A partner did not have to report a share of partnership income until his partnership interest “vested.”

The president of Crescent Resources, a real estate development business belonging to Duke Energy, was given a 2% partnership interest under a new employment agreement in September 2007 when the business was dropped into a partnership with several real estate investment funds managed by Morgan Stanley.

The interest was not transferable for three years and would be forfeited if the president terminated his employment within three years.

Crescent Resources filed for bankruptcy less than two years later in early June 2009. The president resigned shortly before the bankruptcy filing.

The partnership sent the president US tax forms called K-1s at the end of 2007 and again after 2008 indicating that he should report a 2% share of the partnership’s income. He disagreed each time, but reported the income. After the 2008 K-1, the board agreed to pay him additional money to make him whole and to make an advance against his tax liabilities for 2009. When the company went bankrupt, the lawyers handling the bankruptcy sent a demand letter asking for the additional compensation to be returned.

The US Tax Court said in December that the president should not have had to report a share of partnership income until his interest vested. The court said this was a question of first impression for any court. It said the income share allocated to the president should have been reported by the other partners: Duke and the Morgan Stanley funds.

Anyone receiving a “capital interest” — as opposed to a bare “profits interest” — in a partnership as part of his compensation for services must report the value when the interest vests. However, he can make an election under section 83 of the US tax code to report the value upon receipt when the value might be lower. No such election was filed in this case.

A capital interest is an interest that entitles the holder to a share of whatever value remains in the partnership when it liquidates. A bare profits interest is an interest solely in partnership income and loss without an interest also in partnership assets at liquidation. One US appeals court has held that a bare profits interest does not have to be reported as income upon vesting because the value is too uncertain.

The case is Crescent Holdings, LLC v. Commissioner.

by Keith Martin