[Federal Register Volume 80, Number 141 (Thursday, July 23, 2015)]
[Proposed Rules]
[Pages 43652-43661]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 2015-17828]
[[Page 43652]]
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DEPARTMENT OF THE TREASURY
Internal Revenue Service
26 CFR Part 1
[REG-115452-14]
RIN 1545-BM12
Disguised Payments for Services
AGENCY: Internal Revenue Service (IRS), Treasury
ACTION: Notice of proposed rulemaking.
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SUMMARY: This document contains proposed regulations relating to
disguised payments for services under section 707(a)(2)(A) of the
Internal Revenue Code. The proposed regulations provide guidance to
partnerships and their partners regarding when an arrangement will be
treated as a disguised payment for services. This document also
proposes conforming modifications to the regulations governing
guaranteed payments under section 707(c). Additionally, this document
provides notice of proposed modifications to Rev. Procs. 93-27 and
2001-43 relating to the issuance of interests in partnership profits to
service providers.
DATES: Written and electronic comments and requests for a public
hearing must be received by October 21, 2015.
ADDRESSES: Send submissions to CC:PA:LPD:PR (REG-115452-14), Room 5203,
Internal Revenue Service, P.O. Box 7604, Ben Franklin Station,
Washington, DC 20044. Submissions may be hand-delivered Monday through
Friday between the hours of 8 a.m. and 4 p.m. to CC:PA:LPD:PR (REG-
115452-14), Courier's Desk, Internal Revenue Service, 1111 Constitution
Avenue NW., Washington, DC, or sent electronically, via the Federal
eRulemaking Portal at http://www.regulations.gov (indicate IRS and REG-
115452-14).
FOR FURTHER INFORMATION CONTACT: Concerning submissions of comments,
Oluwafunmilayo (Funmi) Taylor (202) 517-6901; concerning the proposed
regulations, Jaclyn M. Goldberg (202) 317-6850 (not toll-free numbers).
SUPPLEMENTARY INFORMATION:
Background
Generally, under the statutory framework of Subchapter K of the
Code, an allocation or distribution between a partnership and a partner
for the provision of services can be treated in one of three ways: (1)
A distributive share under section 704(b); (2) a guaranteed payment
under section 707(c); or (3) as a transaction in which a partner has
rendered services to the partnership in its capacity as other than a
partner under section 707(a).
Distributive Share Treatment
Partnership allocations that are determined with regard to
partnership income and that are made to a partner for services rendered
by the partner in its capacity as a partner are generally treated as
distributive shares of partnership income, taxable under the general
rules of sections 702, 703, and 704. In some cases, the right to a
distributive share may qualify as a profits interest defined in Rev.
Proc. 93-27, 1993-2 C.B. 343. Rev. Proc. 93-27, clarified by Rev. Proc.
2001-43, 2001-2 C.B. 191, provides guidance on the treatment of the
receipt of a profits interest for services provided to or for the
benefit of the partnership.
Arrangements Subject to Sections 707(c) or 707(a)(1).
In 1954, Congress added section 707 to the Code to clarify
transactions between a partner and a partnership. Section 707(a)
addresses arrangements in which a partner engages with the partnership
other than in its capacity as a partner. The legislative history to
section 707(a) provides the general rule that a partner who engages in
a transaction with the partnership, other than in its capacity as a
partner is treated as though it were not a partner. The provision was
intended to apply to the sale of property by the partner to the
partnership, the purchase of property by the partner from the
partnership, and the rendering of services by the partner to the
partnership or by the partnership to the partner. H.R. Rep. No. 1337,
83d Cong., 2d Sess. 227 (1954) (House Report); S. Rep. No. 1622, 83d
Cong., 2d Sess. 387 (1954) (Senate Report).
Congress simultaneously added section 707(c) to address payments to
partners of the partnership acting in their partner capacity. Section
707(c) provides that to the extent determined without regard to the
income of the partnership, payment to a partner for services shall be
considered as made to a person who is not a partner, but only for
purposes of sections 61(a) and 162(a). The Senate Report and the House
Report provide that a fixed salary, payable without regard to
partnership income, to a partner who renders services to the
partnership is a guaranteed payment. The amount of the payment shall be
included in the partner's gross income, and shall not be considered a
distributive share of income or gain. A partner who is guaranteed a
minimum annual amount for its services shall be treated as receiving a
fixed payment in that amount. House Report at 227; Senate Report at
387.
In 1956, the Treasury Department and the IRS issued additional
guidance under Sec. 1.707-1 relating to a partner not acting in its
capacity as a partner under section 707(a) and to guaranteed payments
under section 707(c). See TD 6175. However, it remained unclear when a
partner's services to the partnership were rendered in a non-partner
capacity under section 707(a) rather than in a partner capacity under
section 707(c).
