Disguised Payments Defined as Proposed Regulations Issued
By Jeff Winland, tax partner
Current partnership law allows for many contributions and distributions of cash between a partnership and its partners to be treated as adjustments to the partner’s basis in his partnership interest, rather than a taxable event. However, there are certain situations where services or property are contributed and the classification of the transaction can change. IRC 707 sets forth rules that specify when a payment between partner and partnership would classify as a taxable event. Recently, the IRS has issued proposed regulations which seek to clarify the fact patterns that help distinguish between a disguised payment (taxable event) and an allocation of income.
Partnership rules classify allocations or distributions of cash between partners in three categories:
- 704(b), the partner’s distributive share of income;
- 707(c), guaranteed payments in return for “partner” related activities typically fixed in amount; and
- 707(a), payments to partner for performing services for the partnership in a manner other than acting as a partner.
A disguised payment exists predominantly in 707(a) where the partnership classifies a payment as an allocation or distribution of income when, if the act were not between the partnership and the partner, the payment would generally be classified as an expense to the partnership and ordinary income to the service provider.
Like most regulations, when determining if a disguised payment exists, all facts and circumstances should be analyzed. However, the IRS has proposed regulations that establish a “non-exclusive” six factor test for classifying a disguised payment:
- The arrangement lacks significant entrepreneurial risk (as determined based on the service provider’s entrepreneurial risk relative to the overall entrepreneurial risk of the partnership);
- The service provider holds, or is expected to hold, a transitory partnership interest or a partnership interest for only a short duration;
- The service provider receives an allocation and distribution in a time frame comparable to the time frame that a non-partner service provider would typically receive payment;
- The service provider became a partner primarily to obtain tax benefits that would not have been available if the services were rendered to the partnership in a third-party capacity;
- The value of the service provider’s interest in general and continuing partnership profits is small in relation to the allocation and distribution; and
- The arrangement provides for different allocations or distributions with respect to different services received, the services are provided either by one person or by persons that are related under sections 707(b) or 267(b), and the terms of the differing time and manner required under applicable law as determined by applying all relevant sections of the Internal Revenue Code to the arrangement.
The most important factor the IRS has put in focus is whether the allocation or distribution of income is subject to entrepreneurial risk. This pinpoints the fact that payments to partners are typically based on results of the company, while third parties (acting outside the partner role) receive payments that are not subject to this risk. The following circumstances have been proposed to show arrangement that lack this risk:
- Capped allocations of partnership income if the cap is reasonably expected to apply in most years;
- An allocation for one or more years under which the service provider’s share of income is reasonably certain;
- An allocation of gross income;
- An allocation (under a formula or otherwise) that is predominantly fixed in amount, is reasonably determinable under all the facts and circumstances or is designed to assure that sufficient net profits are highly likely to be available to make the allocation to the service provider (e.g., if the partnership agreement provides for an allocation of net profits from specific transactions or accounting periods and this allocation does not depend on the long-term future success of the enterprise); or
- An arrangement in which a service provider waives its right to receive payment for the future performance of services in a manner that is non-binding or fails to notify the partnership and its partners of the waiver and its terms in a timely manner.
Partnerships should pay close attention to payments to partners to be sure they are in line with these regulations.
Any tax advice contained in this communication (including any attachments) is not intended or written to be used, and cannot be used, for the purpose of (i) avoiding penalties under the Internal Revenue Code or under any state or local tax law or (ii) promoting, marketing or recommending to another party any transaction or matter addressed herein. Please do not hesitate to contact us if you have any questions regarding the matter.