Diamond v. Commissioner of Internal Revenue
492 F.2d 286 (1974)
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Rule of Law:
The receipt of a partnership profits interest in exchange for services is a taxable event, and the fair market value of that interest is treated as ordinary income under § 61 of the Internal Revenue Code if it has a readily ascertainable value at the time of receipt.
Facts:
- Sol Diamond was a mortgage broker.
- Philip Kargman contracted to buy an office building and asked Diamond to secure a $1,100,000 mortgage loan for the full purchase price.
- In exchange for arranging the financing, Kargman agreed to give Diamond a 60% share of the venture's future profits and losses. Diamond contributed no capital to the venture.
- After Diamond secured the loan, the venture was formally created on February 18, 1962, and Diamond received his profits interest.
- On March 8, 1962, just three weeks after receiving the interest, Diamond sold it to a third party for $40,000.
Procedural Posture:
- Sol Diamond filed his 1962 tax return, reporting the $40,000 proceeds from the sale of his partnership interest as a short-term capital gain.
- The Commissioner of Internal Revenue assessed a tax deficiency against Diamond, asserting that the $40,000 should have been recognized as ordinary income upon receipt of the interest on February 18, 1962.
- Diamond petitioned the U.S. Tax Court to challenge the deficiency.
- The Tax Court, as the court of first instance, ruled in favor of the Commissioner, holding that the receipt of the profits interest was a taxable event resulting in ordinary income.
- Diamond (appellant) appealed the Tax Court's decision to the United States Court of Appeals for the Seventh Circuit.
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Issue:
Does a taxpayer realize ordinary income under the Internal Revenue Code upon the receipt of a partnership profits interest in exchange for services when that interest has a determinable market value at the time it is received?
Opinions:
Majority - Fairchild, J.
Yes. A taxpayer realizes ordinary income upon receiving a partnership profits interest for services if that interest has a determinable market value. The court reasoned that the general principle of I.R.C. § 61—that compensation for services is income—governs this transaction. The court rejected Diamond's argument that § 721 and its associated regulations create a non-taxable exception for profits interests received for services. While § 721 provides non-recognition for contributions of property, it does not apply to compensation for services. The court refused to find a negative implication in Treasury Regulation § 1.721-1(b)(1) that would shield profits interests from taxation. The court distinguished this case from the typical situation where a profits interest's value might be speculative, emphasizing that here the interest had a clearly determinable market value of $40,000, as proven by its immediate sale.
Analysis:
The Diamond decision was a landmark and controversial ruling in partnership taxation, departing from the prevailing consensus among commentators that the receipt of a profits interest for services was not a taxable event. It created significant uncertainty for service partners by holding that any profits interest with a 'determinable market value' could trigger immediate ordinary income, even without the receipt of cash. This holding forced tax practitioners to restructure service partnership formations and ultimately led the IRS to issue administrative safe harbors (such as Rev. Proc. 93-27) to limit its application in more typical scenarios. The case remains a foundational lesson on the tension between the broad income recognition principle of § 61 and the specific non-recognition rules within Subchapter K.
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