In 1975, the Tax Court distinguished sections 707(a) and 707(c)
payments in Pratt v. Commissioner, 64 T.C. 204 (1975), aff'd in part,
rev'd in part, 550 F.2d 1023 (5th Cir. 1977). In Pratt, the general
partners in two limited partnerships formed to purchase, develop, and
operate two shopping centers received a fixed percentage of gross
rentals in exchange for the performance of managerial services. The Tax
Court held that these payments were not guaranteed payments under
section 707(c) because they were computed based on a percentage of
gross rental income and therefore were not paid without regard to
partnership income. The Tax Court further held that section 707(a) did
not apply because the general partners performed managerial duties in
their partner capacities in accordance with their basic duties under
the partnership agreement. On appeal, the Fifth Circuit affirmed the
Tax Court's decision. The Fifth Circuit reasoned that Congress enacted
section 707(a) to apply to partners who perform services for the
partnership that are outside the scope of the partnership's activities.
The Court indicated that if the partner performs services that the
partnership itself provides, then the compensation to the service
provider is merely a rearrangement among the partners of their
distributive shares in the partnership income.
In response to the decision in Pratt, the Treasury Department and
the IRS issued Rev. Rul. 81-300, 1981-2 C.B. 143 and Rev. Rul. 81-301,
1981-2 C.B. 144 to clarify the treatment of transactions under sections
707(a) and 707(c). As in the Pratt case, Rev. Rul. 81-300 considers a
partnership formed to purchase, develop, and operate a shopping center.
The partnership agreement required the general partners to contribute
their time, managerial abilities, and best efforts to the partnership.
In return for these services, the general partners received a fee equal
to five percent of the partnership's gross rental income. The ruling
concluded that the taxpayers performed managerial services in their
capacities as general
[[Page 43653]]
partners, and characterized the management fees as guaranteed payments
under section 707(c). The ruling provides that, although guaranteed
payments under section 707(c) frequently involve a fixed amount, they
are not limited to fixed amounts. Thus, the ruling concluded that 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
profits.
Rev. Rul. 81-301 describes a limited partnership which has two
classes of general partners. The first class of general partner
(director general partners) had complete control over the management,
conduct, and operation of partnership activities. The second class of
general partner (adviser general partner) rendered to the partnership
services that were substantially the same as those that the adviser
general partner rendered to other persons as an independent contractor.
The adviser general partner received 10 percent of daily gross income
in exchange for the management services it provided to the partnership.
Rev. Rul. 81-301 held that the adviser general partner received its
gross income allocation in a nonpartner capacity under section 707(a)
because the adviser general partner provided similar services to other
parties, was subject to removal by the director general partners, was
not personally liable to the other partners for any losses, and its
management was supervised by the director general partners.
Enactment of Section 707(a)(2)(A)
Congress revisited the scope of section 707(a) in 1984, in part to
prevent partners from circumventing the capitalization requirements of
sections 263 and 709 by structuring payments for services as
allocations of partnership income under section 704. H.R. Rep. No. 432
(Pt. 2), 98th Cong., 2d Sess. 1216-21 (1984) (H.R. Rep.); S. Prt. No.
169 (Vol. 1), 98th Cong., 2d Sess. 223-32 (1984) (S. Prt.). Congress
specifically addressed the holdings in Rev. Rul. 81-300 and Rev. Rul.
81-301, affirming Rev. Rul. 81-301 and concluding that the payment in
Rev. Rul. 81-300 should be recharacterized as a section 707(a) payment.
S. Prt. at 230. Accordingly, the Treasury Department and the IRS are
obsoleting Rev. Rul. 81-300 and request comments on whether it should
be reissued with modified facts.
Congress also added an anti-abuse rule to section 707(a) relating
to payments to partner service providers. Section 707(a)(2)(A) provides
that if a partner performs services for a partnership and receives a
related direct or indirect allocation and distribution, and the
performance of services and allocation and distribution, when viewed
together, are properly characterized as a transaction occurring between
the partnership and a partner acting other than in its capacity as a
partner, the transaction will be treated as occurring between the
partnership and one who is not a partner under section 707(a)(1). See
section 73 of the Tax Reform Act of 1984 (the 1984 Act). The Treasury
Department and the IRS have concluded that section 707(a)(2) applies to
arrangements in which distributions to the service provider depend on
an allocation of an item of income, and section 707(c) applies to
amounts whose payments are unrelated to partnership income.
Section 707(a)(2) grants the Secretary broad regulatory authority
to identify transactions involving disguised payments for services
under section 707(a)(2)(A). This grant of regulatory authority stems
from Congress's concern that partnerships and service providers were
inappropriately treating payments as allocations and distributions to a
partner even when the service provider acted in a capacity other than
as a partner. S. Prt. at 225. Congress determined that allocations and
distributions that were, in substance, direct payments for services
should be treated as a payment of fees rather than as an arrangement
for the allocation and distribution of partnership income. H.R. Rep. at
1218; S. Prt. at 225. Congress differentiated these arrangements from
situations in which a partner receives an allocation (or increased
allocation) for an extended period to reflect its contribution of
property or services to the partnership, such that the partner receives
the allocation in its capacity as a partner. In balancing these
potentially conflicting concerns, Congress anticipated that the
regulations would take five factors into account in determining whether
a service provider would receive its putative allocation and
distribution in its capacity as a partner. H.R. Rep. at 1219-20; S.
