Proposed Rules Define Disguised Payments for Services in Partnerships

By Sally P. Schreiber, J.D.

The IRS is proposing to apply 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 in proposed regulations issued on Wednesday (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 rules, 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.     

Under the proposed rules, 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 service. 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). 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.

Besides entrepreneurial risk, other less important factors to be considered, which are taken from the legislative history of the provision, 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 rules add a sixth factor that is not in the legislative history. The sixth 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 proposed rules also make changes to some existing guidance. First, Rev. Rul. 81-300 is obsoleted because subsequent legislation specifically targeted its facts and conclusions. The IRS is asking whether it should be issued with modified facts. In addition, the IRS is proposing modifications to Rev. Procs. 93-27 and 2001-43 to reflect the new rules and will add a new provision to Notice 2005-43, which contains a proposed revenue procedure, once the 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.

Sally P. Schreiber ( is a JofA senior editor.

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