the interest, plus any 
amounts paid for the interest. Some commentators suggested that the 
amount included in the service provider's income under section 83, plus 
the amount paid for the interest, may differ from the amount of capital 
that the partnership has agreed to assign to the service provider. 
These commentators contend that the substantial economic effect safe 
harbor in the section 704(b) regulations should be amended to allow 
partnerships to reallocate capital between the historic partners and 
the service provider to accord with the economic agreement of the 
parties.
    The reallocation of partnership capital in these circumstances is 
not consistent with the policies underlying the substantial economic 
effect safe harbor and the capital account maintenance rules. The 
purpose of the substantial economic effect safe harbor is to ensure 
that, to the extent that there is an economic benefit or burden 
associated with a partnership allocation, the partner to whom the 
allocation is made receives the economic benefit or bears the economic 
burden. Under section 83, the economic benefit of receiving a 
partnership interest in connection with the performance of services is 
the amount that is included in the compensation income of the service 
provider, plus the amount paid for the interest. This is the amount by 
which the service partner's capital account should be increased.
    As explained in section 6 below, a proposed revenue procedure 
issued concurrently with these proposed regulations would allow a 
partnership, its partners, and the service provider to elect to treat 
the fair market value of a partnership interest as equal to the 
liquidation value of that interest. If such an election is made, the 
capital account of a service provider receiving a partnership interest 
in connection with the performance of services is increased by the 
liquidation value of the partnership interest received.

[[Page 29678]]

B. Forfeiture of Certain Compensatory Partnership Interests
    If an election under section 83(b) has been made with respect to a 
substantially nonvested interest, the holder of the nonvested interest 
may be allocated partnership items that may later be forfeited. For 
this reason, allocations of partnership items while the interest is 
substantially nonvested cannot have economic effect. Under the proposed 
regulations, such allocations will be treated as being in accordance 
with the partners' interests in the partnership if: (a) The partnership 
agreement requires that the partnership make forfeiture allocations if 
the interest for which the section 83(b) election is made is later 
forfeited; and (b) all material allocations and capital account 
adjustments under the partnership agreement not pertaining to 
substantially nonvested partnership interests for which a section 83(b) 
election has been made are recognized under section 704(b). This safe 
harbor does not apply if, at the time of the section 83(b) election, 
there is a plan that a substantially nonvested interest will be 
forfeited. All of the facts and circumstances (including the tax status 
of the holder of the substantially nonvested interest) will be 
considered in determining whether there is a plan that the interest 
will be forfeited. In such a case, the partners' distributive shares of 
partnership items shall be determined in accordance with the partners' 
interests in the partnership under Sec.  1.704-1(b)(3).
    Generally, forfeiture allocations are allocations to the service 
provider of partnership gross income and gain or gross deduction and 
loss (to the extent such items are available) that offset prior 
distributions and allocations of partnership items with respect to the 
forfeited partnership interest. These rules are designed to ensure that 
any partnership income (or loss) that was allocated to the service 
provider prior to the forfeiture is offset by allocations on the 
forfeiture of the interest. Also, to carry out the prohibition under 
section 83(b)(1) on deductions with respect to amounts included in 
income under section 83(b), these rules generally cause a forfeiting 
partner to be allocated partnership income to offset any distributions 
to the partner that reduced the partner's basis in the partnership 
below the amount included in income under section 83(b).
    Forfeiture allocations may be made out of the partnership's items 
for the entire taxable year. In determining the gross income of the 
partnership in the taxable year of the forfeiture, the rules of Sec.  
1.83-6(c) apply. As a result, the partnership generally will have gross 
income in the taxable year of the forfeiture equal to the amount of the 
allowable deduction to the service recipient partnership upon the 
transfer of the interest as a result of the making of the section 83(b) 
election, regardless of the fair market value of the partnership's 
assets at the time of forfeiture.
    In certain circumstances, the partnership will not have enough 
income and gain to fully offset prior allocations of loss to the 
forfeiting service provider. The proposed revenue procedure includes a 
rule that requires the recapture of losses taken by the service 
provider prior to the forfeiture of the interest to the extent that 
those losses are not recaptured through forfeiture allocations of 
income and gain to the service provider. This rule does not provide the 
other partners in the partnership with the opportunity to increase 
their shares of partnership loss (or reduce their shares of partnership 
income) for the year of the forfeiture by the amount of loss that was 
previously allocated to the forfeiting service provider.
    In other circumstances, the partnership will not have enough 
deductions and loss to fully offset prior allocations of income to the 
forfeiting service provider. It appears that, in such a case, section 
83(b)(1) may prohibit the service provider from claiming a loss with 
respect to partnership income that was previously allocated to the 
service provider. However, a forfeiting partner is entitled to a loss 
for any basis in a partnership that is attributable to contributions of 
money or property to the partnership (including amounts paid for the 
interest) remaining after the forfeiture allocations have been made. 
See Sec.  1.83-2(a).
    Comments are requested as to whether the regulations should require 
or allow partnerships to create notional tax items to make forfeiture 
allocations where the partnership does not have enough actual tax items 
to make such allocations. Comments are also requested as to whether 
section 83(b)(1) should be read to allow a forfeiting service provider 
to claim a loss with respect to partnership income that was previously 
allocated to the service provider and not offset by forfeiture 
allocations of loss and deduction and, if so, whether it is appropriate 
to require the other partners in the partnership to recognize income in 
the year of the forfeiture equal to the amount of the loss claimed by 
the service provider. In particular, comments are requested as to 
whether section 83 or another section of the Code provides authority 
for such a rule.

