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Prop Regs on Disguised Payments for Partnership Services Focus on Importance of Entrepreneurial Risk.

(Parker Tax Publishing July 30, 2015)

On July 23, the IRS issued proposed regulations (REG-115452-14) under Code Sec. 707 which provide guidance to partnerships and their partners on when an arrangement will be treated as a disguised payment for services. The proposed regulations stress that entrepreneurial risk is the most important factor to consider and an arrangement that lacks significant entrepreneurial risk will be considered a disguised payment for services.

The proposed regulations also provide notice of proposed modifications to Rev. Procs. 93-27 and 2001-43, relating to the issuance of interests in partnership profits to service providers, as well as proposed changes to the guaranteed payment rules under Code Sec. 707(c).

The proposed regulations would apply to all arrangements entered into or modified after the date final regulations are published. If an arrangement was entered into or modified on or before that date, the determination of whether it is a disguised fee for services under Code Sec. 707(a)(2)(A) would be based on the statute and the guidance provided in the legislative history of Section 73 of the Tax Reform Act of 1984.

Background

Code Sec. 707(a)(2) was enacted as part of the Tax Reform Act of 1984 and grants the IRS authority to issue regulations identifying transactions involving disguised payments for services. Code Sec. 707(a)(2)(A) provides that if a partner performs services for a partnership and receives a related direct or indirect allocation and distribution, and the performance of services and allocation and distribution, when viewed together, are properly characterized as a transaction occurring between the partnership and a partner acting other than in its capacity as a partner, the transaction will be treated as occurring between the partnership and one who is not a partner under Code Sec. 707(a)(1).

The grant of authority to issue regulations under Code Sec. 707(a)(2) stemmed from Congress's concern that partnerships had been used effectively to circumvent the rule to capitalize certain expenses, and other rules and restrictions concerning various types of expenses, by making allocations of income and corresponding distributions in place of direct payments for property or services.

Congress determined that allocations and distributions that were, in substance, direct payments for services should be treated as a payment of fees rather than as an arrangement for the allocation and distribution of partnership income. Congress differentiated these arrangements from situations in which a partner receives an allocation (or increased allocation) for an extended period to reflect its contribution of property or services to the partnership, such that the partner receives the allocation in its capacity as a partner. In balancing these potentially conflicting concerns, Congress anticipated that the regulations would take several factors into account in determining whether a service provider would receive its putative allocation and distribution in its capacity as a partner, with the most important factor being whether the payment is subject to significant entrepreneurial risk as to both the amount and the fact of payment.

Arrangements Treated as Disguised Payments for Services

Under Prop. Reg. Sec. 1.707-2(b), an arrangement is treated as a disguised payment for services if:

(1) a person (service provider), either in a partner capacity or in anticipation of being a partner, performs services (directly or through its delegate) to or for the benefit of the partnership;

(2) there is a related direct or indirect allocation and distribution to the service provider; and

(3) the performance of the services and the allocation and distribution, when viewed together, are properly characterized as a transaction occurring between the partnership and a person acting other than in that person's capacity as a partner.

If an arrangement is treated as a disguised payment for services under these rules, it is treated as a payment for services for all purposes of the Code. Thus, the partnership must treat the payments as payments to a non-partner in determining the remaining partners' shares of taxable income or loss. Where appropriate, the partnership must capitalize the payments or otherwise treat them in a manner consistent with the recharacterization.

In the preamble to the proposed regulations, the IRS states that Code Sec. 707(a)(2)(A) generally should not apply to arrangements that the partnership has reasonably characterized as a guaranteed payment under Code Sec. 707(c).

Application and Timing

The proposed regulations apply to a service provider who purports to be a partner even if applying the regulations causes the service provider to be treated as a person who is not a partner. Further, the proposed regulations may apply even if their application results in a determination that no partnership exists. The regulations also apply to a special allocation and distribution received in exchange for services by a service provider who receives other allocations and distributions in a partner capacity under Code Sec. 704(b).

The proposed regulations characterize the nature of an arrangement at the time at which the parties enter into or modify the arrangement. Although Code Sec. 707(a)(2)(A)(ii) requires both an allocation and a distribution to the service provider, the IRS noted that a premise of Code Sec. 704(b) is that an income allocation correlates with an increased distribution right, justifying the assumption in the proposed regulations that an arrangement that provides for an income allocation should be treated as also providing for an associated distribution for purposes of applying Code Sec. 707(a)(2)(A).

