“Our Greatest Hits” is an effort to show our readers the most popular – and still avidly read – articles from our archives. This article originally appeared in our July 1995 Issue.
Abstract – Guaranteed payments to partners are applied to ensure that a partner gets a particular amount for specific services provided or for the use of capital. The payments are considered guaranteed because they are first-priority distributions and are given even though a net loss is created for the partnership. Despite the simplicity of this concept, these payments can result in unexpected difficulties for both the receiving partner and the other partners if they are not planned properly. The IRS and the courts cannot even agree on how to define guaranteed payments, making it quite hard for everyone involved to determine the right way to deal with these payments. Given this dilemma, all parties should carefully understand the rules pertaining to guaranteed payments to partners to avoid expensive tax consequences. These rules are discussed.
The purpose of using guaranteed payments to partners is to ensure that a partner will receive a certain minimum amount for certain services rendered or for the use of capital. The partner wants to be sure of receiving this distribution and not have it contingent upon earnings such as his distributive share would be. The payments are “guaranteed” in the sense they are first priority distributions and will be made even if they create a net loss for the partnership. Although the concept is straight- forward enough, it gives rise to many problems both definitional and operational. These payments, ff not structured properly, can cause many unforeseen headaches for both the receiving partner and the other partners in the partnership. Some of these problems can be quite expensive.
What Are Guaranteed Payments?
IRC Sec. 707(c) specifically introduces the concept of guaranteed payments into the law. It defines these payments as those made by a partnership to a partner for services or for the use of capital to the extent such payments are determined without regard to the income of the partnership. Payments meeting this definition are considered as made to a person who is not a partner. In other words, it doesn’t matter whether or not the services performed are within the partner’s scope of responsibility as a partner. As long as these payments are not contingent upon the income of the partnership, they will be deemed to fall within the scope of IRC Sec. 707(a). The section goes on to enumerate how such payments are handled both by the partner and the partnership. For the partner, the payments are ordinary income. For the partnership, these payments are deductible under IRC Sec. 162 (relating to ordinary or necessary business expenses) or capitalized under IRC Sec. 263. Of course, the specific rules of these sections must be taken into account. IRC Sec. 707 clearly states that guaranteed payments are considered as paid to a non-partner only for the purposes of IRC Sec. 61 (the “shotgun clause” relating to gross income) and IRC Sees. 162 or 263. The partner who receives the guaranteed payment is not considered an employee of the partnership for purposes of withholding taxes, FICA, deferred compensation plans, etc.
Is It a Guaranteed Payment?
IRC Sec. 707(c) is very clear on the criterion for a guaranteed payment: Payments to a partner for services or for the use of capital are guaranteed payments to the extent they are determined without regard to the income of the partnership. But what about certain minimum payments that coordinate with a partner’s distributive share? For example, suppose the ABC Partnership agreement states that Partner B is to receive 20% of partnership income as determined before taking into consideration any guaranteed payments, but not less than $13,000. Further suppose the income of the partnership is $100,000, so B is entitled to receive $20,000 as her distributive share (20% of $100,000). In this case, no pan of this amount is considered a guaranteed payment. But, if the partnership income had been only $30,000 instead of $100,000, then $6,000 (20% of $30,000) would be Partner B’s distributive share, and the remaining $7,000 payable to B would be a guaranteed payment.
The IRS View. There has been some confusion and disputes about what the phrase “income of the partnership” means. The IRS itself hasn’t helped. Although the wording of IRC Sec. 707(c) is quite clear that for a distribution to be a guaranteed payment it must be “determined without regard to the income of the partnership,” the IRS blithely chose to ignore this wording in an important revenue ruling in 1981 (Rev. Rul. 81-300, 1981-2 CB 143).
