taxbusiness fall2005 prf4a

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Copyright 2005 Tax & Business Law Report Flaster/Greenberg P

A Newsletter of the Tax & Corporate Practice Group FALL 200

New Proposed Tax Regs Could Change TaxTreatment of Partnership Interests Givenfor Services

BY MICHAELP. SPIRO

Many emerging growth companies are founded when an ind

vidual with an idea joins together with an individual with moneyfinance that idea, and the two form either a partnership or a limitliability company. Generally, the individual with the idea will receihis interest in return for providing services to the new companyso-called compensatory interest), and the individual with mon

will receive his interest in return for capitalizing the company. Fyears, the proper tax treatment of the compensatory interest has been litigated tquestion being whether the compensatory interest should be taxed currently as incomto the service provider. While it has long been established that the granting of a capiinterest (i.e., an interest in the capital as well as profits of a partnership) is taxablethe recipient, there has been confusion about the treatment of a mere profits interes

which grants an individual no immediate interest in the companys existing capi

accounts, but only the right to share in future partnership profits. However, the IRhas recently published new rules under Internal Revenue Code Section 83 which wnow govern the treatment of compensatory partnership profits interests. IRS Not2005-43.

Background The Current RuleThe current rule applicable to compensatory partnership interests was enunciated

the Eighth Circuit case of William G. Campbell, 943 F.2d 815 (8th Cir. 1991) aadopted by the IRS in Revenue Procedure 93-27 (as clarified in Rev. Proc. 2001-4In Campbell, the taxpayer received a profits interest in a limited partnership interestexchange for performing various future services for the partnership. According to tCampbellCourt, the profits interest was not taxable as it had only speculative value acould not be appropriately valued for tax purposes. In Rev. Proc. 93-27, the IRS

forth a position consistent with Campbellthat where profits are not substantially certaand predictable, the receipt of a profits interest in a partnership is not a taxable eve

The Proposed New RuleProposed Regulation 1.83-3(l) now seeks to eliminate much of the confusi

caused by the distinction between profits interests and capital interests by removithe distinction altogether. The IRS now proposes that taxpayers must recognize t

Editors NoteWith the opening ofour new Philadelphiaoffice (the 15th Floorof 8 Penn Center), wehave substantiallyexpanded ourregional presence.Moreover, with resi-dent lawyers based in

Philadelphia having practices in the fieldsof employment law, intellectual propertylaw, environmental law, and general litiga-tion, we have enhanced our capabilitiesand availability to our clients in thePhiladelphia area.

This current Tax and Business LawReport provides a cross-section of articlesof interest ranging from federal taxa-tion of compensatory partnership inter-ests, expanded scope of New Jerseyincome taxation, new payroll tax responsi-bilities for disregarded entities, andchanges in individual income tax returnfiling procedures.

If you provide us with your e-mailaddress and the e-mail addresses ofcolleagues who would be interested inreceiving this Report, we would be

pleased to include that information inthe data bank for this Report. Pleasesend that information to me [email protected].

TAX &BUSINESSLAW REPORT

In This Issue. . .Disregarded Entities Now

Responsible for Employmentand Excise Taxes........................2

Expanded Scope for Taxing NJSource Income ..........................3

Longer Automatic ReturnFiling Extension ........................3

This report is for general use and information, and the content should not be interpreted as rendering legal

advice on any matter. Specific situations may raise additional or different issues and such information should be

coordinated with professional legal advice.

Richard J. Flaster

(continued on page


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Tax & Business Law Report Flaster/Greenberg P.C.

value ofall compensatory partnership interests as taxable

income. The Regulation then establishes a safe harborpursuant to which the value of a compensatory partnershipinterest shall be equal to the liquidation value of that interest.Compare with In Re Hills Estate193 F.2d 724 (2d. Cir. 1954).Under the safe harbor, the value of a profits interest will neces-sarily be zero, as the holder of such an interest is not entitled toany capital upon liquidation. Essentially, this new safe harborcodifies the pre-existing rule with respect to profits interestsand eliminates the taxability of profits interests even where profitsare substantially certain and predictable.

The key significance of the safe harbor is that such treatmentmust be elected by a partnership in order to be applicable.

Moreover, Notice 2005-43, provides that upon adoption of theRegulation, Revenue Procedures 93-27 and 2001-43 willbecome obsolete. Therefore, if the election under Prop. Reg.1.83-3(l) is not made, the IRS can tax the grant of a compen-satory partnership profits interest (after the date of adoption ofthe final Regulations). It is therefore crucial to understand themethod for making the safe harbor election under Prop. Reg.1.83-3(l).

Safe Harbor ElectionThe safe harbor election requires both a filing by the part-

nership and for certain provisions to be placed in the partner-ship agreement.

First, the partnership must prepare a document, executed bythe partner who has responsibility for Federal income taxreporting by the partnership (i.e., the Tax Matters Partner),stating that the partnership is making this election (on behalf ofthe partnership and each of its partners) to have the safe harborapply irrevocably as of the stated effective date, and the docu-ment must be attached to the tax return of the partnership forthat year.

Second, the partnership agreement must contain the follow-ing provisions:

The partnership is authorized and directed to elect the safeharbor; and

The partnership and each of its partners agrees to complywith all requirements of the safe harbor with respect to allpartnership interests transferred in connection with the per-formance of services while the election remains effective. Ifthe partnership agreement does not contain the requiredprovisions, each partner in the partnership must sign a sepa-rate document containing those provisions.