5. Valuation of Compensatory Partnership Interests

    Commentators requested guidance regarding the valuation of 
partnership interests transferred in connection with the performance of 
services. Section 83 generally provides that the recipient of property 
transferred in connection with the performance of services recognizes 
income equal to the fair market value of the property, disregarding 
lapse restrictions. See Schulman v. Commissioner, 93 T.C. 623 (1989). 
However, some authorities have concluded that, under the particular 
facts and circumstances of the case, a partnership profits interest had 
only a speculative value or that the fair market value of a partnership 
interest should be determined by reference to the liquidation value of 
that interest. See Sec.  1.704-1(e)(1)(v); Campbell v. Commissioner, 
943 F.2d 815 (8th Cir. 1991); St. John v. U.S., 1984-1 USTC 9158 (C.D. 
Ill. 1983). But see Diamond v. Commissioner, 492 F.2d 286 (7th Cir. 
1974) (holding under pre-section 83 law that the receipt of a profits 
interest with a determinable value at the time of receipt resulted in 
immediate taxation); Campbell v. Commissioner, T.C. Memo 1990-162, 
aff'd in part and rev'd in part, 943 F.2d 815 (8th Cir. 1991).
    The Treasury Department and the IRS have determined that, provided 
certain requirements are satisfied, it is appropriate to allow 
partnerships and service providers to value partnership interests based 
on liquidation value. This approach ensures consistency in the 
treatment of partnership profits interests and partnership capital 
interests, and accords with other regulations issued under subchapter 
K, such as the regulations under section 704(b).
    In accordance with these proposed regulations, the revenue 
procedure proposed in Notice 2005-43 (2005-24 I.R.B.) will, when 
finalized, provide additional rules that partnerships, partners, and 
persons providing services to the partnership in exchange for interests 
in that partnership would be required to follow when electing under 
Sec.  1.83-3(l) of these proposed regulations to treat the fair market 
value of those interests as being equal to the liquidation value of 
those interests. For this purpose, the liquidation value of a 
partnership interest is the amount of cash that the holder of that 
interest would receive with respect to the interest if, immediately 
after the transfer of the interest, the partnership sold all of its 
assets (including goodwill, going

[[Page 29679]]

concern value, and any other intangibles associated with the 
partnership's operations) for cash equal to the fair market value of 
those assets, and then liquidated.

6. Application of Section 721 to Partnership on Transfer

    There is a dispute among commentators as to whether a partnership 
should recognize gain or loss on the transfer of a compensatory 
partnership interest. Some commentators believe that, on the transfer 
of such an interest, the partnership should be treated as satisfying 
its compensation obligation with a fractional interest in each asset of 
the partnership. Under this deemed sale of assets theory, the 
partnership would recognize gain or loss equal to the excess of the 
fair market value of each partial asset deemed transferred to the 
service provider over the partnership's adjusted basis in that partial 
asset. Other commentators believe that a partnership should not 
recognize gain or loss on the transfer of a compensatory partnership 
interest. They argue, among other things, that the transfer of such an 
interest is not properly treated as a realization event for the 
partnership because no property owned by the partnership has changed 
hands. They also argue that taxing a partnership on the transfer of 
such an interest would result in inappropriate gain acceleration, would 
be difficult to administer, and would cause economically similar 
transactions to be taxed differently.
    Generally, when appreciated property is used to pay an obligation, 
gain on the property is recognized. The Treasury Department and the IRS 
are still analyzing whether an exception to this general rule is 
appropriate on the transfer of an interest in the capital or profits of 
a partnership to satisfy certain partnership obligations (such as the 
obligations to pay interest or rent). However, the Treasury Department 
and the IRS believe that partnerships should not be required to 
recognize gain on the transfer of a compensatory partnership interest. 
Such a rule is more consistent with the policies underlying section 
721--to defer recognition of gain and loss when persons join together 
to conduct a business--than would be a rule requiring the partnership 
to recognize gain on the transfer of these types of interests. 
Therefore, the proposed regulations provide that partnerships are not 
taxed on the transfer or substantial vesting of a compensatory 
partnership interest. Under Sec.  1.704-1(b)(4)(i) (reverse section 
704(c) principles), the historic partners generally will be required to 
recognize any income or loss attributable to the partnership's assets 
as those assets are sold, depreciated, or amortized.
    The rule providing for nonrecognition of gain or loss does not 
apply to the transfer or substantial vesting of an interest in an 
eligible entity, as defined in Sec.  301.7701-3(a) of the Procedure and 
Administration Regulations, that becomes a partnership under Sec.  
301.7701-3(f)(2) as a result of the transfer or substantial vesting of 
the interest. See McDougal v. Commissioner, 62 T.C. 720 (1974) (holding 
that the service recipient recognized gain on the transfer of a one-
half interest in appreciated property to the service provider, 
immediately prior to the contribution by the service recipient and the 
service provider of their respective interests in the property to a 
newly formed partnership).