The ruling dealt with the classification of management fees paid to partners of a partnership formed to purchase, develop, and operate a shopping center. The partnership agreement provided that the partners must contribute their time, aerial abilities, and best efforts to the partnership, and in return for their managerial services, each will receive a fee of 5% of the gross rentals received by the partnership. These amounts were to be paid to the partners in all events. After an extensive analysis of the law, especially the very pertinent wording of IRC Sec. 707(c), the IRS noted that “although a fixed amount is the most obvious form of guaranteed payment, there are situations in which compensation for services is determined by reference to an item of gross income. Such compensation arrangements do not give the provider of the service a share in the profits of the enterprise, but are designed to accurately measure the value of the services provided.” It goes on to say, therefore, that “the term guaranteed payments should not be limited to fixed amounts. A payment for services determined by reference to an item of gross income will be a guaranteed payment if, on the basis of all facts and circumstances, the payment is compensation rather than a share of partnership profits.”
The IRS stated it will look toward all relevant facts especially – 1) the reasonableness of the payment for the services provided and 2) whether the method used to determine the amount of payment would have been used to compensate an unrelated party for the services.
The Courts’ View. The courts have not treated the language of IRC Sec. 707(c) so lightly. In Pratt v. Commissioner USTC, 64 TC 203, CCH Dec. 33, 189 (1975), the partners’ compensation was based upon gross rentals. The partners argued that “gross rentals” are not the same as “income” for the purpose of determining whether distributions are guaranteed payments. The court stated, “the parties make some argument as to whether payments based on gross rentals should be considered as payments based on ‘income.’ In our view there is no merit to such distinction.” Since the payments were tied in some way to partnership income, the court rejected, out of hand, that they could be considered guaranteed payments.
Guaranteed payments are always ordinary income to the receiving partner and must be included in taxable income for his or her tax year within which ends the partnership tax year in which the partnership deducted such payments as paid or accrued according to its method of accounting. This allows some tax deferral opportunities.
For example, let’s assume a partner is on a calendar year and a partnership is on a fiscal year ending September 30. If the partner receives a guaranteed payment in December 1993, it would have to be included in the partner’s income for 1994, not 1993. This is the partner’s fiscal year within which the partnership’s taxable year ends in which it deducted the payment. In effect, the payment is deemed to have been made in September 1994. Of course, it’s a two way street: If the partnership were on an accrual basis with a calendar year ending December 31, 1993, and it made a guaranteed payment to a partner in January 1994, but accrued the payment on December 30, 1993, the partner must include the payment in his or her 1993 income.
Retirement Payments to Partners
Although a partner may be considered “retired” and not take any active interest in the partnership, he or she will still be considered a partner for Federal income tax purposes until his or her entire partnership interest has been liquidated. This is true even if he or she is considered retired under local law.
Payments to a retiring partner or a deceased partner’s successor in interest by a continuing partnership are covered by IRC Sec. 736. IRC Sec. 736 merely classifies the payments; it does not provide the rules for their taxation. Essentially, the payments are classified as either income payments under IRC Sec. 736(a) or property payments under IRC Sec. 736(b). These distinctions are critical regarding how they are taxed. (Although it is true that the payments in question could be made in property rather than cash, most of the time they will, in fact, be in cash and the following discussion assumes this usual case.)
Payments that fall under IRC Sec. 736(b) are made in exchange for a retiring partner’s pro rata share of his or her interest in partnership assets. Indeed, they may be thought of as being made in lieu of pieces of these assets. Of course, a partner would be paid his share of the fair values of such assets rather than their book values. These payments are considered property payments and are a return of capital up to the partner’s basis in the assets. Payments in excess of the partner’s basis result in capital gain; payments that fall short of this basis result in capital loss. Looked at from the other side, since the payments are considered to be made to buy out a partner’s interest, they are not deductible by the partnership even if they exceed the partner’s basis. (To prevent the conversion of ordinary income into capital gain, the property payment rules do not apply to payment for a partner’s pro rata share of unrealized receivables, substantially appreciated inventory, and, in some cases, partnership goodwill and certain annuity and lump- sum payments.)
Payments that fall under IRC Sec. 736(a) are commonly referred to as income payments. These are payments that, for one reason or another, are not classified as IRC Sec. 736(b) payments. These would include IRC Sec. 736(b) payments made in excess of the partner’s pro rata share of his or her interest in the fair value of partnership assets. These IRC Sec. 736(a) income payments are further divided into two categories:
* Those that are not determined with reference to partnership income are deemed to be guaranteed payments and, as such, are fully taxable to the receiving partner as ordinary income and deductible by the partnership.
