Transactions with Partners
Is a guaranteed payment considered an interest in profits for purposes of § 707(b)?
A partner's distributive share is considered part of that partner's distributive share of partnership income. However, under § 1.707-1(c), § 707(c) guaranteed payment is not considered an interest in profits for purposes of § 707(b). Thus, must determine whether any partner receives compensation for services or for use of capital based on the partnership income. Note that income based compensation may exist even though it is not explicitly provided for in the partnership agreement. Consider the actual practices of the partnership rather than just the terms of the agreement. Note that "more than 50% of the profits interest" may be interpreted to include interests in losses as well.
When are allocations contingent in amount recharacterized as fees?
Allocations contingent in amount may be recharacterized as fees when: (1) The partner normally performs, has previously performed, or is capable of performing similar services for third parties, and (2) The allocation is determined in a manner that is substantially similar to the manner in which compensation for third parties is determined.
Why are partners incentivized to disguise the acquisition of property as a contribution of property to the partnership in exchange for a related allocation and distribution of income from the partnership?
Because the cost of acquiring property must typically be capitalized under § 263, by allocating the cost to the contributing partner, this reduces the amount of partnership income otherwise allocable to the partnership, and the result is the same as if there had been a deduction. § 707(a)(2)(A) is aimed at preventing a partnership from obtaining an effective deduction for the cost of services rendered, or property received that must otherwise be capitalized.
What factors are used to determine whether a partner is acting as a third-party in receiving allocations and distributions of partnership income in exchange for the transfer of property or rendition of services?
(1) Risk factor (2) Duration factor (3) Time factor (4) Purpose factor (5) Relative interest factor
What is a capped allocation?
A capped allocation is specified in terms of a percentage or fixed dollar amount of partnership income subject to an annual maximum amount that the partner could expect would apply in most years. Capped allocations and distributions require that the risk as to both amount and fact be significantly limited and would warrant third-party treatment. Similar treatment is provided for allocations lasting for a fixed number of years, during which the income to the partner is reasonably certain.
How is a guaranteed payment to a partner treated?
A guaranteed payment is treated as ordinary income to the recipient partner under § 707(c), even though paid to the partner for acting in the capacity of a partner.
What is required for a payment from the partnership to the partner to be characterized as a guaranteed payment?
In order for a transfer from the partnership to a partner to be treated as a guaranteed payment, the payment must be determined "without regard to the income of the partnership," and the recipient partner must have provided services or capital in the capacity of a partner. Thus, the two determinations that must be made are: Was the payment made to a partner acting in the capacity of a partner, either in return for the rendition of services, or for the use of capital? Was the payment determined without regard to partnership income?
How is purpose considered in determining whether a transaction between the partnership and a partner is treated as a third party transaction?
In order to determine whether a disguised sale exists, we must consider whether the recipient became a partner primarily to obtain tax benefits for himself or the partnership that would otherwise not have been available had he performed the services in a non-partner capacity. The focus of this factor is whether the allocation and distribution, if it had been structured as a payment to a third party or as a guaranteed payment, would be subject to the rules for capitalization and amortization under § 263 and § 709. Note that significant non-tax motives do not factor into the determination.
When is a guaranteed payment included in the recipient partner's income?
Issues may arise when the partnership and the partner have different accounting methods. The issue is whether an accrual method partnership can claim a deduction for an expense item accrued to a cash method partner, while the partner's obligation to include the item in gross income is postponed until payment is received. Under § 706(a), inclusions required for guaranteed payments are based on the partnership's income for any taxable year of the partnership ending within or with the taxable year of the partner. Under § 1.707-1(c), a partner must include such payments as ordinary income for his taxable year within or with which ends the partnership taxable year in which the partnership deducted such payments as paid or accrued under its method of accounting. Limited partners whose interests were redeemed by an accrual method partnership through the issuance of an installment note continued their partner status under § 1.736-1(a)(1)(ii), throughout the term of the note. Thus, interest paid pursuant to the note was considered a guaranteed payment, includable by the partners in the year accrued by the partnership. Where there is a cash method partnership and accrual method partner, the partner reports the guaranteed payment in the year of its payment and deduction by the partnership, regardless of the fact that the partner is an accrual method taxpayer.
How are payments to a partner by the partnership for the use of capital treated?
Payments for the use of capital should be treated as third-party payments where the recipient partner faces minimal risk with respect to the fact or amount of payment.
Where payments are treated as being made to a third party, what is the result to the partnership?
Payments treated as made to a third party are deductible by the partnership unless subject to the capitalization requirements under § 707(a), § 263, and § 263A. Thus, payments in return for the acquisition of property generally must be capitalized and give rise to a basis for the property. Note that guaranteed payments may give rise to a partnership deduction in computing taxable income, however they are also subject to the capitalization requirements.
When is a guaranteed payment deductible by the partnership?
Under § 707(c), a guaranteed payment is deductible by the partnership provided that the payment need not be capitalized. Under § 706, the recipient of a guaranteed payment is required to include the payment in income in the partner's taxable year in which the partnership deducts the payment. Guaranteed payments under § 707(c) are includable in the recipient partner's income in the year received even if the partnership failed to take them into account and claim a deduction, regardless of the fact that the payment had to be capitalized. Under Rev. Ruling 80-234, a basis adjustment would be available as guaranteed payments are a part of a partner's distributive share of profit.
When does a distribution made to a partner produce gain to the partner?
When the payment of a partner's distributive share is made, even in a later year, it is treated as a distribution under § 731 and produces gain to the partner only if distributed cash or marketable securities in an amount exceeding the adjusted basis of the partnership's interest.