7. Revaluations of Partnership Property

    The proposed regulations concerning noncompensatory partnership 
options published on January 22, 2003, contained special rules 
regarding the revaluations of partnership property while 
noncompensatory partnership options were outstanding. Specifically, the 
regulations proposed modifications to Sec.  1.704-1(b)(2)(iv)(f) and 
(h) to provide that any revaluation during the period in which there 
are outstanding noncompensatory options generally must take into 
account the fair market value, if any, of outstanding options. These 
proposed regulations do not contain similar provisions, because under 
recently proposed modifications to the regulations under Sec.  1.704-
1(b)(2)(iv), the obligation to issue a partnership interest in 
satisfaction of an option agreement is a liability that is taken into 
account in determining the fair market value of partnership assets as a 
result of a revaluation. See REG-106736-00, 68 FR 37434 (June 24, 2003) 
(relating to the assumption of certain obligations by partnerships from 
partners).

8. Characterization Rule

    The proposed regulations concerning noncompensatory partnership 
options published on January 22, 2003 contained a rule (Sec.  1.761-3) 
providing that the holder of a noncompensatory option is treated as a 
partner under certain circumstances. However, the Treasury Department 
and the IRS have concluded that these proposed regulations should not 
contain a similar rule for partnership options transferred in 
connection with the performance of services because of the possibility 
that constructive transfers of property, subject to section 83, may 
occur under circumstances other than those described in the proposed 
rules for treating the holder of a noncompensatory option as a partner. 
The Treasury Department and the IRS request comments on whether anti-
abuse rules are necessary to prevent taxpayers from using the rules in 
these proposed regulations or the rules in Notice 2005-43 to 
inappropriately shift items of partnership income or loss between the 
service provider and the other partners.

9. Retroactive Allocations

    Section 761(c) generally allows a partnership to modify its 
agreement at any time on or prior to the due date for the partnership's 
return for the taxable year (without regard to extensions). Thus, for 
example, a partnership could, at the end of its taxable year, amend its 
partnership agreement to provide that a service provider was entitled 
to a substantially vested or nonvested interest in partnership profits 
and losses from the beginning of the partnership's taxable year. It is 
expected that, if a substantially vested compensatory partnership 
interest is transferred to an employee or independent contractor (or an 
election under section 83(b) is made with respect to the transfer of a 
substantially nonvested compensatory partnership interest to an 
employee or independent contractor), the partnership will report the 
transfer on Form W-2, ``Wage and Tax Statement,'' or Form 1099-MISC, 
``Miscellaneous Income,'' as appropriate. The Form W-2 or Form 1099-
MISC would be issued to the service provider by the partnership by 
January 31 of the year following the calendar year in which the 
partnership interest is transferred, and the partnership would file 
such forms with the Social Security Administration or IRS, 
respectively, by February 28 (March 31 if filed electronically) of the 
year following the calendar year in which the partnership interest is 
transferred. The service provider would be required to report any 
income recognized on the transfer of the partnership interest on the 
service provider's return for the taxable year (of the service 
provider) in which the transfer occurs.
    It is unclear whether the retroactive commencement date of such an 
interest should be treated as the date of the transfer of the interest 
for purposes of section 83 and other provisions of the Code outside of 
subchapter K. If the retroactive effective date of the interest is 
treated as the transfer date for all purposes, a number of 
administrative concerns arise. For example, the

[[Page 29680]]

partnership may not, by the January 31 deadline, have the information 
necessary to issue Form W-2 or Form 1099-MISC to the service provider. 
Also, the service provider may not, by the due date for filing the 
section 83(b) election, have the information necessary to file the 
election. The Treasury Department and the IRS request comments on the 
timing for section 83 purposes of retroactive transfers of partnership 
interests and on any actions that may be appropriate to address the 
associated administrative concerns.

