Chapter 7
Q13. Explain the general difference
A13. The character of items classified as a distributive share is determined at the partnership level and those items pass through to the partners in the year in which the partnerships taxable year ends. In contrast, if Section 707(a)(1) applies, the partner and the partnership generally determine their character and timing consequences as if they were dealing as unrelated parties. Thus these payments for services are always ordinary income to the recipient and are taxed according to the recipients method of accounting, when received or accrued depending on if they are a cash or accrual taxpayer. The payer ordinarily may deduct such payments as a business expense in accordance with its method of accounting subject to capitalization requirements.
Q34. How are guaranteed payments a hybrid for tax purposes?
A34. Like section 707 payments, they are taxable to the partner as ordinary income regardless of the amount or character of the partnership's taxable income and they are deductible by the partner under section 162 (subject to capitalization requirements). For timing purposes however, guaranteed payments resemble distributive shares in that the yare included in income for a partners taxable year "within or with which ends the partnership taxable year in which the partnership deducted such payment as paid or accrued under its method of accounting". The partner thus must include them in income whether or not they are received
Q35. Since a guaranteed payment is taxable whether or not it has been received, is there a mechanism to ensure that the partner is not taxed a second time when the payment is actually received?
A35. A bit unclear from the book, but it seems like when a partner is taxed on a guaranteed payment he would simply increase his basis in his partnership interest and he would when he reports his distributive share. This way receipt of the payment, like receipt of a partners distributive share, simply would reduce the partners outside basis under section 705.
Q36. In the Gains V. Commissioner case, there was an issue where the general partner received guaranteed payments from the limited partnerships it was managing but those partnerships were accrual basis and the GP was cash basis. In this scenario, the partnerships accrued guaranteed payments to the GP and took the expense now but since the GP was cash basis he did not include the income. Was this ok?
A36. No, between 707(c) and 706(a) it makes it clear that payments made to a partner for services or for the use of capital are includible in his income at the same time as his distributive share of partnership income for the partners year when the payments are made or accrued. So treat this as if it was pass through income which you would pick up whether you got it or not
Q37. What is the guaranteed payment amount?
A37. F's guaranteed payment, as defined under section 707(c) of the code is 40x, 100x dollars (minimum guarantee) less 60x dollars distributive share (30% of partnership income of 200x dollars).
Q38. What is the final taxable income of the partnership?
A38. After the guaranteed payment is taken into account, the partnership's ordinary income is 80 dollars, so now for federal tax purposes, the taxable income tax for partnership amounts to 160 dollars (80 dollars of ordinary income and 80 of capital gains)
Q39. What is the rule when the partnership agreement does not specifically provide for the manner of sharing a particular item or class of items of income ,gain, loss, deduction, or credit of the partnership?
A39. Code section 704(b) of the Code and section 1.704-(1)(b)(1) of the regs say that a partner's distribute share of any such item shall be determined in accordance with the manner provided in the partnership agreement for the division of the general profit or losses.
Q4. In enacting the 1954 Code which way did Congress veer?
A4. Veered toward the Entity approach
Q40. So what happens with the allocation in this circumstance?
A40. The partnership income for the taxable year, after deduction of the guaranteed paying is 160 dollars. Of this amount, F's share is 60 dollars, therefore G's distributive share is 100 dollars. Hence the effective profit sharing ratio for the year in question is 6/16 for F and 10/16 for G. Thus as provided by section 704(b) of the code, the partnership capital gains as well as the partnership ordinary income are to be shared in the ratio of 6/16 for F and 10/16 for G.
Q41. So at the end of the day, how much ordinary and how much capital would each partner report on their tax return?
A41. Partner F received a total of 70 dollars of ordinary income (30 dollars of allocated ordinary and 40 dollars of ordinary guaranteed payments), and received 30 dollars of capital gains for a total of 100 dollars. Partner G received an allocation of 50 dollars of ordinary income and 50 dollars of capital gains for a total of 100 total dollars
Q42. Example - Partner C in the CD partnership is to receive 30% of partnership income as determined before taking into account any guaranteed payments, but not less than $10K. The income of the partnership is $60K. How much does C get?
A42. Partner C is entitled to $18K (30% of $60K), as his distributive share. No part of this is a guaranteed payment
Q43. What if the partnership income had been $20K instead?
A43. Then $6K (30% of 20K) would be partner C's distributive share, and the remaining $4K payable to C would be a guaranteed payment
Q44. What is the treatment of guaranteed payments in reference to code section 199A?