How is duration considered in determining whether a transaction between the partnership and a partner is treated as a third party transaction?
If the recipient's status as a partner is transitory, the allocation and distribution are more likely a fee for services than a bona fide allocation of partnership income, and the partner would not be treated as acting as a partner in the situation. The fact that a partner's status as a partner is continuing is not relevant in determining whether the allocation and distribution in a particular situation should be viewed as occurring in a partner or non-partner capacity. Note however, that a long-term allocation and distribution to a continuing partner is unlikely to be treated as a third-party payment.
A is a partner in the ABC Partnership. The partnership leases a building from A at an annual rent of $20,000 (its fair rental value). A continues to depreciate the building. Assume that the ABC Partnership uses an accrual method of accounting, A is a cash-method taxpayer, A and the partnership are calendar-year taxpayers, and the payment is a § 707(a) payment. The partnership accrues the rental payment in Year 1, but does not make payment until April 1, Year 2. What result?
If this is a third-party transaction, focus on each separately (i.e., deduction in Year 1 and income in Year 2). However, potential abuse exists where A receives a deduction (1/3) in Year 1 and income inclusion in year 2. § 267(a)(2) postpones the deduction if recipient partner does not currently include income; thus the deduction follows income inclusion. § 267(e) treats the partnership as a related party as specified in § 267(b) and thus deduction is postponed to Year 2. Contrary to § 707(c), guaranteed payments in which income inclusion follows deduction and thus such abuse cannot arise.
How are payments of salary to the partner treated?
Under § 707(a), the entity theory applies to treat the payment of salary to a partner as a transaction between a third party and the partnership.
A and B are brother and sister. D, the father of C, sells the computers, with an adjusted basis of $10,000, to the ABC partnership for $6,000. A, B, and C have equal interests in the capital, profits, and losses of the partnership. What is the result to D and to the partnership?
D, the father of C, sells computer to the partnership. C only has a 1/3 interest in the partnership, so this sale does not meet § 707(b). However, § 267 comes into play, and C and D are related persons thereunder. The sale is treat as a sale of only 1/3 of the asset. Thus, loss of $4,000 arises, but only $1,667 is disallowed. The partnership is entitled to § 267(d) offset. Consider whether the aggregate approach should continue to apply and the offset be allocated exclusively to D upon suggested sale by partnership.
What are the categories that payments made by a partner to the partnership may fall into?
Depending on the characterization of the relationship between the partner and partnership as a result of the transaction, payments made by a partner to the partnership will fall into one of three categories: (1) If partner is acting in a capacity other than that of a partner, payment is treated as being made from the partnership to a third-party under § 707(a)(1). (2) If partner is acting in his capacity as a partner, payment is for services or the use of capital, and the amount of the payment is determined without regard to the income of the partnership. Payment is a guaranteed payment and is treated as a payment to a third party. (3) If the partner is acting in his capacity as a partner and the amount of the payment is determined with regard to the income of the partnership, the payment is treated as a distributive share of partnership income and is a distribution of property under § 704(a), § 702, and § 731.
When is gain on the sale of property by a person to a partnership, or vice versa, converted into ordinary income?
Gain on the sale of property by a person to a partnership (or vice versa) will not be converted into ordinary income unless the purchaser or seller owns an interest, actually or constructively, of more than 50% in the partnership. Under § 1231, gain may be capital gain where each equal partner sells property to the partnership because recharacterization does not apply. Must ensure that the profits interests and the capital interests are actually equal. · However, if both equal partners own real property as partners in another partnership, § 707(b)(2)(B) determines the results. Where two people own property as tenants in common, the characterization of gain would depend on whether the tenancy in common was a partnership for income tax purposes.
Why must guaranteed payments be determined without regard to the income of the partnership?
Guaranteed payments from the partnership to the partner must be made regardless of the partnership's taxable income for the year. Where the partner's receipt of a guaranteed payment is conditioned on the partnership's income, the payment is contingent and risk as to the fact or amount of payment exists so that the payment is not treated as being made to a third party. For example, under Pratt, where management fees were determined as a percentage of gross rentals received by the partnership, the fees constituted the partners' distributive share of partnership income and not a guaranteed payment. The result was that the payments were includable in the partners' gross incomes in the taxable year of the partners in which the partnership's taxable year ended, and no deduction was available to the partnership. Similarly, where payments to an adviser general partner are determined as a percentage of gross income, the services performed by the partner are in substance performed in the capacity of a person who is not a partner, and the payment is treated as a third-party payment. In contrast, guaranteed payments determined as a percentage of gross rentals should be treated as guaranteed payments. Where the compensation is determined by reference to gross income, it will be a guaranteed payment if it is compensation rather than a share of partnership profits.
What is the result where a payment is made to a recipient partner other than in the capacity as partner?
If payment is made to the recipient partner in a capacity other than that of partner, the payment is typically ordinary income determined as if the transaction involved an unrelated third party.
How is a payment to the recipient partner treated where the payment consists of a portion of the partnership's distributive share of income?
If the payment consists of a portion of the partner's distributive share of partnership income, it is characterized for tax purposes under the general rules of § 702 and § 704 applicable to distributive shares of partnership income and distributions of partnership property.
How is relative interest considered in determining whether a transaction between the partnership and a partner is treated as a third party transaction?
