William G. Campbell Norma T. Campbell v. Commissioner of Internal Revenue
68 A.F.T.R.2d (RIA) 5090, 1991 U.S. App. LEXIS 19884, 943 F.2d 815 (1991)
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Rule of Law:
The receipt of a partnership profits interest in exchange for services is not a taxable event if the interest has no readily ascertainable fair market value at the time of receipt because its value is speculative.
Facts:
- William Campbell was employed by Summa T. Group, a firm that organized and syndicated limited partnerships.
- As part of his compensation, Campbell's agreement stipulated he would receive special limited partnership interests (profits interests) for his services in forming and financing new partnerships.
- In 1979 and 1980, Campbell received profits interests in three newly formed limited partnerships he helped create: Phillips House Associates, The Grand, and Airport.
- These partnerships were new ventures with no operating history, and their offering memoranda projected tax losses for the initial years.
- Campbell's interests were subordinate to the Class A limited partners, who had priority for cash distributions and return of capital.
- Resale of Campbell's partnership interests was restricted, requiring approval from the general partner which could be arbitrarily withheld.
- The offering memoranda warned investors that the Internal Revenue Service (IRS) was likely to audit the partnerships and disallow many of the claimed tax deductions.
Procedural Posture:
- The Commissioner of the IRS issued a notice of deficiency to William and Norma Campbell for tax years 1979 and 1980, asserting that the value of the partnership interests was taxable income.
- The Campbells challenged the deficiency in the United States Tax Court.
- The Tax Court held for the Commissioner, finding the profits interests were taxable income upon receipt, but it recalculated their fair market value at a lower amount than the Commissioner's initial assessment.
- The Campbells (appellants) appealed the Tax Court's decision to the United States Court of Appeals for the Eighth Circuit, with the Commissioner as the appellee.
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Issue:
Is a partnership profits interest, received in exchange for services rendered to the partnership, taxable as income upon receipt when its value is speculative and not readily ascertainable?
Opinions:
Majority - Beam, Circuit Judge.
No. A partnership profits interest received for services is not taxable income upon receipt if its value is speculative and not readily ascertainable. The court distinguished this case from Diamond v. Commissioner, where the profits interest was immediately sold for a substantial sum, thereby proving its value. Here, the court found the tax court's valuation of Campbell's interests to be clearly erroneous. The value was purely speculative because the partnerships were new ventures with no track record, their financial projections were merely predictions, and the promised tax benefits were likely to be disallowed by the IRS. Furthermore, Campbell's interests were subordinate, illiquid, and not freely transferable. Because the interests had no determinable fair market value at the time of receipt, they did not constitute taxable income in the years they were received.
Analysis:
This decision established a crucial safe harbor for service partners, particularly in startups and speculative ventures, clarifying that the receipt of a pure profits interest is not immediately taxable if its value is uncertain. It significantly limited the scope of the earlier Diamond decision, shifting the inquiry from whether a profits interest is 'property' to whether its value can be reliably determined at the time of grant. This holding provided much-needed certainty in partnership formation and compensation, encouraging the use of profits interests to align the incentives of founders and service providers without creating an immediate, and potentially unaffordable, tax liability.