* Those payments computed with reference to partnership income are treated as distributive shares of partnership income. These payments, therefore, retain their character from the partnership.
Retirement Payments as Guaranteed Payments
The classification of retirement payments as guaranteed payments has several ramifications, one of which can be relatively expensive. First, as a guaranteed payment it is fully deductible by the partnership and taxable as ordinary income for services rendered to the partner. Thus, as earned income, it is always subject to self-employment tax. Assuming a 15.3% rate with an OASDI base of $61,200, this can be quite expensive and should be taken into consideration with any tax planning for retirement. This is especially true if the nature of the partnership income would not ordinarily be subject to self-employment tax such as income from a partnership that owns and manages real estate. In this case, if the retirement payment were categorized as a distributive share rather than a guaranteed payment, there would be no self-employment tax.
What can be done to avoid the self-employment tax? Three possibilities come to mind. First, if the nature of the income is such that a distributive share of income would not be subject to self-employment tax, the agreement could be structured so that it doesn’t qualify as a guaranteed payment. To disqualify it as a guaranteed payment, it would only be necessary to require some reference to partnership income in its computation.
A second approach would be to lump the payments into larger annual amounts since most of the sell-employment tax has an annual base.
Example. Assume a partner is to receive $200,000 in retirement payments. If the payments are spread evenly over four years at $50,000 per year, the self-employment tax would be $30,600 ($50,000 x .153) x 4. If, however, the payments are bunched into two years of $100,000 per year, the serf-employment tax would be only $20,978, 2 x ($61,200 x .153) + ($38,800 x .029).
A third possible approach to avoid the self-employment tax burden is to structure the retirement agreement and payments so they conform to the requirements of IRC Sec. 1402 (a)(10). If the provisions of this section are followed, the payments will not be subject to self-employment tax. The requirements are as follows:
* Payments must continue at least until death.
* The retired partner must not provide or perform any services for the partnership.
* The retired partner’s entire share of partnership capital must be paid out before the close of the partnership year.
* The retired partner must not have any financial interest in the partnership at the end of the year with the exception of the right to receive retirement payments.
Three of the four requirements are self-explanatory, but, perhaps, the third could use an example:
Assume Partner Q in the QXR Partnership has a capital account balance of $60,000 and his retirement agreement stipulates he is to receive 5% of gross rentals for the rest of his life. Assume further that his capital account will be paid out in four equal installments. The 5% distributions will be subject to self-employment tax until the capital account is completely paid out. This can be significant money and can be avoided by paying out his capital account sooner. If not enough cash is the problem, it is probably better to borrow short term than to pay the steep rate of the self-employment tax.
Local Business Taxes
Certain local taxing jurisdictions impose a tax on unincorporated businesses operating within their jurisdictions. An example is the New York City Unincorporated Business Tax (UBT). This tax is imposed on all unincorporated businesses carried on in The City of New York and, as it has no ceiling, can be quite expensive. The tax is levied on both sole proprietorships and partnerships. Excluded from the tax, however, is the net income generated from the ownership and rental of real property. This is a typical situation where a real estate partnership must give serious thought to the tax consequences of rewarding a partner’s services with guaranteed payments.
These payments are always income for services rendered to the receiving partner. Therefore, they are deemed to be self-employment income, which after allowing for expenses, is subject to the UBT as well as self- employment Social Security.
Example. Assume the following: BC is a real estate partnership that owns two apartment houses. Partner A provides services for which she wishes to be rewarded with $30,000 per year and this is structured as a guaranteed payment. Assume the net rental income of the partnership is $15,000 before any guaranteed payments, and the partners divide income/losses equally.
Partner A would report the net amount of $25,000 in two very different pieces. The $30,000 guaranteed payment is self-employment income, which after expenses, would be subject to self-employment tax. In addition, this net amount is subject to any local business taxes such as the UBT. The $5,000 loss is part of A’s distributive share and would be reported on Schedule E as an active real estate rental loss and as such would be deductible against other items of income unless A’s AGI is too high. Each of the other partners would show a loss of $5,000 as his distributive share.