Relative interest considers the relationship between the value of the service partner's interest in general and continuing partnership profits and the value of the partner's allocation. Where the value of the continuing profits interest is small in relation to the value of the allocation and distribution at issue, the allocation and distribution are more likely a payment for the services rendered. The relative interest factor is relevant where the allocation is for a limited period of time. For example, where the partner's interest in partnership income is 1%, but the partner is entitled to an allocation of 50% of income for the year in which the services will be rendered, the allocation and distribution are more likely a fee that should be treated as a third-party payment. However, a substantial interest in the general and continuing partnership profits does not necessarily indicate that the allocation is not to be treated as a third-party payment. Even a partner with substantial continuing interest may have an allocation treated as payment depending on other factors.
How would an allocation and distribution to a partner for services rendered or property transferred that is subject to significant entrepreneurial risk as to the fact and amount of payment be treated?
The allocation and distribution to a partner for services rendered or property transferred that is subject to significant entrepreneurial risk as to the fact and amount of payment should be recognized as an allocation to a partner in his capacity as partner because there is sufficient risk that the partner will not see a return on his investment in the partnership. However, where the allocation and distribution involves limited risk, the transaction resembles a fixed fee for services or property and the partner receiving that allocation should be treated as acting in the capacity of a third party.
How is the allocation and distribution treated where instead of hiring an architect for $40,000 to construct an office building (the cost of which would be capitalized into the building) projected to generate gross income of $100,000), the partnership admits the architect as a partner contributing cash for a 25% interest in the partnership?
The allocation and distribution will be considered a third-party fee that must be capitalized. In this case, the architect received a 25% share of partnership net income and an allocation of $20,000 of gross income for the first two years of operations after the building was leased. Because the partnership was expected to have sufficient cash in the first two years to distribute the $20,000 allocation to the new partner, the architect received his usual $40,000 fee for services rendered. Factors leading to treatment as a third-party transaction: (1) Allocation was in a fixed amount and partnership was expected to have sufficient income to meet the allocation and distribution; (2) The general partnership interest held by the architect was small in relation to the allocation and distribution; (3) The allocation and distribution were close in time to the rendition of services; and (4) It was reasonable to assume that the transaction was structured as such for tax-motivated reasons. Thus, the architect was effectively isolated from the risk of the joint enterprise. § If instead of the fixed allocation of $20,000 of gross income in the first two years of partnership operations after the construction of the building, the architect received 20% of the partnership's gross income over the same time period, treatment of the transaction would depend on the likelihood that the architect would receive substantially more or less than his usual fee. For example, if the building were pre-leased, or there was low-vacancy rate for comparable space in the area, and $100,000 in rent could be expected each year, the architect would be considered as having assumed only limited risk that the normal fee would not be paid and the allocation and distribution would be treated as a disguised fee. However, if the building were a "spec building" and there was a "significant entrepreneurial risk" that the partnership would be unable to lease the building, the payment would be upheld as an allocation and distribution to a partner.
Are deductions for losses allowed from sales between a partnership and a controlling person?
The code provides for disallowance of losses arising between a partner and a partnership. Under § 707(b)(1)(A) and § 1.707-1(b), no deduction is allowed from the sale or exchange of property, other than an interest in the partnership, that occur directly or indirectly between a partnership and the person owning, directly or indirectly, more than 50% of the capital interest or profits interest in the partnership. This type of transaction is deemed to occur between the person and the controlled partnership. Under § 707(b)(1)(B), the loss disallowance rules apply in the case of a transaction involving two partnerships in which the same person owns, directly or indirectly, more than 50% of the capital or profits interest. Note that even non-partners may have their sales transaction with a partnership governed by this provision.
What is the distinction between § 707(a) payments and § 707(c) payments?
The distinguishing factor is whether the performance of services by one who is a partner is rendered in a capacity of being a partner (facts and circumstances test). Note that in either case, the recipient receives ordinary income, and the partnership is entitled to an attendant deduction. Payments under § 704(a) or § 731 are determined with respect to the income of the partnership. · Payments under § 707(a) or § 707(c) are not determined with respect to the income of the partnership. In a § 707(a) transaction where the purchaser (partnership) must capitalize the purchase price under § 263 and § 1012 and recoup it through depreciation and amortization deductions under § 167, 168, and § 197, treatment of parties will differ significantly from typical § 707(a) and § 707(c) principals. The seller of the property (partner) determines gain or loss by reference to the seller's relationship to the property sold (e.g., holding period and capital asset status).
Does the partnership deduct payments for payment of a partner's distributive share or for distribution of the partnership's property?
The partnership is not entitled to deduct payments that represent a partner's distributive share of partnership income and a distribution of the partnership's property. However, allocation to the recipient partner reduces the amount of income otherwise allocable to the other partners, so the effect of the allocation is similar to a deduction. Note that the allocation may be treated as a payment under § 707(a)(1) and be subject to § 263 under § 707(a)(2)(A), where the allocation is structured in order to circumvent the capitalization requirements.
What is the main factor used to determine the classification of a transaction between the partner and the partnership?
The risk faced by the recipient partner with respect to the fact of payment is used to classify the transaction between the partner and partnership.
How is the risk surrounding an allocation and distribution determined?
The risk surrounding allocation and distribution must be considered in relation to the risks of the partnership itself, and not in relation to some degree of outside risk. So where the partnership is engaged in a low-risk business, the allocation and distribution will be subject to a similar low level of risk. The partner receiving the allocation will not be considered as engaged in a third-party transaction because of the absolute level of risk involved.
A and B are brother and sister. A sells a computer used in his business, with an adjusted basis of $10,000, to the ABC partnership for $6,000. A, B, and C have equal interests in the capital, profits, and losses of the partnership. What are the results to A and the partnership?