A44. Section 199A©(4)(B) provides that QBI does NOT include any guaranteed payment for services rendered with respect to the partnership's trade or business. However, any partnership deduction allowed for the guaranteed payment reduces QBI if the deduction is properly allocable to the partnership's trade or business. Since a guaranteed payment to a partner for services is comparable to salary or wages, exclusion from QBI is proper.
Q1. Assume Realtor is the General Partner in a limited partnership organized to acquire and lease an apartment building. If Realtor is also a mortgage broker who helps to arrange financing for the project and is paid a $50K fee by the partnership for her services, then how would the aggregate approach treat this and how would the entity approach treat this?
A1. If you think about it from an aggregate approach you would assume that this payment should be part of their distributive share of, and if you take the entity approach you would treat the payment as if it occurred between the partnership and an unrelated third party.
Q10. Are the rules clear in identifying when a partner is acting as a partner or as an independent person when dealing with their partnership?
A10. Not at all
Q11. What was the line that the Tax Court created due to the Pratt case?
A11. The tax court held that when a partner performs services that are ongoing and integral to the business of the partnership, he is acting in in his capacity as a partner and that non-partner status is more likely to exist when a partner is acting in an independent capacity, rendering services of a limited technical nature (a partner who is also an accountant prepares the partnership's tax returns), or in connection with a specific transaction
Q12. Why does it matter so much, the difference between being classified under code section 707(a)(1) (partner not acting in capacity as a partner) or, alternatively, as a distributive share?
A12. The timing and character of a partners and the partnership's income or losses may differ depending on this
Q64. Do you often see the issuance of a capital interest in a partnership to a service provider?
Why? A64. No, it carries significant practical drawbacks. The partners in the partnership naturally will be reluctant to currently part with an interest in the partnership's capital for the future services of a new partner. In addition, in any transfer of a capital interest, the value of the pro-rata interest in partnership property deemed transferred to the partner under Step 1 of the MDougal analysis must be determined, potentially necessitation costly appraisals etc..
Q46. Example - Partnership purchased Blackacre for $500. A is entitled to a guaranteed payment under 707(c) of $800. Subsequently, when the FMV of Blackacre is $800 and the partnership's adjusted basis in it is $500, partnership transfers Blackacre to A in satisfaction of the guaranteed payment. How should this be treated?
A46. A transfer of partnership property to a partner in satisfaction of a guaranteed payment under 707(c) is a sale or exchange under section 1001, and not a distribution under section 731. Because the transfer is a sale or exchange under section 1001, it is not a distribution within the meaning of section 731. Accordingly, the nonrecognition rule in section 731(b) does not apply to the transfer. Partnership realizes a $300 gain when partnership transfers Blackacre in satisfaction of its section 707(c) guaranteed payment to A
Q47. What was the Service trying to make very clear here?
A47. That code section 707(c) apparently was enacted to make it clear that a partner realizes ordinary income as a result of receiving payments for services in his partner capacity
Q48. How would you treat a partner who receives a partnership interest in exchange for services? How is it reflected?
A48. Whether by past, present or future, is being compensated and should realize ordinary income under section 61. The partner takes a Section 1012 "tax cost" basis in the partnership interest equal to the amount that is included in income.
Q49. What are the two different types of interests that a service partner may receive?
A49. They can receive a capital interest or a profit interest
Q5. What did they do?
A5. They divided partner-partnership transactions for services into 3 broad categories
Q50. Explain a capital interest?
A50. Generally defined as an interest in both the future earnings and the underlying assets (the capital) of the partnership. A partner who has a capital interest will be entitled to a share of the partnership's net assets in the event the partner withdraws or the partnership is liquidated.
Q51. Explain a profits interest
A51. A partner may receive merely a profits interest, which entitles him to a share of future earnings (including, perhaps, gain on the sale of property) but gives him no current right to a distribution of a share of the partnership's capital in the event of a withdrawal or liquidation.
Q52. Example - Proprietor, Investor and Manager join forces to form a partnership. Proprietor and Investor each contribute $60K but Manger contributes nothing except his agreement to provide needed expertise to the business. The partners agree to share profits and losses equally. So describe the two ways this can happen?
A52. If Manager also is credited with a 1/3rd interest in the partnership's capital ($40K) he has received a capital interest, and the other partners have relinquished $20K each of their capital accounts, presumably to compensate Manager for his services. But if Manger's capital account is zero, he has received only a "profits interest" and would receive nothing on a subsequent liquidation apart from his share of undistributed earnings of the business.
