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STATEMENT OF LAURENS WILLIAMS, OF THE FIRM OF SUTHER
LAND, ASBILL & BRENNAN, WASHINGTON, D. C. Mr. WILLIAMS. Mr. Chairman and gentlemen, in the 1954 code, in section 721, you made specific provision as to whether or not any tax consequence, in terms of currently taxable gain or loss, would result from the transfer of property to a partnership. In other words, when two men form a partnership and contribute property to the partnership, is that or is that not, itself, a taxable transaction?
And you said in section 721, as was believed and assumed to have been the law under the 1939 code, that no gain or loss shall be recognized to a partnership or to any of its partners in the case of a contribution of property to a partnership in exchange for an interest in the partnership
Now, there are those who claim that the word "property” in the statute includes services; that, therefore, when you adopted this statute, which says no gain or loss is recognized either to the partnership or to members of the partnership when they contribute property to the partnership, that you included services.
And, therefore, if, for example, you and I were to form a partnership and you said I will put in $10,000, and I said I don't have any money but I will contribute my services, and we are to be equal partners, sharing not only the profits equally but, also, having equal interests in the partnership capital, equal interest, if you please, in the $10,000 which you put into the partnership, there are those who say that under this statute, I, who rendered services to the partnership and received in exchange an interest in partnership property worth $5,000, have not received any taxable income. Now, we think that clearly was never intended.
The Treasury Department, in the regulations under this section, took the position that it did not cover services. The Treasury took the position, rather, that, where a partner receives an interest in the partnership property, the partnership capital, in exchange for, or in consideration of, rendering services to the partnership, he realizes ordinary income.
Now, two problems arise in that connection. No. 1: How much income has he received? On how much income shall he be taxed ? Secondly, when shall he be taxed ?
As to the amount of income, the Treasury Department's regulations take the position that the amount on which such a partner is to be taxed is the fair market value of the interest in the partnership capital which he receives where the transfer of a capital interest to him is in consideration of services which already have been rendered occurs where the services are complete and that, where he receives the transfer of property in advance of completion of the services, then he is to be taxed on an amount measured by the value of the property at the time he does complete the services.
Then, as to the time when he is to be taxed, under the regulations Mr. Keogh. Excuse me, Mr. Williams. Taxed as ordinary income?
Mr. WILLIAMS. Yes, sir. Because this is compensation for personal services. He is being paid by receiving an interest in the partnership capital rather than receiving dollars.
Mr. KEOGH. It is noncash remuneration ?
Mr. WILLIAMS. There is nothing in the statute covering this. And that is the reason we are making the recommendation that there be something in the statute covering it.
But, going back: Under the regulations, the Treasury says, the time he is taxed depends upon all the facts and circumstances, but in substance it boils down to this: that he is to report this income and pay tax on it at the time it is subject to his withdrawal—that is, when there are no restrictions or limitations on his right to this capitalwhen he could sell it and realize on it, or could draw it out.
This, then, is the time he is to be taxed.
Mr. Mason. I give my services and you give the $10,000 and we go in together, but I haven't performed any services so far, so my services are being paid, you might say, in this capital ahead of time. You say in the agreement you cannot sell your half of this until 5 years from now or whenever it is. Is that the idea?
Mr. WILLIAMS. That is right, sir; yes, sir.
Mr. Krogh. Mr. Chairman, suppose an employee of a partnership in its employ on a salary for 10 or 15 years is finally rewarded by an interest in the partnership and receives, therefore, his percentage interest in the capital assets of the partnership; are you contending that in the year he is given interest he should include the value of that interest in his income for that year!
Mr. WILLIAMS. If it is compensation for his personal services, yes, sir.
Mr. KEOGH. Well, I have given you the facts. He has worked; he has been paid a salary for his work; and the time has now come to elevate him to the doubtful status of a partner; and you are going to tax that?
Mr. WILLIAMS. Yes, sir. Mr. KEOGH. Why not recommend spreading it over the period of his employment?