10. Information Reporting to Partners

    As explained above, the proposed regulations treat the transfer of 
a partnership interest to a partner in connection with the performance 
of services as a guaranteed payment. To ensure that the service 
provider partner has the information necessary to include the transfer 
in income for the taxable year in which the transfer occurs (rather 
than the taxable year in which or with which ends the partnership 
taxable year in which the transfer occurs), the Treasury Department and 
the IRS are considering the possibility of amending the section 6041 
regulations to provide that this type of guaranteed payment must be 
reported by the partnership on Form 1099-MISC, which is required to be 
issued to the service provider on or before January 31 of the year 
following the calendar year of such transfer. The Treasury Department 
and the IRS request comments on whether such a requirement is 
appropriate and administrable.

Proposed Effective Date

    These regulations are proposed to apply to transfers of property on 
or after the date final regulations are published in the Federal 
Register.

Special Analyses

    It has been determined that this notice of proposed rulemaking is 
not a significant regulatory action as defined in Executive Order 
12866. Therefore, a regulatory assessment is not required. It also has 
been determined that section 553(b) of the Administrative Procedure Act 
(5 U.S.C. chapter 5) does not apply to these regulations. It is hereby 
certified that the collection of information in these regulations will 
not have a significant economic impact on a substantial number of small 
entities. This certification is based upon the fact that the reporting 
burden, as discussed earlier in this preamble, is not expected to be 
significant. Partnerships with partnership agreements that contain the 
binding provisions referred to in Sec.  1.83-3(l) only will be required 
to submit a single election form in order to rely on the safe harbor 
described in that paragraph. Partnerships that desire to elect to use 
the safe harbor described in Sec.  1.83-3(l), but which do not have 
partnership agreements containing these provisions, are required to 
obtain partner-level consents to the election. However, these 
partnerships are expected to be rare. Moreover, in most cases the 
partners in such partnerships are not expected to be small businesses. 
Therefore, a Regulatory Flexibility Analysis under the Regulatory 
Flexibility Act (5 U.S.C. chapter 6) is not required. Pursuant to 
section 7805(f) of the Code, this notice of proposed rulemaking will be 
submitted to the Chief Counsel for Advocacy of the Small Business 
Administration for comment on its impact on small business.

Comments and Public Hearing

    Before these proposed regulations are adopted as final regulations, 
consideration will be given to any electronic or written comments (a 
signed original and eight copies) that are submitted timely to the IRS. 
The IRS and the Treasury Department request comments on the clarity of 
the proposed rules and how they can be made easier to understand. All 
comments will be available for public inspection and copying.
    A public hearing has been scheduled for October 5, 2005, beginning 
at 10 a.m. in the IRS Auditorium, Internal Revenue Building, 1111 
Constitution Avenue, NW., Washington, DC. Due to building security 
procedures, visitors must enter at the Constitution Avenue entrance. In 
addition, all visitors must present photo identification to enter the 
building. Because of access restrictions, visitors will not be admitted 
beyond the immediate entrance area more than 30 minutes before the 
hearing starts. For information about having your name placed on the 
building access list to attend the hearing, see the FOR FURTHER 
INFORMATION CONTACT portion of this preamble.
    The rules of 26 CFR 601.601(a)(3) apply to the hearing. Persons who 
wish to present oral comments must submit written comments and an 
outline of the topics to be discussed and the time to be devoted to 
each topic (a signed original and eight (8) copies) by September 14, 
2005. A period of 10 minutes will be allotted to each person for making 
comments. An agenda showing the scheduling of the speakers will be 
prepared after the deadline for reviewing outlines has passed. Copies 
of the agenda will be available free of charge at the hearing.

Drafting Information

    The principal authors of these regulations are Audrey Ellis and 
Demetri Yatrakis of the Office of Associate Chief Counsel (Passthroughs 
and Special Industries), and Stephen Tackney of the Office of Associate 
Chief Counsel (Tax Exempt and Government Entities). However, other 
personnel from the IRS and Treasury Department participated in their 
development.

Withdrawal of Notice of Proposed Rulemaking

    Accordingly, under the authority of 26 U.S.C. 7805, Sec.  1.721-
1(b) of the notice of proposed rulemaking that was published in the 
Federal Register on June 3, 1971 (36 FR 10787) is withdrawn.

List of Subjects in 26 CFR Part 1

    Income taxes, Reporting and record keeping requirements.

