Paul L. Caron

Saturday, May 31, 2008

From Human Capital to Capital Gains: The Puzzle of Profits Interests

Sarah Pendergraft (McKee Nelson, Washington, D.C.; J.D. 2007, Virginia) has published Note, From Human Capital to Capital Gains:  The Puzzle of Profits Interests, 27 Va. Tax Rev. 709 (2008).  Here is the abstract:

This note discusses the tax treatment of a “money and brains” partnership. The tax treatment of a “brains” partner who performs services in exchange for a capital interest in a partnership is well settled. The treatment of a partner who receives an interest only in the partnership’s profits, however, has been controversial. Under current law, a partner who receives a profits interest can avoid paying ordinary income tax on the return to her labor, instead paying only capital gains. This surprising feature of the tax law has received a great deal of scholarly attention. The current literature has not, however, considered the nature of the services that the brains partner performs in exchange for her profits interest in the partnership. By failing to consider the nature of the contributed services, commentators have overlooked the gray area between services and property. Drawing a clear distinction between services and property is important, as property contributed to a partnership in return for an interest in that partnership is a tax-free exchange, while the contribution of services for such an interest is taxable. Such a distinction can only be drawn by recognizing that some human capital should be considered a form of property. In order to appropriately tax service partners, it is necessary to distinguish the services they provide from the property they contribute in the form of human capital.

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