The sale to the partnership generates a $4,000 loss for A. Under § 707(a), this would be a capital loss transaction. § 707(b) is concerned about trafficking in losses. - Sale from partner (directly or indirectly) owning more than 50% to partnership results in loss disallowance to the partner and carryover loss to partnership. Under the constructive ownership rules, family includes siblings, therefore no loss is allowed here. If the sale was by mother, although the regulations reference to sale by a "partner," the statute changes reference to "person," so the result would likely not be different. If the partnership subsequently sells the computer to an unrelated party, what are the results to A and the partnership? If the partnership sells asset for $7,000. - Gain of $1,000, but is offset by carryover loss of $4,000, which disappears. - Assuming A, B, and C contributed $10,000 cash each and partnership purchased the asset, each would have an increase to post-sale tax and book accounts of $333. If the partnership sells asset for $14,000, it has actual gain of $8,000, but sheltered by the carryover loss of $4,000. Thus, the partnership is only taxed on the excess of $4,000. Post-sale, the partnership has $38,000 cash, and A, B, and C's tax and book basis increases by $2,666. We don't use the § 704(c) approach, making the sale taxable to non-seller partners to the extent of book because A and B each recognize $2,000 of taxable gain, which is less than book of $2,667. Otherwise, $1,333 each to A, B, and C.
A is a partner in the ABC Partnership. The partnership leases a building from A at an annual rent of $20,000 (its fair rental value). A continues to depreciate the building. How should the transaction be characterized?
The starting point recognized by the code is separate and distinct third-party relationship, thus focus on capacity. § 707(a) addresses this issue, stating that where a transaction occurs in a non-partner capacity, it is treated as being with a third-party, even if it is a transaction with a partner. The partnership needs a building and A happens to have one. A leases the building to it for $20,000. Under § 707(a), the transaction is treated as being with a third-party. Focus on the nature of the transaction and accounting method. Here, this is rental income, and therefore ordinary income to A. The partnership has $20,000 deduction for rent. Amortize or depreciate this amount if it is a capital expenditure. The reality of the transaction is that: - B and C receive their share of the deduction ($6,666), representing the depletion of their income or capital. - A includes the $20,000 offset by his share of the deduction ($6,666) = net of $13,333.
The AMB Partnership (a law firm) agreement provides that A, one of its partners, will receive a "salary" of $21,000 per year for his services as a lawyer without regard to the partnership's income, plus 1/3 of the taxable income or loss of the partnership's deduction for A's salary. At the end of the year, before deducting A's salary, the partnership has net ordinary income of $12,000, long-term capital gain of $30,000, and short-term capital gain of $9,000. Before year-end, it pays $21,000 to A. The partnership and its partners are cash-method, calendar year taxpayers. What are the results to A and the partnership?
The transaction here appears to be in a partnership capacity. If so, § 707(c), rather than § 707(A), treats the payment as made to a third party, but timing rules provide that the recipient's income inclusion follows deduction by partnership. Both are cash method taxpayers, so Year 1 when paid. Since the payment is for services rendered, ordinary deduction to the partnership and ordinary income to the partners. If payment was for a capital expenditure, capitalize and depreciate or amortize over life. Because it is deductible, the partnership has $9,000 ordinary income, $30,000 LTCG, and $9,000 STCG. A's share is $3,000 ordinary income, $10,000 LTCG, and $3,000 STCG. Still, the case that A has funded 1/3 of the payment. A would have received $4,000 (1/3 of $12,000) and instead lost $3,000 ($7,000 differential). See § 1.707-1(c), example (1). If the partnership is an accrual method taxpayer, which postpones the $21,000 salary payment to A until Year 2, if this is a guaranteed payment, it will have symmetry in all cases. Under § 706 and § 1.707-1(c), the accounting method of the partnership is controlling for the recipient's income inclusion. Thus, even though A is cash method, must include as income in Year 1 when accrual method partnership deducts in Year 1.
How is a transaction treated where an agreed foreclosure sale is followed by an agreed sale back to the mortgagor?
Under Davis v. Commissioner, the court held that § 707(b)(1)(B) applies to an agreed foreclosure sale followed by an agreed sale back to the mortgagor, treating the transaction as an indirect sale between two related partnerships due to the pre-arranged aspect of the transaction.
What is the treatment of management fees paid to the partners for management services rendered pursuant to the partnership agreement?
Under Rev. Rul. 81-300, management fees paid to partners by the partnership are treated as payments determined with respect to partnership income and not guaranteed payments. Although the partnership was accrual method, and the partners were cash method taxpayers, the income was includable by the partners in the year in which the services were rendered, rather than in the year the partners ultimately received the payments.
What is the treatment of payments to the adviser general partner, who under the terms of the partnership agreement, was authorized to manage the investment of the partnership's assets and was responsible for the payment of any expenses incurred as a result of its investment advisory duties, including office space, equipment, and personnel.
Under Rev. Rul. 81-301, because adviser's services were substantially similar to the services rendered as an independent contractor or agent to parties other than the partnership and under the partnership agreement, the advisor was not precluded from providing the same services to others, the adviser partner was not considered to be acting in his capacity as a partner in rendering the services for which he received compensation and the payments received were properly treated as payments to third parties.
Under § 704, what is the character of income to the partner?
Under the entity approach used by § 704, the character of income in the hands of the partner is dependent on its characterization at the partnership level. When the payment is made, even in a later year, it is treated as a distribution under § 731 and produces gain to the partner only if distributed cash or marketable securities in an amount exceeding the adjusted basis of the partnership's interest.