Mr. WILLIAMS. Well, if he qualifies under the other sections of the code, to spread it back, he could.
Mr. IKARD. In the example that Mr. Keogh gave, he would be tasable on whatever his pro rata share of the capital assets of the partnership are in the year that he became a partner!
Mr. WILLIAMS. Yes. Provided that there were no restrictions on his interest, on the transferability of his interest.
If the agreement said, as Mr. Mason indicated, and most agreements do provide, or if the State law imposed a condition that he cannot convey this, he cannot sell this, he cannot realize on it, then the time would not be when he became a partner but when those restrictions were removed.
Mr. IKARD. I do not want to get ahead of you until you have finished your basic statement. If you would like to go ahead, that is all right with me. I have several questions.
Mr. WILLIAMS. I am talking so far not about our recommendations, but about what the Treasury Department's regulations currently say is the current law.
Mr. IKARD. All right. Let's go ahead.
Mr. WILLIAMS. I think I have practically covered it.
The advisory group has concluded that on balance the Treasury Department regulations are a sound solution to the problem, but believe that there should be a statutory base for the regulations.
There is nothing in the statute on this subject. There might be a question, as I said at the start, of the validity of the Treasury Department's regulations on this subject. And so we are recommending that there be a new section which
under the current structure of subchapter K would be section 724. This new section would say in substance that where a partner receives an interest in partnership capital as compensation for his personal services he shall be deemed to have received ordinary income, just as if he had been paid in cash or other property.
As to the amount to be taxed, however, there is one basic problem in the current treatment of this problem in the Treasury Department's present approach in its regulations.
This is: Suppose that a transfer of a capital interest to me occurs today in consideration of my promise to render services over the next 2 years. Mr. EBERHARTER. Particularly with respect to professional services? Mr. WILLIAMS. It might be a professional service. Mr. EBERHARTER. Doctors and lawyers and scientists. Mr. WILLIAMS. Yes, it might well be so.
In this case, however, suppose that it is not in a professional organization but in a business organization. Suppose that such a partner receives a one-tenth interest in the partnership capital. But he has no right to draw it down at that time. He cannot then sell it. He cannot realize on it.
Perhaps he is forbidden to borrow against it or even encumber it. Under the present regulations he would not be taxed now, nor would the amount on which he is to be taxed in the future be determined now. The amount would be determined later at the end of the 2-year period when he can draw it down.
Now, this 10 percent interest may well have appreciated in value at the end of 2 years. A part of the increase in value at the end of 2 years may, well be not due to his personal services. This appreciation in value is not compensation for his personal services—this is an appreciation in value which ought to have capital gains treatment. We believe that under the Treasury's regulations they might in instances be taxing as ordinary income what is purely and truly capital gains.
So, we recommend changing that and measuring the amount to be taxed as ordinary income in such a manner as to exclude from such taxation anything that really is capital gain.
As to the time of taxation, no major change is recommended. The time when it is to be taxed is at the time the service partner receives it, if there are no restrictions or limitations at that time. On the other hand, where there are limitations or restrictions as to transferability, the time of taxation will be the time when those restrictions or limitations have been removed.
Now, there are two other facets of this problem which I would like to mention. First of all, let's take the original illustration of the man who contributed $10,000 cash and the other chap who puts in his services.
Now, we are going to tax the man who rendered the services and received a one-half interest in that $10,000 capital at ordinary income rates. What about the fellow who put in the $10,000! Half of it now is gone. It is not his any more. It is gone. What about him! What about the partnership?
Hasn't it in effect paid $5,000 salary to this man out of its capital? Isn't it a like thing?
We think it is. Therefore, we say where a partner relinquishes an interest in the capital, where he gives it up because it is transferred to another partner, he will be entitled to an appropriate deduction. The deduction of the transferor partner matches the taxing of it, on the other side of the transaction, to the man who rendered the services.