ObservationAccording to representatives of the IRS, Proposed Regulation

1.83-3(l) is expected to be finalized in June of 2006.

Disregarded Entities NowResponsible for Employmentand Excise Tax Filings

BY RICHARD J. FLASTER

Under existing rules, single-owndisregarded entities (such as singmember LLCs or Qualified SubchapterSubsidiaries) were not responsible femployment tax and excise tax obligationRather, the owners of such entities hthis responsibility.

However, with the announcement of Proposed Regulatio307.7701-2(c)(2), the IRS seeks to treat the disregardentity as the employer and to establish its responsibility for:

Employment Taxes/Back-Up Withholding: DepositiFICA, FUTA and income tax withholding with the IRfiling 941 returns, and issuing W-2 forms.

Excise Taxes: Reporting and payment of applicable exctaxes, registering as a buyer or seller in a transaction subjeto excise taxation and claiming refunds and credits such transactions.

Observation: The new employment tax rules will taeffect when the final regulations are issued. The new excise trules will take effect for years beginning after January 1, 2006

New Proposed Tax Regs Could Change TaxTreatment of Partnership Interests Givenfor Services

(CONTINUED FROM PAGE 1)

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New Jersey Taxes onCompany with No In-StatePhysical Presence

BY MARKLEYS. RODERICK

The Appellate Division of the SuperiorCourt recently held that Lanco, Inc., aDelaware corporation with no physicalpresence in New Jersey, is subject to theCorporation Business Tax (CBT) onroyalties it receives from a New Jersey retailer.Lanco, Inc. v. Division of Taxation, 379

N.J.Super. 562 (A.D. 2005) reversing an earlier decision of theNew Jersey Tax Court, this decision changes the rules of thegame for many out-of-state companies which have previouslyassumed they were constitutionally protected from New Jersey

tax as long as they maintained no physical presence here.Lanco owns certain intellectual property (trademarks, trade

names, and service marks) which it licenses to Lane Bryant, aretailer with multiple New Jersey locations and receives royaltieson Lane Bryants New Jersey sales. However, Lanco has nooffices, employees, or property of its own in New Jersey.

In 2003 the New Jersey Tax Court held that New Jerseycould notimpose the Corporation Business Tax on the royaltiesreceived by Lanco. Relying on the decision of the U.S. SupremeCourt in Quill Corp. v. North Dakota, a case that involved theimposition of sales and use taxes on catalog sellers, the TaxCourt held that there was insufficient nexus between Lanco

and New Jersey to satisfy the Commerce Clause of the U.S.Constitution.

However, following recent decisions from other states, theAppellate Division held that while a physical presence might berequired to impose sales and use taxes under Quill, it is notrequired to impose state income taxes. The court appears to haveaccepted the argument made by the New Jersey Division ofTaxation that the benefits obtained by Lanco, including theexistence of the New Jersey legal system and New Jerseyseducated workforce, established a constitutionally-sufficientnexus for the imposition of income tax even in the absence ofa physical presence.

Observation: While the opinion of the Appellate Divisionclearly provides that New Jerseymayimpose the CBT on Lancoand other companies receiving royalties from New Jersey sales,it does not establish or even suggest guidelines fordetermining under what circumstances New Jersey may notimpose the CBT on out-of-state companies. Consequently,unless the decision is modified or overturned by a highercourt, prudent taxpayers will assume that all income fromNew Jersey will be subject to the CBT, without regard to anyconstitutional restraint.

Office Locations1810 Chapel Avenue West

Cherry Hill, NJ 08002-4609

Tel 856-661-1900Fax 856-661-1919

2900 Fire Road, Suite 102AEgg Harbor Twp., NJ 08234

Tel 609-645-1881Fax 609-645-9932

89 Headquarters Plaza North14th Floor, Suite 1472Morristown, NJ 07960

Tel 973-605-1799Fax 973-605-1344

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Tel 609-695-4000Fax 609-695-5111

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Philadelphia, PA 19103Tel 215-279-9393Fax 215-279-9394

Automatic Extension forFiling 2005 Tax ReturnsIncreased to Six Months

BY ALAN H. ZUCKERMAN

In recently issued regulations, the IRannounced that individuals, partnership(including LLCs taxed as partnershipsand certain trusts and other entities filin2005 federal income tax returns will bpermitted to obtain an automatic sixmonthextension of the due date for th

return. Previously, the automatic extension was for onlthree or four months (depending on the type of taxpayerthen the taxpayer had to file another form to request th

additional extension up to a total of six months. For individuareturns (i.e., Form 1040), individuals now need to file onlForm 4868 to obtain an automatic six-monthand no longeneed to file Form 2688 to obtain the additional two-montextension. For partnerships and LLCs taxed as partnership(and for certain trusts and other entities), these entitie

would now file Form 7004 to obtain the automatic sixmonth extension, instead of having to file first a Form 873for an initial three-month extension, and would then a Form8800 to request the additional three-month extensionCorporations had, and still do have, the ability to obtain anautomatic six-month extension by filing Form 7004.

Observations: Caution: As before, the obtaining of a

extension of time to file a tax return does not extend the dudate for paymentof the tax. Accordingly, in order to avoipenalties and interest, the tax must still be paid by thoriginal due date (or, perhaps even earlier if the taxpayer iotherwise required to make estimated tax payments or havtax withheld throughout the year).


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