What is the character of income from a guaranteed payment to the recipient partner?
Under the entity theory of taxation, a guaranteed payment is treated as being made in the context of a third party relationship between partner and partnership. Under the aggregate theory of taxation, determination of the character of a guaranteed payment focuses on composition of partnership earnings for the year. The entity approach is applied to guaranteed payments. So, guaranteed payments are treated as ordinary income to the recipient partner, even where all income of the partnership is capital gains or tax exempt income. See example page 11-38-39; § 1.707-1(c), examples (3) and (4). The regulations require that a guaranteed payment to a partner arises solely from the ordinary income of the partnership. If ordinary income is less than the amount of the guaranteed payment, the income is converted to an operating loss which will be allocated among the partners. No part of the guaranteed payment is considered a distribution of the partnership's capital gain.
Does loss limitation apply to certain sales between two partnerships?
Under § 707(b)(1)(B), losses are disallowed from the sale or exchange of property, directly or indirectly, between two partnerships in which the same person own, directly or indirectly, more than 50% of the capital interests or profits interest. Note that one partner need not own more than 50% of the capita or profits interest in both partnerships for the loss to be disallowed.
How is the character of a guaranteed payment determined when a partner is entitled to receive a salary payment equal to the greater of a specified amount or a fixed percentage of partnership income computed before the guaranteed payment is taken into account?
Under § 1.707-1(c), example (2), a guaranteed payment arises only when the specified amount is greater than the partner's distributive share of partnership income, and then only to the extent that the specified amount exceeds the partner's distributive share of income. A guaranteed payment generally does not affect the computation of a partner's distributive share of income. Under Revenue Ruling 66-95, even where a partnership provides for minimum payments to partners, the payment should be treated as if it were an expense of the partnership, it will not control whether the entire minimum payment will be considered an expense for federal income tax purposes. - Under this ruling, only the difference between the partner's guaranteed minimum and their distributive share of partnership income is a guaranteed payment for Federal tax purposes because only the amount determined under § 707(c) should be considered a business expense under § 162(a) for federal income tax purposes. The preferable solution is to apply regulations and interpret the partnership agreement as providing that the partner is only to share in those loss items not attributable to the guaranteed payment. - This requires determinations of partner's expectations as to which of the partners is to bear the economic burden of the excess payment to that partner. - See Revenue Ruling 69-180, where partnership income consisted of capital gain and ordinary income, and the guaranteed payment of $100 or 30% of partnership income to one partner was attributable to the partnership's ordinary income and deducted only from ordinary income, the remaining payment to which the partner was entitled was made from capital gain (but not deducted from the capital gain).
When does § 1239 apply to characterize gain realized on the sale of property between a partner and partnership as ordinary income?
Under § 1239, gain recognized on the sale of property between a partner and partnership is ordinary if the property is depreciable in the hands of the transferee and the partner owns more than a 50% interest in the capital or profits of the partnership. Under § 707(b)(2), the provision also applies to any property that is a capital asset in the hands of the transferee, rather than just depreciable property. Under § 1239, congress intended to apply to partners and partnerships to limit abuse in installment sale transactions. Note § 1239 will rarely apply to a transaction in which § 707(b)(2) is inapplicable because § 707(b)(2)(B) is broader than § 1239.
When may the partnership deduct the accrued liability where a cash method partner renders services to an accrual method partnership in a capacity other than that of a partner?
Under § 267(a)(2), where a cash method partner renders services to an accrual method partnership in a capacity other than that of a partner, the partnership may not deduct the accrued liability until the payment is includable in the income of the recipient partner under his method of accounting. The result of deferral of the deduction by an accrual method partnership for which services are rendered by a cash method partner in year 1, even where the payment is not actually made until year 2.
How is the sale of tenancy in common property by two unrelated individuals to an equal partnership treated, if the tenancy in common is classified as a partnership for tax purposes?
Under § 267(b), the sale to an equal partnership by two unrelated individuals of tenancy in common property, if the tenancy in common is classified as a partnership for tax purposes, will be treated as a transaction involving a sale between two commonly controlled partnerships governed by § 707(b)(1).
Where gain is realized on subsequent disposition of property contributed to the partnership and loss was disallowed on the transaction, will the loss be permanently disallowed?
Under § 267(d) and § 707(b)(1), loss may not be permanently disallowed where gain is realized on subsequent disposition of the property. Gain is recognized only to the extent that it exceeds the loss previously disallowed. Note, in order to prevent the importation of tax loss to a tax-indifferent related party, § 267(d) provides that the gain recognized by the transferee will not be reduced by the amount of the disallowed loss of the transferor to the extent that the loss would not be taken into account in determining the transferor's tax imposed. Thus, the transferee's basis in the property would be the cost of the purchased asset. o See PLR 201613001. Note that a special allocation would likely be required under § 704(b), where the partner transferring disallowed loss property, which is later sold for a gain, because the partner will only benefit from the reduction in gain to the extent of her interest in the partnership, creating a disparity. · See example page 11-62-63. Special allocation of partnership's gain from the subsequent sale of property properly reflects the economic reality of the two transactions.
What is the result where the amount of a partner's compensation is limited to the partner's distributive share of partnership income?
Under § 702, the aggregate theory applies where the amount of a partner's compensation is limited to the partner's distributive share of partnership income.
Under § 704, when is income taxed to the partner?
Under § 704, the entity approach is used for measurement and calculation of income and the income is taxed to the partner when earned by the partnership.
In the case of a guaranteed payment, when does the recipient include the payment into income?