While the IRS acknowledged that some arrangements provide for distributions in a later year, and those later distributions may be subject to independent risk, it said that recharacterizing an arrangement retroactively is administratively difficult. Thus, the proposed regulations characterize the nature of an arrangement when the arrangement is entered into (or modified) regardless of when income is allocated and when money or property is distributed. The proposed regulations apply to both one-time transactions and continuing arrangements.

The proposed regulations do not address the timing of inclusion by the service provider or the timing of a deduction by the partnership other than to provide that each is taken into account by applying all relevant sections of the Code and all relevant judicial doctrines.

Prop. Regs Stress the Importance of Significant Entrepreneurial Risk

The proposed regulations follow Congress' lead in stressing entrepreneurial risk as the most important factor in determining whether or not an arrangement constitutes a payment for services. Under the proposed regulations, an arrangement that lacks significant entrepreneurial risk constitutes a disguised payment for services. An arrangement in which allocations and distributions to the service provider are subject to significant entrepreneurial risk will generally be recognized as a distributive share but the ultimate determination depends on the totality of the facts and circumstances.

Whether an arrangement lacks significant entrepreneurial risk is based on the service provider's entrepreneurial risk relative to the overall entrepreneurial risk of the partnership. For example, a service provider who receives a percentage of net profits in both a partnership that invests in high-quality debt instruments and a partnership that invests in volatile or unproven businesses may have significant entrepreneurial risk with respect to both interests.

The following facts and circumstances create a presumption that an arrangement lacks significant entrepreneurial risk and will be treated as a disguised payment for services unless other facts and circumstances establish the presence of significant entrepreneurial risk by clear and convincing evidence:

(1) capped allocations of partnership income if the cap is reasonably expected to apply in most years;

(2) an allocation for one or more years under which the service provider's share of income is reasonably certain;

(3) an allocation of gross income;

(4) 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

(5) 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 timely notify the partnership and its partners of the waiver and its terms.

Secondary Considerations in Determining If an Arrangement Is a Payment for Services

Besides entrepreneurial risk, the proposed regulations list the following additional factors the IRS will consider in determining whether or not an arrangement constitutes a payment for services:

(1) the service provider holds, or is expected to hold, a transitory partnership interest or a partnership interest for only a short duration;

(2) 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;

(3) 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;

(4) the value of the service provider's interest in general and continuing partnership profits is small in relation to the allocation and distribution; or

(5) 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 Code Secs. 707(b) or 267(b), and the terms of the differing allocations or distributions are subject to levels of entrepreneurial risk that vary significantly.

Example: ABC Partnership constructed a building that is projected to generate $100,000 of gross income annually. Al, an architect, performs services for ABC for which Al's normal fee would be $40,000 and contributes cash in an amount equal to the value of a 25 percent interest in ABC. In exchange, Al will receive a 25 percent distributive share for the life of the partnership and a special allocation of $20,000 of ABC gross income for the first two years of the partnership's operations. The ABC partnership agreement satisfies the requirements for economic effect, including requiring that liquidating distributions are made in accordance with the partners' positive capital account balances. The special allocation to Al is a capped amount and the cap is reasonably expected to apply. The special allocation is also made out of gross income. Under the proposed regulations, the capped allocations of income and gross income allocations are presumed to lack significant entrepreneurial risk. No additional facts and circumstances establish otherwise by clear and convincing evidence. Thus, the allocation lacks significant entrepreneurial risk. Accordingly, the arrangement provides for a disguised payment for services as of the date that Al and ABC enter into the arrangement and the payment should be included in income by Al.

Modifications to Revenue Procedures 93-27 and 2001-43

Rev. Procs. 93-27 and 2001-43 provide guidance on the treatment of the receipt of a partnership profits interest for services provided to or for the benefit of the partnership and lists specific situations to which the procedures do not apply. In the preamble to the proposed regulations, the IRS indicates that it intends to modify the exceptions set forth in those revenue procedures to include an additional exception for profits interests issued in conjunction with a partner forgoing payment of a substantially fixed amount. (Staff Editor Parker Tax Publishing)

Disclaimer: This publication does not, and is not intended to, provide legal, tax or accounting advice, and readers should consult their tax advisors concerning the application of tax laws to their particular situations. This analysis is not tax advice and is not intended or written to be used, and cannot be used, for purposes of avoiding tax penalties that may be imposed on any taxpayer. The information contained herein is general in nature and based on authorities that are subject to change. Parker Tax Publishing guarantees neither the accuracy nor completeness of any information and is not responsible for any errors or omissions, or for results obtained by others as a result of reliance upon such information. Parker Tax Publishing assumes no obligation to inform the reader of any changes in tax laws or other factors that could affect information contained herein.

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