If we assume A has $6,000 of expenses against the guaranteed payment of $30,000, the net of $24,000 will be subject to both the UBT and self- employment Social Security. Assuming the rates to be 5% and 15.3% respectively, these additional taxes would come to $4,872.
There is a second alternative. Let the partnership reimburse A for all expenses and give A a “salary allowance” of $24,000 based in some fashion on the rents received. The net income of the partnership is now $9,000 ($15,000-6,000).
All three partners are in the same economic position they were before with the guaranteed payment. Partners B and C each have a $5,000 distributive loss. A now has income of $19,000 as her distributive share. This is the same net amount as with the guaranteed payment approach ($30,000-6,000-5,000). However, look at the difference in taxes. The $19,000 is now part of A’s distributive share which is not subject to self-employment Social Security because the partnership is actively managing real estate. There is also no local tax obligation such as the UBT because there is no separate self-employment income without the guaranteed payment. The $19,000 is subject only to ordinary income taxes.
Guaranteed Payments and the Disguised Sale Rules
Under IRC Sec. 721 no gain or loss is recognized to a partnership or any of its partners when a contribution of property is made to the partnership in exchange for a partnership interest. Additionally, under IRC Sec. 731, in the case of a distribution from a partnership to a partner, no gain is recognized to a partner except to the extent the distribution exceeds the partner’s adjusted basis of his or her interest in the partnership. Now a clever mind could take advantage by combining these two sections to produce an excellent tax avoidance scheme as illustrated by the following scenario:
A, a partner in the ABC partnership, owns an asset that cost him $5,000 and that is now worth $10,000. He contributes this asset to the partnership in exchange for an additional $10,000 partnership interest. Shortly thereafter, he receives a $5,000 cash distribution from the partnership. A has, in effect, “cashed in” the appreciated gain, but will not be taxed on it.
Otey v. Commissioner USTC, 70 TC 312, CCH Dec. 35, 167 (1978) was an interesting case with a variation on this theme. Otey contributed appreciated land to a partnership he had formed with a real estate developer. The plan was to get FHA-insured financing and build a moderate-income apartment complex on the land. However, as soon as the financing was obtained, the partnership distributed to Otey an amount just about equal to the fair value of the contributed land. The government maintained the distribution was a sale of the land to the partnership subject to IRC Sec. 707 as a transaction between a partnership and a partner not acting in the capacity of a partner. Otey, of course, maintained that IRC Secs. 721 and 731 came into play and there should be no recognized taxable event. After a very careful analysis and probing for the substance of the matter, the court agreed with Otey that no taxable event had occurred.
To help deal with this situation, Congress enacted IRC Sec. 707(a)(2)(B) known as the “disguised sale rules.” This section covers situations where there is a direct or indirect transfer of money or other property by a partner to a partnership followed by a transfer of money or other property by the partnership to the partner (or another partner). When the transactions, viewed together, are properly characterized as a sale or exchange of property, they shall be treated either as transactions between a partnership and a partner not acting in his capacity as a partner or as between two partners not acting within the partnership.
Guaranteed payments for services should not be affected by these rules as they should be clearly spelled out in the partnership agreement as compensation for particular services rendered and not payments related to any contribution of property to the partnership. Even with these payments, however, it would be wise to keep the payments reasonable and explicitly state how they were determined.
The most care should be taken with guaranteed payments for the use of capital. There is a presumption that a guaranteed payment for the use of capital is a true guaranteed payment and not a disguised sale. The presumption will be sustained as long as the amount is reasonable and the relevant acts and circumstances clearly show that a disguised sale has not taken place. The guaranteed payment should, of course, have its basis in the written provisions of the partnership agreement and should be of a reasonable amount for the use of capital. What is a reasonable amount? The guaranteed payment should not exceed the product of the partner’s beginning or average capital for the year multiplied by 150% of the highest applicable Federal rate as indicated under IRC Sec. 1274(D).
Barry Martin, MS, CPA, is an assistant professor at the College of Staten Island – The City University of New York.