Q53. What would be the character of a service partner who receives a capital interest?
A53. He would realize ordinary income in an amount equal to the value of the interest received less the amount, if any, paid for the interest.
Q54. What would the timing of that realization be for the partner? Are there things to consider?
A54. If the interest is received without restrictions, income is realized upon its receipt. But if the interest is transferred subject to substantial restrictions, Section 83(a) provides that its FMV is included in gross income when the restrictions lapse i.e. in the first taxable year in which the service partner's rights are "transferable or are not subject to a substantial risk of forfeiture"
Q55. Can the transferee of restricted property elect to include the value of the property into income at the time of its receipt?
A55. Yes, under code section 83(b) you can do this
Q56. Why would someone want to make this election?
A56. Where a partnership interest has minimal value upon receipt but is expected to appreciate by the time the restrictions lapse, service partners usually are motivated to make the election in the hope that the future appreciation in the property will be taxed a preferential capital gains rates at a later date when the property is sold.
Q57. How does the other side of this transaction work? Assume the prior example where Manager receives an unrestricted 1/3rd interests in the capital and profits with a value of $40K. Is the partnership entitled to deduct this $40K? What does this depend on?
A57. Allowance of this deduction depends on the nature of Manager's services
Q58. What would happen if Manager is the company lawyer who received his interest for services rendered in connection with the formation of the partnership or the construction manager for the partnership's new hotel? How would this be treated?
A58. An ordinary and necessary deduction for the entire $40K would not be appropriate. The attorney's fee is an organization expense, the first $5K of which could be deducted and the remainder of which would be amortizable over 180 months if the partnership so elects. Amounts paid to the construction manger would be capitalized and added to the partnership's bass in the building.
Q59. Could the transfer of a capital interests for services cause the partnership to recognize gain? Example?
A59. If could. Assume that manager receives a 1/3rd capital interest in a partnership previously formed by Prop & Inv and their sole asset is land with a value of $120K and basis of $45K. How would the transfer of a capital interest be viewed? A59. The transfer of the capital interest to Manager can be viewed as a 2 step transaction (1). The transfer of a 1/3rd undivided interest in the land from the partnership to Manager as compensation for his services and (2). The contribution of that interest back to the partnership by the Manager.
Q6. What are those categories?
A6. (1). Transactions between a partnership and a partner who is not acting in his capacity as a partner. (2). Guaranteed payments (payments to a partner in this partner capacity for services) and (3). Payments to partners in their capacity as partners for services rendered as a partner which are based on a percentage of partnership profits
Q60. What does the first step involve?
A60. The first step involves the transfer of appreciated property (1/3rd interest in the land, having a basis of $15K and a value of $40K) in a section 83 compensatory transfer to Manager and thus is a taxable event resulting in $25K of capital gain to the partnership (Proprietor & investor).
Q61. The second step?
A61. Is a tax-free contribution of Manager's $40K interest in the land back to the partnership under Section 721, and Manager's $40K "tax cost" basis is transferred to the partnership under Section 723.
Q62. What happens to allocations attributable to unvested capital interests?
A62. Not taxable until vested
Q29. If this technique were successful then what did the partnership succeed in doing?
A29. The partners should eb allowed the equivalent of a current deduction for an expense that should have been capitalized
Q3. And the entity approach?
A3. The transaction should be treated as if it occurred between the partnership and an unrelated third party
Q30. What are guaranteed payments?
A30. Are payments by a partnership to a partner for services which are determined without regard to partnership income
Q31. Example - If a real estate partnership pays its general partner a fixed annual amount for ongoing management services, irrespective of partnership profits then the fee is?
A31. A guaranteed payment
Q32. How do guaranteed payments share attributes of both a distributive shares and section 707(a)(1) payments?
A32. They resemble distributive shares in that they relate to services that are an integral part of the partnership's ongoing activities and they relate to section 707 payments as they are fixed in amount
Q33. So how are they treated?
A33. They are made to partners in their capacity as partners rather than as unrelated third parties
Q1. What are the two main way to think about tax treatment for a partner who does work for or actually works for a partnership?