Prt. at 227.
Congress identified as its first and most important factor whether
the payment is subject to significant entrepreneurial risk as to both
the amount and fact of payment. In explaining why entrepreneurial risk
is the most important factor, Congress provides that ``[p]artners
extract the profits of the partnership with reference to the business
success of the venture, while third parties generally receive payments
which are not subject to this risk.'' S. Prt. at 227. An arrangement
for an allocation and distribution to a service provider which involves
limited risk as to amount and payment is treated as a fee under section
707(a)(2)(A). Congress specified examples of allocations that
presumptively limit a partner's risk, including (i) capped allocations
of income, (ii) allocations for a fixed number of years under which the
income that will go to the partner is reasonably certain, (iii)
continuing arrangements in which purported allocations and
distributions are fixed in amount or reasonably determinable under all
facts and circumstances, and (iv) allocations of gross income items.
An arrangement in which an allocation and distribution to a service
provider are subject to significant entrepreneurial risk as to amount
will generally be recognized as a distributive share, although other
factors are also relevant. The legislative history to section
707(a)(2)(A) includes the following examples of factors that could bear
on this determination: (i) Whether the partner status of the recipient
is transitory; (ii) whether the allocation and distribution that are
made to the partner are close in time to the partner's performance of
services; (iii) whether the facts and circumstances indicate that the
recipient became a partner primarily to obtain tax benefits for itself
or the partnership that would not otherwise have been available; and
(iv) whether the value of the recipient's interest in general and in
continuing partnership profits is small in relation to the allocation
in question.
Explanation of Provisions
Section 1.707-1 sets forth general rules on the operation of
section 707. Section 1.707-2 is titled ``Disguised payments for
services'' and is currently reserved. Sections 1.707-3 through 1.707-7
provide guidance regarding transactions involving disguised sales under
section 707(a)(2)(B). These proposed regulations are issued under Sec.
1.707-2 and provide guidance regarding transactions involving disguised
payments for services under section 707(a)(2)(A). The effective date of
the proposed regulations is provided under Sec. 1.707-9.
I. General Rules Regarding Disguised Payments for Services
A. Scope
Consistent with the language of section 707(a)(2)(A), Sec. 1.707-
2(b) of the proposed regulations provides that an arrangement will be
treated as a disguised payment for services if (i) a person (service
provider), either in a
[[Page 43654]]
partner capacity or in anticipation of being a partner, performs
services (directly or through its delegate) to or for the benefit of
the partnership; (ii) there is a related direct or indirect allocation
and distribution to the service provider; and (iii) the performance of
the services and the allocation and distribution when viewed together,
are properly characterized as a transaction occurring between the
partnership and a person acting other than in that person's capacity as
a partner.
The proposed regulations provide a mechanism for determining
whether or not an arrangement is treated as a disguised payment for
services under section 707(a)(2)(A). An arrangement that is treated as
a disguised payment for services under these proposed regulations will
be treated as a payment for services for all purposes of the Code.
Thus, the partnership must treat the payments as payments to a non-
partner in determining the remaining partners' shares of taxable income
or loss. Where appropriate, the partnership must capitalize the
payments or otherwise treat them in a manner consistent with the
recharacterization.
The consequence of characterizing an arrangement as a payment for
services is otherwise beyond the scope of these regulations. For
example, the proposed regulations do not address the timing of
inclusion by the service provider or the timing of a deduction by the
partnership other than to provide that each is taken into account as
provided for under applicable law by applying all relevant sections of
the Code and all relevant judicial doctrines. Further, if an
arrangement is subject to section 707(a), taxpayers should look to
relevant authorities to determine the status of the service provider as
an independent contractor or employee. See, generally, Rev. Rul. 69-
184, 1969-1 C.B. 256. The Treasury Department and the IRS believe that
section 707(a)(2)(A) generally should not apply to arrangements that
the partnership has reasonably characterized as a guaranteed payment
under section 707(c).
Allocations pursuant to an arrangement between a partnership and a
service provider to which sections 707(a) and 707(c) do not apply will
be treated as a distributive share under section 704(b). Rev. Proc. 93-
27 and Rev. Proc. 2001-43 may apply to such an arrangement if the
specific requirements of those Revenue Procedures are also satisfied.
The Treasury Department and the IRS intend to modify the exceptions set
forth in those revenue procedures to include an additional exception
for profits interests issued in conjunction with a partner forgoing
payment of a substantially fixed amount. This exception is discussed in
part IV of the Explanation of Provisions section of this preamble.
B. Application and Timing
These proposed regulations apply to a service provider who purports
to be a partner even if applying the regulations causes the service
provider to be treated as a person who is not a partner. S. Prt. at
227. Further, the proposed regulations may apply even if their
application results in a determination that no partnership exists. The
regulations also apply to a special allocation and distribution
received in exchange for services by a service provider who receives
other allocations and distributions in a partner capacity under section
704(b).