Proposed Amendments to the Regulations

    Accordingly, 26 CFR part 1 is proposed to be amended as follows:

PART 1--INCOME TAXES

    Paragraph 1. The authority citation for part 1 continues to read, 
in part, as follows:

    Authority: 26 U.S.C. 7805 * * *

    Par. 2. Section 1.83-3 is amended as follows:
    1. Paragraph (e) is amended by adding two new sentences after the 
first sentence.
    2. Paragraph (l) is added.
    The revision and addition read as follows:


Sec.  1.83-3  Meaning and use of certain terms.

* * * * *
    (e) Property. * * * Accordingly, property includes a partnership 
interest. The previous sentence is effective for transfers on or after 
the date final regulations are published in the Federal Register. * * *
* * * * *
    (l) Special rules for the transfer of a partnership interest. (1) 
Subject to such additional conditions, rules, and procedures that the 
Commissioner may prescribe in regulations, revenue rulings, notices, or 
other guidance published in the Internal Revenue Bulletin (see Sec.  
601.601(d)(2)(ii)(b) of this chapter), a partnership and all of its 
partners may elect a safe harbor under which the fair market value of a 
partnership interest that is transferred in connection with the 
performance of services is treated as being equal to the

[[Page 29681]]

liquidation value of that interest for transfers on or after the date 
final regulations are published in the Federal Register if the 
following conditions are satisfied:
    (i) The partnership must prepare a document, executed by a partner 
who has responsibility for Federal income tax reporting by the 
partnership, stating that the partnership is electing, on behalf of the 
partnership and each of its partners, to have the safe harbor apply 
irrevocably as of the stated effective date with respect to all 
partnership interests transferred in connection with the performance of 
services while the safe harbor election remains in effect and attach 
the document to the tax return for the partnership for the taxable year 
that includes the effective date of the election.
    (ii) Except as provided in paragraph (l)(1)(iii) of this section, 
the partnership agreement must contain provisions that are legally 
binding on all of the partners stating that--
    (A) The partnership is authorized and directed to elect the safe 
harbor; and
    (B) The partnership and each of its partners (including any person 
to whom a partnership interest is transferred in connection with the 
performance of services) agrees to comply with all requirements of the 
safe harbor with respect to all partnership interests transferred in 
connection with the performance of services while the election remains 
effective.
    (iii) If the partnership agreement does not contain the provisions 
described in paragraph (l)(1)(ii) of this section, or the provisions 
are not legally binding on all of the partners of the partnership, then 
each partner in a partnership that transfers a partnership interest in 
connection with the performance of services must execute a document 
containing provisions that are legally binding on that partner stating 
that--
    (A) The partnership is authorized and directed to elect the safe 
harbor; and
    (B) The partner agrees to comply with all requirements of the safe 
harbor with respect to all partnership interests transferred in 
connection with the performance of services while the election remains 
effective.
    (2) The specified effective date of the safe harbor election may 
not be prior to the date that the safe harbor election is executed. The 
partnership must retain such records as may be necessary to indicate 
that an effective election has been made and remains in effect, 
including a copy of the partnership's election statement under this 
paragraph (l), and, if applicable, the original of each document 
submitted to the partnership by a partner under this paragraph (l). If 
the partnership is unable to produce a record of a particular document, 
the election will be treated as not made, generally resulting in 
termination of the election. The safe harbor election also may be 
terminated by the partnership preparing a document, executed by a 
partner who has responsibility for Federal income tax reporting by the 
partnership, which states that the partnership, on behalf of the 
partnership and each of its partners, is revoking the safe harbor 
election on the stated effective date, and attaching the document to 
the tax return for the partnership for the taxable year that includes 
the effective date of the revocation.
    Par. 3. Section 1.83-6 is amended by revising the first sentence of 
paragraph (b) to read as follows:


Sec.  1.83-6  Deduction by employer.

* * * * *
    (b) Recognition of gain or loss. Except as provided in section 721 
and section 1032, at the time of a transfer of property in connection 
with the performance of services the transferor recognizes gain to the 
extent that the transferor receives an amount that exceeds the 
transferor's basis in the property. * * *
* * * * *
    Par. 4. Section 1.704-1 is amended as follows:
    1. In paragraph (b)(0), an entry is added to the table for Sec.  
1.704-1(b)(4)(xii).
    2. In paragraph (b)(1)(ii)(a), a sentence is added at the end of 
the paragraph.
    3. Paragraph (b)(2)(iv)(b)(1) is revised.
    4. Paragraph (b)(2)(iv)(f)(5)(iii) is revised.
    5. Paragraph (b)(4)(xii) is added.
    6. Paragraph (b)(5) Example 29 is added.
    The additions and revisions read as follows:


Sec.  1.704-1  Partner's distributive share.

