IRS Proposes Rules on Disguised Payments for Services

The IRS issued proposed regulations that require the application of a nonexclusive six-factor test to determine whether payments from a partnership to a partner are disguised payments for services that are not rendered in the partner’s capacity as a partner in the partnership (REG-115452-14).

Under the partnership rules, an allocation or distribution between a partnership and a partner for the provision of services can be treated in one of three ways: (1) as a Sec. 704(b) distributive share; (2) as a Sec. 707(c) guaranteed payment; or (3) as a transaction under Sec. 707(a) in which a partner has rendered services to the partnership in a capacity other than as a partner.

A disguised payment occurs when a partner performs services for a partnership, but the payment for the services is treated as an allocation or distribution of partnership income, even though the performance of services and allocation or distribution, when viewed together, would properly be characterized as a transaction occurring between the partnership and a partner acting other than in its capacity as a partner. In those cases, the transaction will be treated as occurring between the partnership and one who is not a partner.

Under the proposed regulations, an arrangement will be treated as a disguised payment for services if (1) a service provider, either as a partner or in anticipation of being a partner, performs services (directly or through its delegate) to or for the benefit of the partnership; (2) there is a related direct or indirect allocation and distribution to the service provider; and (3) the performance of the services and the allocation and distribution are properly characterized as a transaction occurring between the partnership and a person acting other than in that person’s capacity as a partner.

An arrangement that is treated as a disguised payment for services is treated as a payment for services for all purposes of the Code. Therefore, the partnership must treat the payments as payments to a nonpartner in determining the remaining partners’ shares of taxable income or loss and must capitalize the payments or otherwise treat them consistently.

Whether an arrangement constitutes a payment for services (in whole or in part) depends on all of the facts and circumstances, and six nonexclusive factors may indicate that an arrangement is a payment for services. The most important of the six factors is the absence of significant entrepreneurial risk, as to both the amount and the fact of payment. An arrangement to allocate and distribute a payment to a service provider that involves limited risk as to amount and payment is treated as a fee under Sec. 707(a)(2)(A). In the preamble to the proposed regulations, the IRS said it will consider comments arguing that a payment to a service provider that lacks significant entrepreneurial risk could pass the test to be treated as not disguised in certain circumstances.

The proposed regulations also specify other less important factors to be considered, which are taken from the legislative history of the provision. These factors are that the service provider holds, or is expected to hold, a transitory partnership interest or an interest for only a short time; the service provider receives an allocation and distribution in a time frame similar to the time in which a nonpartner service provider would typically receive payment; the service provider became a partner primarily to obtain tax benefits that would not have been available to a third party; and the value of the service provider’s interest in general and continuing partnership profits is small compared to the allocation and distribution.

In addition, the proposed regulations add a factor that is not in the legislative history. This factor looks at whether the arrangement provides for different allocations or distributions for different services, if the services are provided either by a single person or by related persons (under Sec. 707(b) or 267(b)), and the differing allocations or distributions are subject to levels of entrepreneurial risk that vary significantly.

The IRS is also making changes to some existing guidance in the proposed regulations. First, Rev. Rul. 81-300 is obsoleted because subsequent legislation specifically targeted its facts and conclusions; however, the IRS is asking whether it should be issued with modified facts. In addition, the IRS stated in the preamble to the proposed regulations that it is planning to issue a revenue procedure providing an additional exception to the safe harbor in Rev. Proc. 93-27 in conjunction with the publication of the proposed regulations in final form and will add the additional exception to the proposed revenue procedure in Notice 2005-43, if that procedure is finalized.

Although the regulations are to apply prospectively to any arrangement entered into or modified on or after the date they are published as final in the Federal Register, the IRS believes that the proposed regulations generally reflect congressional intent about which arrangements are appropriately treated as disguised payments for services.