The proposed regulations characterize the nature of an arrangement
at the time at which the parties enter into or modify the arrangement.
Although section 707(a)(2)(A)(ii) requires both an allocation and a
distribution to the service provider, the Treasury Department and the
IRS believe that a premise of section 704(b) is that an income
allocation correlates with an increased distribution right, justifying
the assumption that an arrangement that provides for an income
allocation should be treated as also providing for an associated
distribution for purposes of applying section 707(a)(2)(A). The
Treasury Department and the IRS considered that some arrangements
provide for distributions in a later year, and that those later
distributions may be subject to independent risk. However, the Treasury
Department and the IRS believe that recharacterizing an arrangement
retroactively is administratively difficult. Thus, the proposed
regulations characterize the nature of an arrangement when the
arrangement is entered into (or modified) regardless of when income is
allocated and when money or property is distributed. The proposed
regulations apply to both one-time transactions and continuing
arrangements. S. Prt. at 226.
II. Factors Considered
Whether an arrangement constitutes a payment for services (in whole
or in part) depends on all of the facts and circumstances. The proposed
regulations include six non-exclusive factors that may indicate that an
arrangement constitutes a disguised payment for services. Of these
factors, the first five factors generally track the facts and
circumstances identified as relevant in the legislative history for
purposes of applying section 707(a)(2)(A). The proposed regulations
also add a sixth factor not specifically identified by Congress. The
first of these six factors, the existence of significant
entrepreneurial risk, is accorded more weight than the other factors,
and arrangements that lack significant entrepreneurial risk are treated
as disguised payments for services. The weight given to each of the
other five factors depends on the particular case, and the absence of a
particular factor (other than significant entrepreneurial risk) is not
necessarily determinative of whether an arrangement is treated as a
payment for services.
A. Significant Entrepreneurial Risk
As described in the Background section of this preamble, Congress
indicated that the most important factor in determining whether or not
an arrangement constitutes a payment for services is that the
allocation and distribution is subject to significant entrepreneurial
risk. S. Prt. at 227. Congress noted that partners extract the profits
of the partnership based on the business success of the venture, while
third parties generally receive payments that are not subject to this
risk. Id.
The proposed regulations reflect Congress's view that this factor
is most important. Under the proposed regulations, an arrangement that
lacks significant entrepreneurial risk constitutes a disguised payment
for services. An arrangement in which allocations and distributions to
the service provider are subject to significant entrepreneurial risk
will generally be recognized as a distributive share but the ultimate
determination depends on the totality of the facts and circumstances.
The Treasury Department and the IRS request comments on whether
allocations to service providers that lack significant entrepreneurial
risk could be characterized as distributive shares under section 704(b)
in any circumstances.
Whether an arrangement lacks significant entrepreneurial risk is
based on the service provider's entrepreneurial risk relative to the
overall entrepreneurial risk of the partnership. For example, a service
provider who receives a percentage of net profits in each of a
partnership that invests in high-quality debt instruments and a
partnership that invests in volatile or unproven businesses may have
significant entrepreneurial risk with respect to both interests.
Section 1.707-2(c)(1)(i) through (v) of the proposed regulations
set forth arrangements that presumptively lack significant
entrepreneurial risk. These
[[Page 43655]]
arrangements are presumed to result in an absence of significant
entrepreneurial risk (and therefore, a disguised payment for services)
unless other facts and circumstances can establish the presence of
significant entrepreneurial risk by clear and convincing evidence.
These examples generally describe facts and circumstances in which
there is a high likelihood that the service provider will receive an
allocation regardless of the overall success of the business operation,
including (i) capped allocations of partnership income if the cap would
reasonably be expected to apply in most years, (ii) allocations for a
fixed number of years under which the service provider's distributive
share of income is reasonably certain, (iii) allocations of gross
income items, (iv) an allocation (under a formula or otherwise) that is
predominantly fixed in amount, is reasonably determinable under all the
facts and circumstances, or is designed to assure that sufficient net
profits are highly likely to be available to make the allocation to the
service provider (for example, if the partnership agreement provides
for an allocation of net profits from specific transactions or
accounting periods and this allocation does not depend on the overall
success of the enterprise), and (v) arrangements in which a service
provider either waives its right to receive payment for the future
performance of services in a manner that is non-binding or fails to
timely notify the partnership and its partners of the waiver and its
terms.
With respect to the fourth example, the presence of certain facts,
when coupled with a priority allocation to the service provider that is
measured over any accounting period of the partnership of 12 months or
less, may create opportunities that will lead to a higher likelihood
that sufficient net profits will be available to make the allocation.
One fact is that the value of partnership assets is not easily
ascertainable and the partnership agreement allows the service provider
or a related party in connection with a revaluation to control the
determination of asset values, including by controlling events that may
affect those values (such as timing of announcements that affect the
value of the assets). (See Example 3(iv).) Another fact is that the
service provider or a related party controls the entities in which the
partnership invests, including controlling the timing and amount of
distributions by those controlled entities. (These two facts by
themselves do not, however, necessarily establish the absence of
significant entrepreneurial risk.) By contrast, certain priority
allocations that are intended to equalize a service provider's return
with priority allocations already allocated to investing partners over
the life of the partnership (commonly known as ``catch-up
allocations'') typically will not fall within the types of allocations
covered by the fourth example and will not lack significant
entrepreneurial risk, although all of the facts and circumstances are
considered in making that determination.