* * * * *
    (b) * * * (0) * * *
* * * * *
    Substantially nonvested interests--1.704-1(b)(4)(xii)
* * * * *
    (1) * * *
    (ii) * * * (a) * * * In addition, paragraph (b)(4)(xii) and 
paragraph (b)(5) Example 29 of this section apply to compensatory 
partnership interests (as defined in Sec.  1.721-1(b)(3)) that are 
transferred on or after the date final regulations are published in the 
Federal Register.
* * * * *
    (2) * * *
    (iv) * * *
    (b) * * *
    (1) the amount of money contributed by that partner to the 
partnership and, in the case of a compensatory partnership interest (as 
defined in Sec.  1.721-1(b)(3)) that is transferred on or after the 
date final regulations are published in the Federal Register, the 
amount included on or after that date in the partner's compensation 
income under section 83(a), (b), or (d)(2).
* * * * *
    (f) * * *
    (5) * * *
    (iii) In connection with the transfer or vesting of a compensatory 
partnership interest (as defined in Sec.  1.721-1(b)(3)) that is 
transferred on or after the date final regulations are published in the 
Federal Register, but only if the transfer or vesting results in the 
service provider recognizing income under section 83 (or would result 
in such recognition if the interest had a fair market value other than 
zero).
* * * * *
    (4) * * *
    (xii) Substantially nonvested interests--(a) In general. If a 
section 83(b) election has been made with respect to a substantially 
nonvested interest, the holder of the nonvested interest may be 
allocated partnership income, gain, loss, deduction, or credit (or 
items thereof) that will later be forfeited. For this reason, 
allocations of partnership items while the interest is substantially 
nonvested cannot have economic effect.
    (b) Deemed Compliance with Partners' Interests in the Partnership. 
If a section 83(b) election has been made with respect to a 
substantially nonvested interest, allocations of partnership items 
while the interest is substantially nonvested will be deemed to be in 
accordance with the partners' interests in the partnership if--
    (1) The partnership agreement requires that the partnership make 
forfeiture allocations if the interest for which the section 83(b) 
election is made is later forfeited; and
    (2) All material allocations and capital account adjustments under 
the partnership agreement not pertaining to substantially nonvested 
partnership interests for which a section 83(b) election has been made 
are recognized under section 704(b).
    (c) Forfeiture allocations. Forfeiture allocations are allocations 
to the service provider (consisting of a pro rata portion of each item) 
of gross income and gain or gross deduction and loss (to the extent 
such items are available) for the taxable year of the forfeiture in a 
positive or negative amount equal to--

[[Page 29682]]