Under § 706 and § 1.707-1(c), the accounting method of the partnership is controlling for the recipient's income inclusion. Thus, even where the recipient is cash method, he must include a guaranteed payment as income in Year 1 when the accrual method partnership deducts in Year 1.
When must a partner include in his income the payment that is considered a part of the partner's distributive share of partnership income?
Under § 706(a), a payment that is considered part of a partner's distributive share of partnership income is includable in the partner's income in the year in which the income is earned by the partnership, regardless of the partner's method of accounting or the year of actual distribution. The actual distribution of the distributive share by the partnership is subject to § 731 and may give rise to other tax consequences if the amount distributed exceeds basis of the distributee partner's partnership interest.
When is a guaranteed payment includable in the partnership's income?
Under § 707(a) and § 707(c), a guaranteed payment is includable in the partner's income in the taxable year during which it is entitled to deduct the payment under its method of accounting. The result is the acceleration of income for a cash method partner who renders services to an accrual method partnership in Year 1, but the payment is not actually made until Year 2. Note that the capitalization and amortization of a guaranteed payment does not permit the recipient partner to defer inclusion of the guaranteed payment in gross income over the amortization period.
Why are guaranteed payments to a partner generally treated as payments to a third party under § 707(c)?
Under § 707(a)(1), when the risk of receiving the allocation and distribution is minimal, the recipient partner will be considered as acting in the capacity of a non-partner. Because guaranteed payments are generally fixed in amount, the recipient partner's risk of actually receiving the payment is minimal and would be treated as a payment to a third-party under § 707(c).
In order for the limitation on loss deductions in a sale between a partnership and a controlling person, what is required?
Under § 707(b)(1), the person involved must own more than a 50% interest in the partnership for the limitation to apply, taking into account the constructive ownership rules under § 707(b)(3) and § 1.707-1(b)(3). So, if A and B are equal partners and are not related to each other, either A or B could sell property to the partnership for a loss, which would be allowable. Regardless of what is stated in the partnership agreement, a determination should be made that the capital accounts of the partners are actually equal. Where drawing accounts are reflected in the partnership's accounting records, the partnership agreement should specify that the drawing account balances are separate and distinct from the partners' interests in the capital of the partnership.
What is the effect where a transferee has subsequent gain on the sale of a disallowed loss property?
Under § 707(b)(1), where loss is disallowed under § 267(a)(1), § 267(d) treats disallowed loss in the same manner. Where the transferee has subsequent gain on the sale of disallowed loss property, that gain may be offset by the previously disallowed loss.
What is the treatment of gain recognized in connection with the sale or exchange of property between partners or partnerships and their controlled partnerships?
Under § 707(b)(2), any gain recognized in connection with the sale or exchange of property between partners or partnerships and their controlled partnerships must be treated as ordinary income if the property is something other than a capital asset in the hands of the transferee. Under § 707(b)(2)(A), the recharacterization will apply only to the sale or exchange of property, directly or indirectly, between a partnership and a person owning, directly or indirectly, more than 50% of the capital interest, or the profits interest in the partnership. Under § 707(b)(2)(B), recharacterization will also apply to a transaction involving two partnerships in which the same persons own, directly or indirectly, more than 50% of the capital or profits interests.
When is a person deemed to constructively hold an interest in partnership capital or profits held by related parties?
Under § 707(b)(3) and § 267(e), the attribution rules applicable to the stock of a corporation are applied to determine the constructive ownership of the capital or profits interest in a partnership. The consequence is that a person is deemed to constructively hold interest in partnership capital or profits held by related parties, in addition to the actual interests owned by that person. Applicable rules for constructive ownership of an interest in capital or profits of a partnership: (1) A capital interest or profits interest in a partnership owned, directly or indirectly, by or for a corporation, partnership, estate, or trust is considered as owned proportionately by or for its shareholders, partners, or beneficiaries; and (2) An individual is considered as owning any capital interest or profits interest owned, directly or indirectly, by or for members of his family. Note that a capital or profits interest in a partnership constructively owned by an individual by application of the family ownership rules is not attributed to any other person.
When can losses arising between a partnership and a person who is not a partner?
Under § 707(b)(3), losses are disallowed if they arise between a partnership and a person who is not a partner if under the constructive ownership rules that person's interest in capital or profits is greater than 50%. Even if § 707(b)(1) is not applicable, the transaction must be tested under the general loss provisions of § 267. Regulations under § 267 will disallow a loss arising in a transaction between a partnership and a person who does not constructively own more than 50% of the capital or profits interest in the partnership, but is related to one or more of the partners under § 267(b). The loss limitation applies to sales or exchanges directly or indirectly between a partnership and a controlling person because the intent is to deny loss for successful use of an unrelated party and a two-step transaction to accomplish what would otherwise not be accomplished directly.
A is a 90% partner in the AB Partnership. A sells vacant land with an adjusted basis of $50,000 to the partnership for $200,000. The partnership begins subdividing the property into lots for sale. What are the tax consequences to A? What if A held the property primarily for sale?
Under § 707(b), a sale between person owning more than 50% and a partnership, for which the property is not a capital asset, generates ordinary income. The issue is whether the land is a capital asset to the partnership. If not, then the sale is treated as generating ordinary income even if property was a capital asset in the hands of A. If A is a dealer in land, § 707(b) is irrelevant because his sale to anyone would generate ordinary income. If A's mother, D, sells vacant land to the partnership, we get the same result where the property sold does not constitute a capital asset to the purchasing partnership. Employ constructive ownership rules for the partnership and any person. Thus, D has $150,000 ordinary income.