With respect to the fifth example, the Treasury Department and the
IRS request suggestions regarding fee waiver requirements that
sufficiently bind the waiving service provider and that are
administrable by the partnership and its partners.
Congress's emphasis on entrepreneurial risk requires changes to
existing regulations under section 707(c). Specifically, Example 2 of
Sec. 1.707-1(c) provides that if a partner is entitled to an
allocation of the greater of 30 percent of partnership income or a
minimum guaranteed amount, and the income allocation exceeds the
minimum guaranteed amount, then the entire income allocation is treated
as a distributive share under section 704(b). Example 2 also provides
that if the income allocation is less than the guaranteed amount, then
the partner is treated as receiving a distributive share to the extent
of the income allocation and a guaranteed payment to the extent that
the minimum guaranteed payment exceeds the income allocation. The
treatment of the arrangements in Example 2 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). Accordingly, the proposed regulations modify Example 2
to provide that the entire minimum amount is treated as a guaranteed
payment under section 707(c) regardless of the amount of the income
allocation. Rev. Rul. 66-95, 1966-1 C.B. 169, and Rev. Rul. 69-180,
1969-1 C.B. 183, are also inconsistent with these proposed regulations.
The Treasury Department and the IRS intend to obsolete Rev. Rul. 66-95
and revise Rev. Rul. 69-180, when these regulations are published in
final form.
B. Secondary Factors
Section 1.707-2(c)(2) through (6) describes additional factors of
secondary importance in determining whether or not an arrangement that
gives the appearance of significant entrepreneurial risk constitutes a
payment for services. The weight given to each of the other factors
depends on the particular case, and the absence of a particular factor
is not necessarily determinative of whether an arrangement is treated
as a payment for services. Four of these factors, described by Congress
in the legislative history to section 707(a)(2)(A), are (i) that the
service provider holds, or is expected to hold, a transitory
partnership interest or a partnership interest for only a short
duration, (ii) that the service provider receives an allocation and
distribution in a time frame comparable to the time frame that a non-
partner service provider would typically receive payment, (iii) that
the service provider became a partner primarily to obtain tax benefits
which would not have been available if the services were rendered to
the partnership in a third party capacity, and (iv) that the value of
the service provider's interest in general and continuing partnership
profits is small in relation to the allocation and distribution.
To these four factors, the proposed regulations add a fifth factor.
The fifth factor is present if the arrangement provides for different
allocations or distributions with respect to different services
received, where the services are provided either by a single person or
by persons that are related under sections 707(b) or 267(b), and the
terms of the differing allocations or distributions are subject to
levels of entrepreneurial risk that vary significantly. For example,
assume that a partnership receives services from both its general
partner and from a management company that is related to the general
partner under section 707(b). Both the general partner and the
management company receive a share in future partnership net profits in
exchange for their services. The general partner is entitled to an
allocation of 20 percent of net profits and undertakes an enforceable
obligation to repay any amounts distributed pursuant to its interest
(reduced by reasonable allowance for tax payments made on the general
partner's allocable shares of partnership income and gain) that exceed
20 percent of the overall net amount of partnership profits computed
over the partnership's life and it is reasonable to anticipate that the
general partner can and will comply fully with this obligation. The
proposed regulations refer to this type of obligation and similar
obligations, as a ``clawback obligation.'' In contrast, the management
company is entitled to a preferred amount of net income that, once
paid, is not subject to a clawback obligation. Because the general
partner and the management company are service providers that are
related parties under section 707(b), and because the
[[Page 43656]]
terms of the allocations and distributions to the management company
create a significantly lower level of economic risk than the terms for
the general partner, the management company's arrangement might
properly be treated as a disguised payment for services (depending on
all other facts and circumstances, including amount of entrepreneurial
risk).
III. Examples
Section 1.707-2(d) of the proposed regulations contains a number of
examples illustrating the application of the factors described in Sec.
1.707-2(c). The examples illustrate the application of these
regulations to arrangements that contain certain facts and
circumstances that the Treasury Department and the IRS believe
demonstrate the existence or absence of significant entrepreneurial
risk.
Several of the examples consider arrangements in which a partner
agrees to forgo fees for services and also receives a share of future
partnership income and gains. The examples consider the application of
section 707(a)(2)(A) based on the manner in which the service provider
(i) forgoes its right to receive fees, and (ii) is entitled to share in
future partnership income and gains. In Examples 5 and 6, the service
provider forgoes the right to receive fees in a manner that supports
the existence of significant entrepreneurial risk by forgoing its right
to receive fees before the period begins and by executing a waiver that
is binding, irrevocable, and clearly communicated to the other
partners. Similarly, the service provider's arrangement in these
examples include the following facts and circumstances that taken
together support the existence of significant entrepreneurial risk: The
allocation to the service provider is determined out of net profits and
is neither highly likely to be available nor reasonably determinable
based on all facts and circumstances available at the time of the
arrangement, and the service provider undertakes a clawback obligation
and is reasonably expected to be able to comply with that obligation.