The other point is this: Particularly in the oil and gas and mineral field, there historically have been many situations in which the geologist, the lawyer, the professional man, has rendered services in and about the development of a mineral property and has received in exchange an interest in the mineral property.
Normally those are received in advance, during the promotional stage. The Internal Revenue Service for years has ruled that the receipt of such interests are not taxable as ordinary income at the time of the transaction. Now that may apply not only in the case of mineral ventures but in other situations. I used minerals only to illustrate the type of thing that can occur.
We recommend that if you adopt the proposed treatment of taxing as ordinary income interest in capital received as compensation for services, that you except from that provision any income which would not be taxed if you were not in partnership form.
In other words, we say, “Don't penalize people because they happen to choose the partnership form of doing business.” Whatever the circumstances, if you have a situation in which the individuals involved would not be taxed had they used some other form of business organization, then we say don't impose a tax where they use the partnership form of organization.
I might summarize by saying that in substance what we are suggesting here would do two things: One, it would provide specific statutory coverage of a problem that currently is not covered; and, secondly, with the exceptions I have mentioned, would provide a statutory basis for the way the Treasury Department is imposing the tax at the present time.
Mr. KEOGH. Mr. Chairman.
Mr. KEOGH. Do I state correctly that in connection with this last item which you have discussed-which I understand is included in your suggested section 770, subdivision (d), on page 34that in an attempt to equate different situations you adopt—that is, to achieve equity between a partnership and some other form of business-you have adopted for the partnership the lesser restrictive provisions applicable to the other form or type of business?
Mr. WILLIAMS. Yes, I think it might be stated that way. Mr. KEOGH. That is in line with the question you asked earlier. Mr. WILLIAMS. What we are trying to say is this: If the nature of the interest received in exchange for services is the sort of thing which is not taxed to individuals in nonpartnership situations today, then we would not impose a tax here simply because if you and I do something as individuals and you pay me in a certain way and we are not partners at all, and there is no tax, then why impose a tax because we happen to put ourselves in a partnership instead of doing it as individuals ?
Mr. KEOGH. That is in line with what we hope will be the continuing trend of, according to partners, the right of, say, officers of corporations, for example.
The CHAIRMAN. Let me ascertain if I may for the record: Is there anything in your report concerning the Jenkins-Keogh bill?
Mr. IKARD. Yes, sir. We just got a recommendation on it.
Mr. WILLIAMS. I think the only reference is the page numbers—9 and 10.
Mr. IKARD. In one of the examples you gave about the appreciation of property and the value of it, how would you determine the value of the services where normally there also would be some capital gains involved.
How would you propose to determine that now!
I know that in the clearcut cases it would be easy. But it would seem to me there would be a lot of twilight operations there.
Mr. WILLIAMS. I think perhaps the simplest way to answer your question would be to refer you to the paragraph on page 22 of the revised report.
You notice there that this first paragraph under (e) in italic refers to the amount; and that as I understand it is your question: How much are we going to tax as ordinary income?
That paragraph states: Now, if at the time the partnership interest is transferredI am starting with the second sentence it is not subject to restrictions or limitations as to its transferability, the amount to be taken into account is the fair market value at the time of the transfer.
Now, we do not get this problem except when we have to postpone determination of amount, because there are restrictions. So, that is in the next part.
The second sentence says: Or the transferee partner's proportionate share of the adjusted basis of the partnership property at that time, whichever is lesserwhich I did not mention, but which is a problem of equating the deduction which occurs to the partner whose capital interest is diminished.
If at the time the partnership interest is transferred it is subject to restrictions and limitations as to transferabilityand that is our situationthe amount to be taken into account is the lesser of, first, the transferee partner's proportionate share of the adjusted basis of the partnership property, the same as where it is not subject to the restrictions, or, second, the fair market value the interest would have had at the time of the exchange if there had been no limitations or restrictions as to transferability at that time.
In other words, you look back and say if at the time this was transferred to you in the first instance there had been no limitations or restrictions how much would it be worth at that time?
That is one.