The IRS has issued proposed partnership regulations that would treat certain partnership arrangements as disguised payments for services, rather than as an interest in the partnership. As a result, the income received from the disguised payments would be compensation, taxed as ordinary income, rather than a distributive share of partnership income that could be capital gain.
Payments from partnerships to partners for services include distributive shares under and a transaction in which the partner renders services in a capacity other than as a partner. Partnership allocations determined by partnership income and made to a partner, as a partner, are treated as distributive shares. A fixed payment to a partner for services, determined without regard to partnership income, is a guaranteed payment under rather than a distributive share.
Disguised payments for services
In 1984, Congress enacted an anti-abuse rule: If a partner provides services to a partnership and receives a related allocation and distribution, the transaction is treated as a payment of fees to a nonpartner, rather than a distributive share of partnership income to a partner. Proposed Reg. §1.707-2(b) uses these elements to define a disguised payment for services. The partnership must apply this characterization when it determines the partners’ distributive shares of partnership income.
Whether an arrangement is a disguised payment for services depends on the facts and circumstances. The regs propose six non-exclusive factors for making this determination, five based on the legislative history. The proposed regs treat the first factor, the existence of significant entrepreneurial risk, as decisive, and claim that this treatment reflects Congress’s view. Partners receive profits from a partnership based on its business success, while payments to third parties generally are not subject to this risk.
The regs describe arrangements that lack significant entrepreneurial risk. One example includes an allocation that is primarily fixed in amount and that is assured to be available. Another example includes an arrangement where the service provider waives its right to payment for future services in a nonbinding manner, or fails to timely notify the partnership of the waiver.
The other five factors are of secondary importance, and their weight depends on the particular case. The absence of one or more of these factors is not determinative. These other factors include whether:
The service provider’s partnership interest is transitory;
The service provider receives an allocation and distribution in a time frame typical for payments to a nonpartner;
The service provider became a partner to obtain tax benefits not available to a third party;
The value of the service provider’s interest is small compared to the allocation and distribution; or
The arrangement provides for different allocations that are subject to varying levels of entrepreneurial risk.
Examples 5 and 6 of Proposed Reg. §1.707-2(d) discuss fee waivers, where a partner agrees to forgo fees for services and to receive a share of future partnership income. In these examples, the arrangement reflects significant entrepreneurial risk by the service provider, who forgoes the right to fees before the service period begins and who executes a waiver that is binding, irrevocable, and clearly communicated to the other partners. The service provider will be allocated income from net profits that, at the time of the arrangement, are not likely to be available or reasonably determinable.
The regs would apply to arrangements entered into or modified after the publication of final regs. The IRS will characterize arrangements before that date based on the statute and the legislative history. The IRS believes that the proposed regs reflect Congress’s intent on treating arrangements as disguised payments for services.
If you have any questions regarding disguised payments, please do not hesitate to contact us.