The presence of each fact described in these examples is not
necessarily required to determine that section 707(a)(2)(A) does not
apply to an arrangement. However, the absence of certain facts, such as
a failure to measure future profits over at least a 12-month period,
may suggest that an arrangement constitutes a fee for services.
The proposed regulations also contain examples that consider
arrangements to which section 707(a)(2)(A) applies. Example 1 concludes
that an arrangement in which a service provider receives a capped
amount of partnership allocations and distributions and the cap is
likely to apply provides for a disguised payment for services under
section 707(a)(2)(A). In Example 3(iii), a service provider is entitled
to a share of future partnership net profits, the partnership can
allocate net profits from specific transactions or accounting periods,
those allocations do not depend on the long-term future success of the
enterprise, and a party that is related to the service provider
controls the timing of purchases, sales, and distributions. The example
concludes that under these facts, the arrangement lacks significant
entrepreneurial risk and provides for a disguised payment for services.
Example 4 considers similar facts, but assumes that the partnership's
assets are publicly traded and are marked-to-market under section
475(f)(1). Under these facts, the example concludes that the
arrangement has significant entrepreneurial risk, and thus that section
707(a)(2)(A) does not apply.
IV. Safe Harbor Revenue Procedures
Rev. Proc. 93-27 provides that in certain circumstances if a person
receives a profits interest for the provision of services to or for the
benefit of a partnership in a partner capacity or in anticipation of
becoming a partner, the IRS will not treat the receipt of such interest
as a taxable event for the partner or the partnership. The revenue
procedure does not apply if (1) the profits interest relates to a
substantially certain and predictable stream of income from partnership
assets, such as income from high-quality debt securities or a high-
quality net lease; (2) within two years of receipt, the partner
disposes of the profits interest; or (3) the profits interest is a
limited partnership interest in a ``publicly traded partnership''
within the meaning of section 7704(b).
Rev. Proc. 2001-43 provides that, for purposes of Rev. Proc. 93-27,
if a partnership grants a substantially nonvested profits interest in
the partnership to a service provider, the service provider will be
treated as receiving the interest on the date of its grant, provided
that: (i) The partnership and the service provider treat the service
provider as the owner of the partnership interest from the date of its
grant, and the service provider takes into account the distributive
share of partnership income, gain, loss, deduction and credit
associated with that interest in computing the service provider's
income tax liability for the entire period during which the service
provider has the interest; (ii) upon the grant of the interest or at
the time that the interest becomes substantially vested, neither the
partnership nor any of the partners deducts any amount (as wages,
compensation, or otherwise) for the fair market value of the interest;
and (iii) all other conditions of Rev. Proc. 93-27 are satisfied.
The Treasury Department and the IRS are aware of transactions in
which one party provides services and another party receives a
seemingly associated allocation and distribution of partnership income
or gain. For example, a management company that provides services to a
fund in exchange for a fee may waive that fee, while a party related to
the management company receives an interest in future partnership
profits the value of which approximates the amount of the waived fee.
The Treasury Department and the IRS have determined that Rev. Proc. 93-
27 does not apply to such transactions because they would not satisfy
the requirement that receipt of an interest in partnership profits be
for the provision of services to or for the benefit of the partnership
in a partner capacity or in anticipation of being a partner, and
because the service provider would effectively have disposed of the
partnership interest (through a constructive transfer to the related
party) within two years of receipt.
Further, the Treasury Department and the IRS plan to issue a
revenue procedure providing an additional exception to the safe harbor
in Rev. Proc. 93-27 in conjunction with the publication of these
regulations in final form. The additional exception will apply to a
profits interest issued in conjunction with a partner forgoing payment
of an amount that is substantially fixed (including a substantially
fixed amount determined by formula, such as a fee based on a percentage
of partner capital commitments) for the performance of services,
including a guaranteed payment under section 707(c) or a payment in a
non-partner capacity under section 707(a).
In conjunction with the issuance of proposed regulations (REG-
105346-03; 70 FR 29675-01; 2005-1 C.B. 1244) relating to the tax
treatment of certain transfers of partnership equity in connection with
the performance of services, the Treasury Department and the IRS issued
Notice 2005-43, 2005-24 I.R.B. 1221. Notice 2005-43 includes a proposed
revenue procedure regarding partnership interests transferred in
connection with the performance of services. In the event that the
proposed revenue procedure provided for in
[[Page 43657]]
Notice 2005-43 is finalized, it will include the additional exception
referenced.