A1. (1). Aggregate approach and the (2). Entity approach
Q14. Example - A, B & C are all cash method taxpayers and 1/3rd partners with $10K of net operating income (all ordinary). Partner A provides regular, ongoing services to the partnership and in return, the partners agree to allocate $4K of partnership income to A and allocate any remaining net income equally among the three of them. Would the different options for paying this partner make a difference in this circumstance?
A14. No, If the $4K allocated to A is part of A's distributive share, the taxable income of the partnership is $10K, allocation $6K to A and $2K to each B & C. But if A in substance is providing the services in a non-partner capacity and the $4K is thus a section 707(a)(1) payment, the partnership's taxable income is only $6K. Of this amount, $2K will be allocated to each partner and A also must include the $4K payment of compensation as ordinary income. When the smoke clears, the net tax consequences are essentially the same in either case
Q15. In more complex situations, could the tax distinctions between section 707(a)(1) payments and allocations of distributive shares shift the character of income among the partners?
A15. Yes, this can happen
Q16. Assume that ABC partnership's net income for the year consisted of $6K LT cap gain and $4K of ordinary income. What would happen now?
A16. The effect of a $4K allocation to A on these facts is to increase A's distributive share of partnership net income from 1/3rd to 3/5ths and to correspondingly decrease the distributive shares of the other partners from 1/3rd to 1/5th each. This results in an allocation to A of $3,600 of cap gain and $2,400 of ordinary income, and allocations to B and C of $1,200 of cap gain and $800 of ordinary income. On the other hand, if A received a section 707(a)(1) compensation payment of $4K and each partner received an equal 1/3rd share of partnership profits then A would recognize $4K of ordinary income under section 707(a)(1) and the partnership would take a corresponding deduction. As a result of the deduction, the partnership would have no net ordinary income, and A, B, and c each would be taxed on 1/3rd of the partnership's $6K LT cap gain. The net result would be $4K of ordinary income and $2K of capital gains for A and no ordinary income and $2K cap gain for each of B and C
Q17. Timing difference example - Assume that Partner A is cash method and partnership is accrual method. Now explain how this could change things?
A17. If the $4K payment for A's services were subject to section 707(a)(1), she would not be requir3d to include the $4K payment in income until she receives it. But if the $4K were treated as an allocation, A would be taxable in full at the close of the partnership's year even if actual payment (by a partnership distribution to A) were deferred until the following year
Q18. At one time (not anymore), taxpayers enjoyed additional timing advantages by classifying certain payments under section 707(a)(1) when the partnership and the partner used different accounting methods. How did that work?
A18. If partner A in the example were a cash method taxpayer and the partnership used the accrual method, the partnership could accrue and deduct the $4K in year one but delay actual payment (and thus inclusion in A's income) until year 2.
Q19. What did Congress do to change this?
A19. Code section 267(a)(2) in conjunction with section 267(e) now provides that a deduction may not be taken prior to the year in which the amount is including in the gross income of the payee. Thus an accrual method partnership may not deduct an item owed to a cash method partner prior to the year in which the item is paid and property included in the payees income.
Q2. What is the aggregate approach?
A2. The fee should simply be a part of their distributive share of income
Q20. How are code section 707(a)(1) payments (partner not acting in capacity as partner) treated under code section 199A?
A20. Qualified business income (QBI) does NOT include any payment described in code section 707(a) to a partner for services rendered with respect to the partnership's trade or business.
Q21. The regulations also provide that if a Section 707(a)(1) payment is deductible by the partnership and properly allocable to its trade or business then?
A21. Then it will reduce QBI
Q22. In explaining its conclusion that Section 707(a)(1) payments for services are not QBI income, what did the Service argue?
A22. Within the context of 199A, payments under section 707(a) for services are similar to, and therefore, should be treated similarly as, guaranteed payments, reasonable compensation, and wages, none of which is includible in QBI.
Q23. If the partnership pays a partner for services in a transaction governed by section 707(a)(1) and the expense is capital in nature (think organization fees), how must the partnership treat the payment?
A23. The partnership must treat the payment for tax purposes as if it were made to an unrelated third party, i.e, as a capital expenditure which at may be deducted or amortized over the applicable recovery period.
Q24. What advantage could the partnership get if they could instead structure the payment to a partner for services as an allocation rather than as a payment governed by section 707(a)(1)?
A24. The timing ramifications of structuring a payment to a partner for services as an allocation rather than as a payment governed by section 707(a)(1) would be dramatic if the parties could convert a capital expenditure into the equivalent of a currently deductible expense.
Q25. What is this called? Is it ok?
