Project developers who receive partnership interests in exchange for services should be careful.

Smaller project developers often form a partnership or limited liability company to own a project and then bring in a money partner to fund the development work. The developer provides labor. He receives an interest in the project for his services. The money partner owns the rest of the project in exchange for putting up the capital.

The danger in such arrangements is the developer must report the value of the partnership interest as income and pay taxes on it just as he would any other compensation.

The IRS said in proposed regulations in late May that it does not matter what kind of partnership interest the developer receives; the developer must still report it as compensation.

However, a mere “profits interest” — as opposed to a capital interest — is less likely to trigger a tax. A “profits interest” gives a partner a share in future profits from the partnership. A “capital interest” would give him an immediate claim on partnership assets if the partnership were to disband the next day. Profits interests must be reported as compensation, but chances are they have little value. The IRS said the developer should report the “liquidation value” of the interest, or the amount of money the developer would be distributed by the partnership if the partnership liquidated.

In the past, some developers may have made elections under section 83(b) of the US tax code to be taxed immediately on the partnership interest — at a time when it is likely to have little value. This was true of anyone whose right to the partnership interest has not fully “vested,” meaning his right to it is still conditioned on his providing more services. (The word “vest” is more often heard in connection with pension benefits. An employee’s right to a pension “vests” after he has been with the company for several years, meaning he is now entitled to a pension whether or not he continues working for the company.) A person is usually not taxed on compensation received in kind until it vests. The problem with waiting to pay tax until vesting is the partnership interest is more likely to have a real liquidation value by then.

The IRS removed any need to make elections. It said the liquidation value on which the developer is taxed becomes fixed when the developer first receives the interest, even if the interest does not vest until later.

The regulations are merely proposed. They will take effect when the IRS reissues them in final form. However, there is no reason to believe the IRS position is any different today than what it is proposing.