Effective Dates
The proposed regulations would be effective on the date the final
regulations are published in the Federal Register and would apply to
any arrangement entered into or modified on or after the date of
publication of the final regulations. In the case of any arrangement
entered into or modified before the final regulations are published in
the Federal Register, the determination of whether an arrangement is a
disguised payment for services under section 707(a)(2)(A) is made on
the basis of the statute and the guidance provided regarding that
provision in the legislative history of section 707(a)(2)(A). Pending
the publication of final regulations, the position of the Treasury
Department and the IRS is that the proposed regulations generally
reflect Congressional intent as to which arrangements are appropriately
treated as disguised payments for services.
Effect on Other Documents
The following publication is obsolete as of July 23, 2015:
Rev. Rul. 81-300 (1981-2 C.B. 143).
The following publications will be obsolete as of the date of a
Treasury decision adopting these rules as final regulations in the
Federal Register:
Rev. Rul. 66-95 (1966-1 C.B. 169); and
Rev. Rul. 69-180 (1969-1 C.B. 183).
Special Analyses
It has been determined that this notice of proposed rulemaking is
not a significant regulatory action as defined in Executive Order
12866, as supplemented by Executive Order 13563. Therefore, a
regulatory assessment is not required. It has also been determined that
section 553(b) of the Administrative Procedure Act (5 U.S.C. chapter 5)
does not apply to these regulations, and because the regulation does
not impose a collection of information on small entities, the
Regulatory Flexibility Act (5 U.S.C. chapter 6) does not apply.
Pursuant to section 7805(f) of the Code, this notice of proposed
rulemaking will be submitted to the Chief Counsel for Advocacy of the
Small Business Administration for comment on its impact on small
business.
Comments and Requests for Public Hearing
The Treasury Department and the IRS invite public comment on these
proposed regulations. The legislative history supporting section
707(a)(2)(A) indicates that an arrangement that lacks significant
entrepreneurial risk is generally treated as a disguised payment for
services. 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. Nonetheless,
the Treasury Department and the IRS request comments on, and examples
of, whether arrangements could exist that should be treated as a
distributive share under section 704(b) despite the absence of
significant entrepreneurial risk. In addition, the Treasury Department
and the IRS request comments on sufficient notification requirements to
effectively render a fee waiver binding upon the service provider and
the partnership.
The Treasury Department and the IRS have become aware that some
partnerships that assert reliance on Sec. 1.704-1(b)(2)(ii)(i) (the
economic effect equivalence rule) have expressed uncertainty on the
proper treatment of partners who receive an increased right to share in
partnership property upon a partnership liquidation without respect to
the partnership's net income. These partnerships typically set forth
each partner's distribution rights upon a liquidation of the
partnership and require the partnership to allocate net income annually
in a manner that causes partners' capital accounts to match partnership
distribution rights to the extent possible. Such agreements are
commonly referred to as ``targeted capital account agreements.'' Some
taxpayers have expressed uncertainty whether a partnership with a
targeted capital account agreement must allocate income or a guaranteed
payment to a partner who has an increased right to partnership assets
determined as if the partnership liquidated at the end of the year even
in the event that the partnership recognizes no, or insufficient, net
income. The Treasury Department and the IRS generally believe that
existing rules under Sec. Sec. 1.704-1(b)(2)(ii) and 1.707-1(c)
address this circumstance by requiring partner capital accounts to
reflect the partner's distribution rights as if the partnership
liquidated at the end of the taxable year, but request comments on
specific issues and examples with respect to which further guidance
would be helpful. No inference is intended as to whether and when
targeted capital account agreements could satisfy the economic effect
equivalence rule.
Before these proposed regulations are adopted as final regulations,
consideration will be given to any written (a signed original and eight
(8) copies) or electronic comments that are submitted timely to the
IRS. The Treasury Department and the IRS request comments on all
aspects of the proposed regulations. All comments will be available for
public inspection and copying upon request. A public hearing will be
scheduled if requested in writing by any person that timely submits
written or electronic comments. If a public hearing is scheduled,
notice of the date, time, and place for the public hearing will be
published in the Federal Register.
Drafting Information
The principal author of these proposed regulations is Jaclyn M.
Goldberg of the Office of Assistant Chief Counsel (Passthroughs and
Special Industries). However, other personnel from the Internal Revenue
Service and the Treasury Department participated in their development.
List of Subjects in 26 CFR Part 1
Income taxes, Reporting and recordkeeping requirements.
Proposed Amendment to the Regulations
Accordingly, 26 CFR part 1 is proposed to be amended as follows:
PART 1--INCOME TAXES
0
Paragraph 1. The authority citation for part 1 is amended by adding
entries in numerical order to read in part as follows:
Authority: 26 U.S.C. 7805 * * *
Section 1.707-0 also issued under 26 U.S.C. 707(a).
Section 1.707-2 also issued under 26 U.S.C. 707(a).
Section 1.707-9 also issued under 26 U.S.C. 707(a). * * *
Section 1.736-1 also issued under 26 U.S.C. 736(a). * * *
0
Par. 2. Section 1.707-0 is amended by revising Sec. 1.707-2 to read as
follows:
Sec. 1.707-0. Table of contents.
