"Passthrough Partner Cancellation of a Nonlapse Restriction Compensation Surprise" by J Leigh Griffith Taxes - The Tax Magazine
A large percentage of closely held businesses restrict or even prohibit the owners’ ability to transfer their equity interests. Often these restrictions require the owner to sell the equity back to the entity or the other owners at a formula value, for example, book value, that is not anticipated to be a true fair market value. These and other permanent restrictions on equity interests are called nonlapse restrictions because by their terms they never go away or “lapse.”1 The purpose is often to permit new owners who are active in the business to be able to “buy in” but with the downside that upon ceasing to provide services to the entity, the “buy out” then uses the same formula.Surprise Compensation Can Almost Double the Anticipated Tax Cost to the Selling Equity Holder In the context of a third party purchasing the entity or substantially all of the assets of the entity, but desiring the service provider owners to continue to be involved in the business thereafter, a cancellation of the nonlapse restriction concerning the mandatory “buy out” formula can be a major tax trap for the service provider! If triggered, the service provider may find that he or she has compensation income equal to the difference between the transaction purchase price and the value of the equity owned encumbered by the nonlapse restriction (i.e., the formula buy out price).4 Rather than the expected federal long term capital gain taxable at 20 percent (or 23.8 percent),5 the service providerowner may find the tax at 39.6 percent 6 plus applicable Social Security and Medicare taxes.7 Considering both the corporate share of employer taxes and the employee, partner or independent contractor tax increases, Social Security and Medicare taxes, full federal tax cost on the compensation to the service provider can reach 43.4 percent.8 Essentially, the potential exists for the federal tax “hit” to essentially double what is expected. While the discussion of this column focuses on transactions, the cancellation of a formula purchase price nonlapse restriction with respect to a retiring service provider is equally applicable and perhaps much harder to demonstrate that it is not compensatory. The refusal by the service recipient to repurchase the equity interest in accordance with the terms of the nonlapse restriction can constitute a cancellation or lapse of a nonlapse restriction.9 An example would be a person who retires and is required to sell the equity back to the entity for book value but the entity pays a far greater fair market value to such person. Unless the taxpayer can carry the burden of proof that such additional amount is not compensation for services and the service recipient is not deducting such amount, the service provider will have compensation income as a result of such payment in excess of the formula amount.