A25. This is called a disguised payment and code section 707(a)(2)(a) prevents taxpayers from disguising payments for services in order to achieve this timing advantage
Q26. Example - Assume the ABC partnership has net income of $30K before paying Partner A a $30K broker fee for services rendered by A in a non-partner capacity related to the acquisition of land. Since this payment is a transaction cost that facilitates the acquisition of real estate how would this be booked?
A26. The partnership would be required to capitalize the payment under Section 263
Q27. So if they capitalize it, then what does each partner receive at the end of the year?
A27. The taxable income of the partnership would remain at $30K, resulting in a $10K distributive share to each partner and an additional $30K of ordinary income to A under code section 707(a)(1).
Q28. What if instead, the parties restructured the arrangement by specially allocating $30K to A and followed up with a distribution of that same amount?
A28. The partnership's $30K of net income all would pass through to A, reducing A's total income from $40K to $30K and leaving B and C with no income
Q63. So in the Crescent Holdings, LLV v. Commissioner case, Fields received a 2% capital interest in a partnership in exchange for his agreement to provide services for the benefit of the partnership; however, the interests was subject to forfeiture if Fields terminated his employment within 3 years after the partnerships formation. He did not make a 83(b) election. The partnership allocated a large amount of income in respect of Field's 2% interest, but none of those profits were distributed. How did the court look at this?
A63. Fields contended that he could not be taxed on a share of undistributed partnership income while his interest remained unvested because he was not yet a partner in the entity as a result of the operation of section 83(a). The court agreed and held that the holder of an unvested capital interest in a partnership does not recognize as income the undistributed profit allocations attributable to such interest. The court reasoned that a service provider's interest in the undistributed profits remains subject to the same risk of forfeiture that applies to the underlying capital interest.
Q65. Under the regulations, would the mere receipt of a partnership interest in future profits create any current tax liability?
A65. No - Section 1.721-(1)(b)
Q66. So what happened in the Hale case, what was his argument?
A66. Hale received for its contribution of future services to Walnut company, a right as a partner to participate in Walnut Co. future profits. Hale then sold 90% of this right to D-K before receiving any money from Walnut. Hale is arguing that the gain received in the sale should be a capital gain since the right to share in income may constitute a partnership interest and a partnership interest is generally a capital asset
Q67. Was this a winning argument? Why?
A67. No, there was authority for the proposition that a gain on the transfer of property technically qualifying as a capital asset may be treated as ordinary income if it is in effect an anticipation of future income. The court did not see any conversion of a capital investment. The substance of what was assigned was the right to receive future income. The lump sum consideration seems essentially the present value of income which the recipient, Hale, would otherwise obtain in the future as ordinary income.
Q68. Was there a big issue when it came to the treatment of the receipt of a partnership profit interest for services provided to or for the benefit of the partnership?
A68. Yes, was discussed in the Hale v. commissioner case as well as the Diamond vs. Commissioner case and the Cambell case that scared everyone. There as a lot of discussion whether the interest should be taxable upon receipt even though you did not have a liquidation value amount but could use a PV formula to estimate the value of the interests etc..
Q69. So what did the Congress do?
A69. They came out with a specific revenue procedure 93-27 to address the issue
Q7. In determining the property tax treatment of compensatory payments to a service provider who also owns an equity interest in the partnership, what is the critical initial question?
A7. Is whether the service provider is acting as a partner or in some other capacity
Q70. What did the procedure say?
A70. Other than 3 exceptions, if a person receives a profits interest for the provision of services to or for the benefit of a partnership in a partner capacity or in anticipation of being a partner, the IRS will not treat the receipt of such an interest as a taxable event for the partner or the partnership
Q71. What were the three exceptions?
A71. (1). If the profits interests relates to a substantially certain and predictable stream of income from partnership assets, such as income from high-quality debt securities or a high-quality net lease (2). If within 2 years of receipt, the partner disposes of the profits interests, or (3). If the profit interest is a limited partnership interest in a PTP
Q8. If they are not acting as a partner then what?
A8. Then tax consequences of the arrangement will be determined under section 707(a)(1) as if that individual had no other relationship with the partnership
Q9. On the other hand, if the partner provides the services in their capacity as a partner, then name the two difference scenario's that could be the case?
A9. The tax consequences of the arrangement generally will be governed by section 704(b) (as a distributive share) if the payment is dependent on partnership profits ad by Section 707(c) (as a guaranteed payment) if it is not.
