United States

Proposed regulations would redefine guaranteed payments


As noted in our July 22 article, IRS issues proposed regulations on disguised payments for services , the Treasury and the IRS recently issued proposed regulations to address certain perceived abuses involving "fee waivers" and profits interests.1  One of the proposal's core elements is the issuance of proposed regulations under section 707(a)(2), authorized by Congress in 1984, to address the question of when payments or allocations-purporting to be part of the distributive share of a partner in exchange for the partner's performance of services‒are really payments made to the service provider in a non-partner capacity. The treatment of such non-partner capacity payments would be determined under the same rules that would be applicable if they were paid to a non-partner.

As anticipated in the 1984 legislation, the proposed regulations outline a series of tests to determine if a payment or allocation is made to a partner or purported partner in a "partner capacity." The most important factor is the presence of "significant entrepreneurial risk" as to the amount of the payment or its likelihood of being paid. Where a payment is not subject to any such risks, the proposal indicates that it should be treated as a payment to a non-partner for all purposes.

Commentators have observed that this change, in effect, eliminates the concept of a guaranteed payment for services. That is because such payments, by definition, must be partner capacity payments. Perhaps in recognition of the significance of this change, the preamble to the proposed regulations seemed to hedge a bit, by indicating that arrangements that were reasonably treated by the partnership as guaranteed payments would not be disturbed. This may mean that the partnership is intended to have the right to treat a fixed payment for services provided by a partner either as a guaranteed payment or as a non-partner capacity payment, which would then be characterized as a fee or a salary based on otherwise applicable tax principles (which are, unfortunately, not as clear as one might wish).

It is unclear whether this concept, if applied to payments for services, will also be extended to payments for capital. For example, a purported guaranteed payment for capital equal to 7 percent of the capital invested in the partnership might be recharacterized as interest on indebtedness bearing a 7 percent interest rate because there is insufficient entrepreneurial risk to characterize it as a partnership interest of any kind.

Be that as it may, in a related development, the proposed regulations do appear to propose a change to the rules for determining when certain payments for capital are treated as guaranteed payments rather than payments out of the partner's distributive share of partnership earnings. An example in the existing regulations indicates that a percentage interest in partnership income subject to a minimum dollar amount or "floor" is only considered to be a guaranteed payment to the extent the floor applies. For example, if a partner was entitled to 10 percent of partnership income, but not less than $100,000, and the partnership's income in a given year was $900,000, the partnership's payment of $100,000 would be considered to be a payment out of the partner's distributive share equal to $90,000 (10 percent of earnings) and a guaranteed payment of only $10,000. The character of such amounts could differ in many cases, since guaranteed payments are always treated as ordinary income and the partner's distributive share may have a different character. The new example provides that, in such a case, a minimum amount of $100,000 each year would be treated as a guaranteed payment. Only to the extent amounts were paid in excess of the $100,000 minimum, say, because earnings exceeded $1 million, 10 percent of that excess would be treated as the partner's distributive share.

Aside from this change to the treatment of floor allocations, the proposed regulations do not appear to apply any new standards, such as the new entrepreneurial risk concept, to payments or allocations that are returns on a partner's investment of capital and not compensation for the partner's performance of services. However, this is an area that bears watching. It is not uncommon for partnership agreements containing complex waterfalls to utilize a combination of caps and gross income allocations that would be problematic, under the proposed regulations, if similar allocations were made in exchange for the performance of services. There is no direct indication in the text of the proposed regulations that the new entrepreneurial risk standards will apply to allocations that are made in exchange for the use of capital. However, there are suggestions to that effect in the preamble. For example, the preamble includes the general statement that, "The Treasury Department and the IRS have concluded that the presence of significant entrepreneurial risk in an arrangement is necessary for the arrangement to be treated as occurring between a partnership and a partner acting in a partner capacity. " In addition, the specific change to the example described above, which apparently involves a return to capital and not a return for the performance of services, is explained as being justified by the fact that the example in the current regulations "is inconsistent with the concept that an allocation must be subject to significant entrepreneurial risk to be treated as a distributive share under section 704(b)."


1 Prop. Reg. section 1.707-2, 80 Fed. Reg. 43,652 (2015)


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