What is the treatment of a transaction between a partnership and a partner or related person owning more than 50% of the capital or profits interest in the partnership?
Under § 707(b), for transactions between a partnership and a partner or a related person owning more than 50% of the capital or profits interest therein; - Where there are losses, deduction is disallowed. - In the case of certain gains, potential capital gain is transmuted into ordinary income. Note that under § 1.267(b)-1(b), an aggregate approach applies in cases where the partnership is not controlled and the sale takes place between the partnership and a person related to the partner. Thus, the loss realized by the partnership or such person is disallowed to the extent it is reflected in the related partner's distributive share of partnership loss or proportionate interest in the acquired assets.
What are the tax implications of a guaranteed payment from the partnership to a partner?
Under § 707(c) and § 1.707-1(c), if all or a portion of any transfer from a partnership to a partner is properly classified as a guaranteed payment, it is treated as made to one who is not a member of the partnership, but only for the purposes of § 61 and § 162(a) (subject to § 263). The recipient partner must include the guaranteed payment in gross income as ordinary income and the partnership must deduct the payment as a business expense unless the payment must be capitalized. Note that § 265 may operate to deny a deduction for any portion of a guaranteed payment that relates to tax-exempt income (necessary in order to avoid tax arbitrage). The entity approach is applied to determine the character of guaranteed payments, treating the payment as occurring between a partnership and a third party, rather than a partner.
How is an allocation and distribution treated where a broker joins a partnership formed to invest stock, contributing 51% of the partnership's capital and receiving 51% in the profits and losses in addition to an allocation of gross income that approximated his foregone commissions?
Where a broker joins a partnership formed to invest stock, contributing 51% of the partnership's capital and receives a 51% in the profits and losses in addition to an allocation of gross income that approximated his foregone commissions, the allocation was deemed to constitute normal brokerage fees, varying with the value and amount of services rendered rather than partnership income. Thus, the senate committee ruled the allocation to be a payment to a third party and not a partnership allocation. The risk factor was most important in this determination. - Because the allocation was determined as a function of the value or amount of services rendered, the partnership removed the upside potential and downside risk that the partner would have borne if the allocation were a straight share of partnership income. Additionally, the partnership would have sufficient income to make the distribution, so the broker did not bear the risk and must be treated as a third-party receiving a fee for services.
How is time considered in determining whether a transaction between the partnership and a partner is treated as a third party transaction?
Where allocation and distribution are close in time to the actual rendition of services, it is most likely a payment for services. If the allocation and distribution are extended over time or are remote when the services are rendered, the payment is less likely to be related to services. The longer the time period between the rendition of services and the allocation and distribution, the greater the risk that the payment will not be made, so the allocation and distribution are less likely to be deemed payment for services.
How may a partnership circumvent the loss disallowance rule under § 707(b)(1)(B)?
Where partnerships are considered "commonly controlled" rather than selling property from one to another at a loss, which would be disallowed, the partnership may sell property at a loss to an unrelated party to take advantage of the loss, or may lease property to the related partnership.
The AMB Partnership (a law firm) agreement provides that A, one of its partners, will receive a "salary" of $21,000 per year for his services as a lawyer without regard to the partnership's income, plus 1/3 of the net ordinary income of the partnership, as determined after taking into account all expenses except any guaranteed payment, but not less than $21,000. In addition, he is to receive 1/3 of the net operating losses of the partnership, as determined after taking into account all expenses except any guaranteed payments. Capital gains and losses are to be shared equally among the three partners. What result of the net ordinary income of the partnership (before deducting any guaranteed payment) is $90,000? What result of the net ordinary income of the partnership (before deducting any guaranteed payment) is $30,000? What result of the net ordinary income of the partnership (before deducting any guaranteed payment) is $12,000?
Where the net ordinary income of the partnership (before deducting any guaranteed payment) is $90,000: - A's 1/3 distributive share is $30,000 -Current regulations conclude that there is no guaranteed payments (§ 1.707-1(c), example (2)). Where the net ordinary income of the partnership (before deducting any guaranteed payment) is $30,000: - Start with a $10,000 distributive share. - Thus, $11,000 shortfall, which regulations conclude is guaranteed payment. - Although not addressed by the example in regulations, guaranteed payments are deductible under the code. - A has $10,000 net income and $11,000 guaranteed payment. - The partnership therefore has remaining income of $30,000 - $11,000 = $19,000. - Of that amount, $10,000 is allocated to A. - B and C share equally the remaining $9,000 (i.e., $4,500 each). - Initially, B and C were entitled to $10,000, but each released $5,500 to A, leaving them with $4,500. - Example in regulations does not address allocation of deduction, so we are left with the question of whether B and C intended to bear the cost, or was A to share in it as well? Where the net ordinary income of the partnership (before deducting any guaranteed payment) is $12,000? - A is entitled to a $4,000 distributive share, and thus guaranteed payment of $17,000. - Partnership income is $12,000 - $17,000 = $5,000 loss. - A's share is determined to be $4,000, which leaves ($9,000), resulting in $4,500 loss for each of B and C. - Each of B and C bore $8,500 of A's guaranteed payment. Difficulty arises under the new Proposed Regulation § 1.707-1(c), example (2) and how to integrate into this analysis. The proposed regulation finds guaranteed payment for the minimum amount. In all three cases, apparently there would be a guaranteed payment of $21,000. Thus, for A, the example would characterize the $21,000 of guaranteed payment and $9,000 distributive share. Partnership income ($90,000 - $21,000 = $69,000). From the remainder, the regulation provides $9,000 to A, yielding $30,000 total to A, $30,000 to B, and $30,000 to C. Note that A bears all, and we must consider whether this was the intent of the parties? Note: proposed regulations fail to address other possibility (i.e., where distributive share is less than guarantee). If the partnership income is $30,000, it appears that the guaranteed payment of $21,000 is deducted and reduces income to $9,000.