    (1) The excess (not less than zero) of the--
    (i) Amount of distributions (including deemed distributions under 
section 752(b) and the adjusted tax basis of any property so 
distributed) to the partner with respect to the forfeited partnership 
interest (to the extent such distributions are not taxable under 
section 731); over
    (ii) Amounts paid for the interest and the adjusted tax basis of 
property contributed by the partner (including deemed contributions 
under section 752(a)) to the partnership with respect to the forfeited 
partnership interest; minus
    (2) The cumulative net income (or loss) allocated to the partner 
with respect to the forfeited partnership interest.
    (d) Positive and negative amounts. For purposes of paragraph 
(b)(4)(xii)(c) of this section, items of income and gain are reflected 
as positive amounts, and items of deduction and loss are reflected as 
negative amounts.
    (e) Exception. Paragraph (b)(4)(xii)(b) of this section shall not 
apply to allocations of partnership items made with respect to a 
substantially nonvested interest for which the holder has made a 
section 83(b) election if, at the time of the section 83(b) election, 
there is a plan that the interest will be forfeited. In such a case, 
the partners' distributive shares of partnership items shall be 
determined in accordance with the partners' interests in the 
partnership under paragraph (b)(3) of this section. In determining 
whether there is a plan that the interest will be forfeited, the 
Commissioner will consider all of the facts and circumstances 
(including the tax status of the holder of the forfeitable compensatory 
partnership interest).
    (f) Cross references. Forfeiture allocations may be made out of the 
partnership's items for the entire taxable year of the forfeiture. See 
Sec.  1.706-3(b) and paragraph (b)(5) Example 29 of this section.
* * * * *
    (5) * * *
    Example 29. (i) In Year 1, A and B each contribute cash to LLC, 
a newly formed limited liability company classified as a partnership 
for Federal tax purposes, in exchange for equal units in LLC. Under 
LLC's operating agreement, each unit is entitled to participate 
equally in the profits and losses of LLC. The operating agreement 
also provides that the partners' capital accounts will be determined 
and maintained in accordance with paragraph (b)(2)(iv) of this 
section, that liquidation proceeds will be distributed in accordance 
with the partners' positive capital account balances, and that any 
partner with a deficit balance in that partner's capital account 
following the liquidation of the partner's interest must restore 
that deficit to the partnership. At the beginning of Year 3, SP 
agrees to perform services for LLC. In connection with the 
performance of SP's services and a payment of $10 by SP to LLC, LLC 
transfers a 10% interest in LLC to SP. SP's interest in LLC is 
substantially nonvested (within the meaning of Sec.  1.83-3(b)). At 
the time of the transfer of the LLC interest to SP, LLC's operating 
agreement is amended to provide that, if SP's interest is forfeited, 
then SP is entitled to a return of SP's $10 initial contribution, 
and SP's distributive share of all partnership items (other than 
forfeiture allocations under Sec.  1.704-1(b)(4)(xii)) will be zero 
with respect to that interest for the taxable year of the 
partnership in which the interest was forfeited. The operating 
agreement is also amended to require that LLC make forfeiture 
allocations if SP's interest is forfeited. Additionally, the 
operating agreement is amended to provide that no part of LLC's 
compensation deduction is allocated to the service provider to whom 
the interest is transferred. SP makes an election under section 
83(b) with respect to SP's interest in LLC. Upon receipt, the fair 
market value of SP's interest in LLC is $100. In each of Years 3, 4, 
5, and 6, LLC has operating income of $100 (consisting of $200 of 
gross receipts and $100 of deductible expenses), and makes no 
distributions. SP forfeits SP's interest in LLC at the beginning of 
Year 6. At the time of the transfer of the interest to SP, there is 
no plan that SP will forfeit the interest in LLC.
    (ii) Because a section 83(b) election is made, SP recognizes 
compensation income in the year of the transfer of the LLC interest. 
Therefore, SP recognizes $90 of compensation income in the year of 
the transfer of the LLC interest (the excess of the fair market 
value of SP's interest in LLC, $100, over the amount SP paid for the 
interest, $10). Under paragraph (b)(2)(iv)(b)(1) of this section, in 
Year 3, SP's capital account is initially credited with $100, the 
amount paid for the interest ($10) plus the amount included in SP's 
compensation income upon the transfer under section 83(b) ($90). 
Under Sec. Sec.  1.83-6(b) and 1.721-1(b)(2), LLC does not recognize 
gain on the transfer of the interest to SP. LLC is entitled to a 
compensation deduction of $90 under section 83(h). Under the terms 
of the operating agreement, the deduction is allocated equally to A 
and B.
    (iii) As a result of SP's election under section 83(b), SP is 
treated as a partner starting from the date of the transfer of the 
LLC interest to SP in Year 3. Section 1.761-1(b). In each of years 
3, 4 and 5, SP's distributive share of partnership income is $10 
(10% of $100), A's distributive share of partnership income is $45 
(45% of $100), and B's distributive share of partnership income is 
$45 (45% of $100). In accordance with the operating agreement, SP's 
capital account is increased (to $130) by the end of Year 5 by the 
amounts allocated to SP, and A's and B's capital accounts are 
increased by the amounts allocated to A and B. Because LLC satisfies 
the requirements of paragraph (b)(4)(xii) of this section, LLC's 
allocations in years 3, 4 and 5 are deemed to be in accordance with 
the partners' interests in the partnership.
    (iv) As a result of the forfeiture of the LLC interest by SP in 
year 6, LLC is required to recognize income ($90) equal to the 
amount of the allowable deduction on the transfer of the LLC 
interest to SP under Sec.  1.83-6(c). LLC repays SP's $10 capital 
contribution to SP, reducing SP's capital account to $120. Under the 
terms of the operating agreement, because SP forfeited SP's 
interest, SP's distributive share of all partnership items (other 
than forfeiture allocations) is zero for Year 6. To reverse SP's 
prior allocations of LLC income, LLC makes forfeiture allocations of 
$30 of deductions ($0 (the difference between the $10 distributed to 
SP and the $10 contributed to LLC by SP) minus $30 (the cumulative 
net LLC income allocated to SP) to SP in Year 6. Notwithstanding 
section 706(c) and (d), these allocations may be made out of LLC's 
partnership items for the entire taxable year of the forfeiture. 
Thus, in Year 6, $30 of deductions are allocated to SP, and the 
remaining $220 of net operating income ($200 of gross receipts and 
$90 of income under Sec.  1.83-6(c) less $70 of remaining 
deductions) are allocated to A and B equally for tax purposes. In 
accordance with section 83(b)(1) (last sentence), SP does not 
receive a deduction or capital loss for the amount ($90) that was 
included in SP's compensation income. Because LLC satisfies the 
requirements of paragraph (b)(4)(xii) of this section, LLC's 
allocations in year 6 are deemed to be in accordance with the 
partners' interests in the partnership.
* * * * *
    Par. 5. Section 1.706-3 is added to read as follows.


