Partnership Interest for Services (2023)

Sweat equity. A popularized term and common arrangement where in the formation of a partnership or LLC someone will contribute and trade services for equity in the partnership. Often, one partner will provide the starting capital and the other partner some of the skills for the operation of the business. This is similar to when startups grant equity to employees as incentives. But what is the tax impact on the person providing services?

Generally, when equity is given for services in a partnership, the service providing partner must recognize the value of their new partnership interest as gross income in they year that they received it. In order to better understand why, it is important to cover the basics of how partnerships are taxed and the impact of other types of partnership contributions (like cash and property).

Looking to start a business and hire employees? See my article on Starting a Utah LLC (2023) for a basic guide on getting your LLC up and running.

How are Partnerships Taxed?

Partnerships are taxed by the federal government as pass-through entities. In other words, the income, losses, etc. of a partnership effectively pass through to the partners of the underlying partnership and are taxed at that partner level. IRC 701 says that

“[a] partnership as such shall not be subject to the income tax imposed by this chapter. Persons carrying on business as partners shall be liable for income tax only in their separate or individual capacities.”

This is different than a regular corporation where income is taxed once at the corporation level and then again when the corporation pays dividends or otherwise makes distributions to its shareholders. This tax at the corporate and then the shareholder level is often called double taxation and is one of the reasons that people choose entities that are classified as partnerships for federal tax purposes—so they can avoid the extra layer of taxation at the entity level.

Different Types of Partnerships for Tax Purposes

Section 761(a) of the Internal Revenue Code defines a partnership for federal tax purposes as

“…a syndicate, group, pool, joint venture, or other unincorporated organization through or by means of which any business, financial operation, or venture is carried on, and which is not, within the meaning of this title, a corporation or a trust or estate.”

Wow, quite the mouthful from the IRC there, but essentially what it is saying is that generally, any unincorporated entity, except for trusts and estates under the code, that exists for the purpose of doing business are considered partnerships for federal tax purposes. What that means is that traditional partnerships are taxed as partnerships (obvious, I know), but also that entities like limited partnerships, limited liability partnerships, and limited liability companies (LLCs) are generally treated as partnerships for federal tax purposes.

Covering specific exceptions to this part of the code is beyond the scope of this article, however.

Partnership Contributions

Throughout the life of a partnership, the partners, whether actual partners or members like in an LLC, may make contributions to the partnership from time to time. The first of these contributions are typically referred to as the initial capital contributions of the partnership or LLC. The initial contribution of services or property to a partnership (as well as subsequent contributions) are often agreed to in a contribution agreement, an operating agreement, or a partnership agreement.

Initial Capital Contributions

The Initial Capital Contribution is often the first method of funding a partnership. Partners (or members for an LLC) will contribute money, services, or other property to the partnership in exchange for equity, also referred to as a partnership or LLC interest. No gain is recognized on cash and property transfers to a partnership in exchange for a partnership interest but a gain is recognized when services are contributed to a partnership in exchange for a partnership interest.

How does the IRS treat an initial capital contribution in exchange for a partnership interest ? In most other circumstances when a transfer of property occurs, it is usually a realization event where someone may have to recognize income and pay taxes on that income. For example, IRC 1001(b) says that

“The amount realized from the sale or other disposition of property shall be the sum of any money received plus the fair market value of the property (other than money) received.”

When there is a realization event the gain or loss on that transaction must be calculated as part of the determination of whether a tax should be assessed. See IRC 1001(a).

In the case of initial capital contributions to a partnership (or LLC) in exchange for a partnership interest however, a partner may not necessarily have to recognize a gain when they make the transfer (which is a realization event). Generally, whether a partner has to recognize income or not depends on whether the contribution is one that is cash, property, or services.

Learn more about obtaining venture, debt, angel, and other financing and capital for your business.

Cash Contributions to a Partnership

Cash contributions to a partnership are not recognized under the Internal Revenue Code. IRC 721(a) says that no gain is recognized when it comes to contributions of property to a partnership in exchange for a partnership interest. Internal Revenue Code Section 721(a) says 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 the partnership in exchange for an interest in the partnership.”

There are of course exceptions, for example this does not apply to initial transfers to partnerships that qualify as an investment company under the code, but the general rule is that when that exchange happens for the partnership interest that any gain or loss is not recognized at that moment.

Property Contributions to a Partnership

Property Contributions to a partnership in exchange for a partnership interest are treated the same way as cash exchanges for a partnership interest. IRC 721(a) generally applies. No gain or loss is recognized on the transfer of property to a partnership in exchange for a partnership interest.

Service Contributions to a Partnership

Service contributions to a partnership, also known as sweat equity or trading services for equity, are treated differently than cash or property under the Internal Revenue Code however. Generally, when a person performs services in exchange for property or money, the property or money received by the service provider is included in their gross income. Internal Revenue Code 83(a) describes this general rule.

But what about when services are made in exchange for a partnership interest? Well, the rule is effectively the same, but with some regulations as well. Revenue Procedure 93-27 describes the application of this rule in the context of what is effectively a transfer of services for a partnership interest. When services are exchanged for a certain type of partnership interest called a capital interest (one where the partner gets a share of proceeds from selling all of the partnerships assets at complete liquidation of the partnership) then IRC 83 applies and the partner recognizes the value of the partnership interest as gross income.

Partnership contributions can become very complicated depending on what kind of property or services are being exchanged for a partnership interest. Often a contribution agreement, partnership agreement, or operating agreement will address each partner’s requirements for contributions. If you are looking for a small business attorney in Ogden, Utah to help with setting up a partnership or other entity. Please contact me and schedule a free initial consultation.