Why is risk the most important factor in determining whether an arrangement constitutes a payment for services?
Whether the allocation and distribution are subject to significant entrepreneurial risk is important in determining whether an arrangement constitutes a payment for services because a partner's allocation and distribution of partnership profits is subject to the risk of the undertaking, whereas a third party attempts to insulate himself from risk. A high probability of payment may effectively insulate the partner from the risks of the partnership, and when allocations are coupled with actual distributions, should be properly characterized as fees. Allocations that appear to constitute distributive shares may be fixed in amount when they are designated, in terms of a specific dollar or percentage amount, and reasonably can be determined under the circumstances. Analysis of entrepreneurial risk applies to both short-lived allocations and continuing arrangements.
Assume that the AB Partnership intends to construct an office building, which is expected to generate $100,000 of rental income per year. C is an architect and is admitted as a one-fourth partner in return for contribution of $90,000 cash. The partnership agreement provides that C will receive a one-fourth interest in net profits and losses as well as an allocation of 15% of the gross income of the partnership for the first two years after his admission. What are the tax consequences to C and to the partnership?
§ 707(a) and § 707(c) are two ways of compensating partners. An allocation of gross income for services rendered is effectively the same as a deduction. Congress enacted § 707(a)(2)(A) to safeguard allocations, focusing on entrepreneurial risk. If lacking entrepreneurial risk is lacking, then the payment to C is not in the capacity as a partner and the transaction is treated as a third-party expenditure In this problem, we have ¼ interest for contribution of $90,000 to the partnership. There is no problem under § 721, provided the payment is not for services. Payment to unrelated, non-partner architect for services would constitute a capital expenditure. If the architect becomes a partner and receives allocation of 15% of gross income, assuming cash flow from rental units is certain, C would receive $15,000 per year. Only $85,000 of net income each year is split three ways. The result is essentially the same as a deduction. § 707(a)(2)(A) treats the payment to C as a third-party payment, resulting in a deduction/ capital expenditure. This is viewed as a payment for non-partner services. In this case, a capital expenditure is amortized/ depreciated over time. § 707(a) and § 707(c) payments do not qualify under § 199A, thus the payments are treated as being made to third parties / employees.
The AB Partnership is an equal partnership between A and B. The CD Partnership is a partnership owned equally by the daughters of A and B. The AB Partnership sells property to the CD Partnership for use in its business. The CD Partnership pays $10,000 for this property, in which the AB Partnership has an adjusted basis of $4,000. What is the result?
§ 707(b) applies to sales between related partnerships, (i.e., more than 50% common ownership). AB partnership is owned by parents, CD Partnership owned by children. The statute applies to any non-capital asset, including § 1231. - Assuming the asset constitutes a non-capital asset to the partnership, must determine if AB and CD are related/controlled partnerships. AB and CD are related through constructive ownerships. - A owns 50% of CD and B owns 50% of CD due to constructive attribution from daughters. - Therefore, amount realized $10,000 minus adjusted basis $4,000 yields $6,000 ordinary income. - Relationship is based on ownership of partnership once it hits 50% threshold. Thus, the statute would apply even if A owns 90% of adjusted basis and C, his daughter, owns 10% of CD while B owns 10% AB and D's daughter owns 90% of CD. - Related individuals here do not own more than 50% of each, but statutory focus is on partnerships when viewed as groups.
What is the result of a transaction between a partnership and a partner or related person owning more than 50% of the capital or profits interest therein?
§ 707(b) governs transactions between a partnership and a partner or a related person owning more than 50% of the capital or profits interest therein. § 707(b) disallows the deduction where there are losses. Under § 707(b), in the case of certain gains, potential capital gain is transmuted into ordinary income. § 1.267(b)-1(b) applies an aggregate approach in cases where the partnership is not controlled and the sale takes place between the partnership and a person related to the partner. Thus, the loss realized by the partnership or such person is disallowed to the extent it is reflected in the related partner's distributive share of partnership loss or proportionate interest in the acquired assets.
When does § 707(b)(2)(B) apply to recharacterize a transaction involving two partnerships in which the same person owns, directly or indirectly, more than 50% of the capital or profits interest?
§ 707(b)(2)(B) will only apply where the property sold is "other than a capital asset as defined in § 1221" in the hands of the transferee. If non-business, unimproved real property, which is a capital asset in the hands of the transferor, is sold to a partnership by a partner owning a capital or profits interest of more than 50%, must focus on the use of the property by the partnership in order to determine whether any gain recognized by the partner is taxable as ordinary income. If the partnership plans to subdivide property or use it in its trade or business, the property would be other than a capital asset, and the partner's gain on sale would be ordinary income. The fact that real property was a capital asset in the hands of the transferor partner is immaterial to the determination.
What are § 707(c) payments?
§ 707(c) payments are guaranteed payments by the partnership to a partner, such as those for salary or interest, and under the entity theory the recipient partner is treated as a non partner, and includes the guaranteed payment from the partnership as ordinary income under § 61(a). The partnership gets a corresponding deduction (where the payment is not required to be capitalized under § 263). In the case of a partnership whose activities do not rise to the level of a trade or business, guaranteed payments may be deductible under § 212.
