The Internal Revenue Service (IRS) recently proposed a new partnership regulation. The proposal suggests certain partnerships could be treated as disguised payments for services instead of as interest in the partnership. The effect would be seen in the income received from the disguised payments, which would be considered compensation. This income would then be taxed as ordinary income. Currently, the income from a partnership is treated as a distributive share of partnership income and is considered a capital gain.
Disguised Payments for Services by Partners
Since the U.S. Congress enacted an anti-abuse rule in 1984, a partner who delivers services to a partnership and receives a related allocation and distribution that is considered the same as a payment to a non-partner. The proposed partnership regulation offers this scenario as a means to define disguised payment for services.
The proposed regulation would be applied to a partner providing services to the partnership even if the treatment requires the service provider not to be treated as a provider or the overall arrangement is not to be treated as a partnership. The proposed regulation characterizes the partnership at the time it is formed.
Determining Factors and Entrepreneurial Risk
The proposal outlines six non-exclusive factors for making a determination. Five of those factors are based on legislative history. The proposal states that the existence of significant entrepreneurial risk is decisive and offers that this claim is congruous with the view outlined by Congress in the past. The IRS offers that partners earn profits from a partnership based on business success; meanwhile, any payments to third parties are not generally subject to this risk.
The proposal outlines arrangements that lack entrepreneurial risk, including an example of an allocation primarily fixed in amount and assured to be available. Another example includes an arrangement where the service provider waives the right to payment for future services in a nonbinding manner or fails to timely notify the partnership of the waiver.
The other five factors are secondary in importance to the entrepreneurial risk. The absence of one or more of these factors is not determinative.
These factors include whether:
• The partner providing the service has a transitory interest in the partnership
• The service provider receives an allocation and distribution in a typical time frame used for payments to a non-partner
• The partner providing the service entered into the arrangement in order to obtain tax benefits not available to a third party
• The value of that partner’s interest is relatively small when compared to the allocation and distribution
• The arrangement provides for different allocations subject to varying levels of entrepreneurial risk
The proposal to treat disguised payment for services as compensation would apply to arrangements entered into or modified after the publication of final regulations.
For questions on how these changes might have tax implications on your partnership or the ability for partners to provide services, contact Timothy Devlin, Partner | Tax Services Practice Leader, at [email protected].