Sec.  1.706-3  Property transferred in connection with the performance 
of services.

    (a) Allocations of certain deductions under section 83(h). The 
transfer of property subject to section 83 in connection with the 
performance of services is not an allocable cash basis item within the 
meaning of section 706(d)(2)(B).
    (b) Forfeiture allocations. If an election under section 83(b) is 
made with respect to a partnership interest that is substantially 
nonvested (within the meaning of Sec.  1.83-3(b)), and that interest is 
later forfeited, the partnership must make forfeiture allocations to 
reverse prior allocations made with respect to the forfeited interest. 
See Sec.  1.704-1(b)(4)(xii). Although the person forfeiting the 
interest may not have been a partner for the entire taxable year, 
forfeiture allocations may be made out of the partnership's items for 
the entire taxable year.
    (c) Effective date. This section applies to transfers of property 
on or after the date final regulations are published in the Federal 
Register.
    Par. 6. In Sec.  1.707-1, paragraph (c) is amended by revising the 
second sentence to read as follows:

[[Page 29683]]

Sec.  1.707-1  Transactions between partner and partnership.

* * * * *
    (c) Guaranteed payments. * * * However, except as otherwise 
provided in section 83 and the regulations thereunder, a partner must 
include such payments as ordinary income for that partner's taxable 
year within or with which ends the partnership taxable year in which 
the partnership deducted such payments as paid or accrued under its 
method of accounting. * * *
* * * * *
    Par. 7. In Sec.  1.721-1, paragraph (b) is revised to read as 
follows.


Sec.  1.721-1  Nonrecognition of gain or loss on contribution.

* * * * *
    (b)(1) Except as otherwise provided in this section or Sec.  1.721-
2, section 721 does not apply to the transfer of a partnership interest 
in connection with the performance of services or in satisfaction of an 
obligation. The transfer of a partnership interest to a person in 
connection with the performance of services constitutes a transfer of 
property to which section 83 and the regulations thereunder apply. To 
the extent that a partnership interest transferred in connection with 
the performance of services rendered by a decedent prior to the 
decedent's death is transferred after the decedent's death to the 
decedent's successor in interest, the fair market value of such 
interest is an item of income in respect of a decedent under section 
691.
    (2) Except as provided in section 83(h) and 1.83-6(c), no gain or 
loss shall be recognized by a partnership upon--
    (i) The transfer or substantial vesting of a compensatory 
partnership interest; or
    (ii) The forfeiture of a compensatory partnership interest. See 
Sec.  1.704-1(b)(4)(xii) for rules regarding forfeiture allocations of 
partnership items that may be required in the taxable year of a 
forfeiture.
    (3) For purposes of this section, a compensatory partnership 
interest is an interest in the transferring partnership that is 
transferred in connection with the performance of services for that 
partnership (either before or after the formation of the partnership), 
including an interest that is transferred on the exercise of a 
compensatory partnership option. A compensatory partnership option is 
an option to acquire an interest in the issuing partnership that is 
granted in connection with the performance of services for that 
partnership (either before or after the formation of the partnership).
    (4) To the extent that a partnership interest is--
    (i) Transferred to a partner in connection with the performance of 
services rendered to the partnership, it is a guaranteed payment for 
services under section 707(c);
    (ii) Transferred in connection with the performance of services 
rendered to a partner, it is not deductible by the partnership, but is 
deductible only by such partner to the extent allowable under Chapter 1 
of the Code.
    (5) This paragraph (b) applies to interests that are transferred on 
or after the date final regulations are published in the Federal 
Register.
* * * * *
    Par. 8. Section 1.761-1(b) is amended by adding two sentences to 
the end of the paragraph to read as follows.


Sec.  1.761-1  Terms defined.

* * * * *
    (b) * * * If a partnership interest is transferred in connection 
with the performance of services, and that partnership interest is 
substantially nonvested (within the meaning of Sec.  1.83-3(b)), then 
the holder of the partnership interest is not treated as a partner 
solely by reason of holding the interest, unless the holder makes an 
election with respect to the interest under section 83(b). The previous 
sentence applies to partnership interests that are transferred on or 
after the date final regulations are published in the Federal Register.

Mark E. Matthews,
Deputy Commissioner for Services and Enforcement.
[FR Doc. 05-10164 Filed 5-20-05; 8:45 am]
BILLING CODE 4830-01-U