* * * * *
Sec. 1.707-2. Disguised payments for services.
(a) In general.
(b) Elements necessary to characterize arrangements as disguised
payments for services.
(1) In general.
(2) Application and timing.
(i) Timing and effect of the determination.
[[Page 43658]]
(ii) Timing of inclusion.
(3) Application of disguised payment rules.
(c) Factors considered.
(d) Examples.
* * * * *
0
Par. 3. Section 1.707-1 is amended by adding a sentence at the end of
paragraph (a) and revising paragraph (c) Example 2 to read as follows.
Sec. 1.707-1. Transactions between partner and partnership.
(a) * * * For arrangements pursuant to which a purported partner
performs services for a partnership and the partner receives a related
direct or indirect allocation and distribution from the partnership,
see Sec. 1.707-2 to determine whether the arrangement should be
treated as a disguised payment for services.
(c) * * *
Example 2. Partner C in the CD partnership is to receive 30
percent of partnership income, but not less than $10,000. The income
of the partnership is $60,000, and C is entitled to $18,000 (30
percent of $60,000). Of this amount, $10,000 is a guaranteed payment
to C. The $10,000 guaranteed payment reduces the partnership's net
income to $50,000 of which C receives $8,000 as C's distributive
share.
* * * * *
0
Par. 4. Section 1.707-2 is added to read as follows:
Sec. 1.707-2 Disguised payments for services.
(a) In general. This section prescribes rules for characterizing
arrangements as disguised payments for services. Paragraph (b) of this
section outlines the elements necessary to characterize an arrangement
as a payment for services, and it provides operational rules regarding
application and timing of this section. Paragraph (c) of this section
identifies the factors that weigh in the determination of whether an
arrangement includes the elements described in paragraph (b) of this
section that make it appropriate to characterize the arrangement as a
payment for services. Paragraph (d) of this section provides examples
applying these rules to determine whether an arrangement is a payment
for services.
(b) Elements necessary to characterize arrangements as disguised
payments for services--(1) In general. An arrangement will be treated
as a disguised payment for services if--
(i) A person (service provider), either in a partner capacity or in
anticipation of becoming a partner, performs services (directly or
through its delegate) to or for the benefit of a partnership;
(ii) There is a related direct or indirect allocation and
distribution to such service provider; and
(iii) The performance of such services and the allocation and
distribution, when viewed together, are properly characterized as a
transaction occurring between the partnership and a person acting other
than in that person's capacity as a partner.
(2) Application and timing.--(i) Timing and effect of the
determination. Whether an arrangement is properly characterized as a
payment for services is determined at the time the arrangement is
entered into or modified and without regard to whether the terms of the
arrangement require the allocation and distribution to occur in the
same taxable year. An arrangement that is treated as a payment for
services under this paragraph (b) is treated as a payment for services
for all purposes of the Internal Revenue Code, including for example,
sections 61, 409A, and 457A (as applicable). The amount paid to a
person in consideration for services under this section is treated as a
payment for services provided to the partnership, and, when
appropriate, the partnership must capitalize these amounts (or
otherwise treat such amounts in a manner consistent with their
recharacterization). The partnership must also treat the arrangement as
a payment to a non-partner in determining the remaining partners'
shares of taxable income or loss.
(ii) Timing of inclusion. The inclusion of income by the service
provider and deduction (if applicable) by the partnership of amounts
paid pursuant to an arrangement that is characterized as a payment for
services under paragraph (b)(1) of this section is taken into account
in the taxable year as required under applicable law by applying all
relevant sections of the Internal Revenue Code, including for example,
sections 409A and 457A (as applicable), to the allocation and
distribution when they occur (or are deemed to occur under all other
provisions of the Internal Revenue Code).
(3) Application of disguised payment rules. If a person purports to
provide services to a partnership in a capacity as a partner or in
anticipation of becoming a partner, the rules of this section apply for
purposes of determining whether the services were provided in exchange
for a disguised payment, even if it is determined after applying the
rules of this section that the service provider is not a partner. If
after applying the rules of this section, no partnership exists as a
result of the service provider failing to become a partner under the
arrangement, then the service provider is treated as having provided
services directly to the other purported partner.
(c) Factors considered. Whether an arrangement constitutes a
payment for services (in whole or in part) depends on all of the facts
and circumstances. Paragraphs (c)(1) through (6) of this section
provide a non-exclusive list of factors that may indicate that an
arrangement constitutes in whole or in part a payment for services. The
presence or absence of a factor is based on all of the facts and
circumstances at the time the parties enter into the arrangement (or if
the parties modify the arrangement, at the time of the modification).
The most important factor is significant entrepreneurial risk as set
forth in paragraph (c)(1) of this section. An arrangement that lacks
significant entrepreneurial risk constitutes a payment for services. An
arrangement that has significant entrepreneurial risk will generally
not constitute a payment for services unless other factors establish
otherwise. For purposes of making determinations under this paragraph
(c), the weight to be given to any particular factor, other than
entrepreneurial risk, depends on the particular case and the absence of
a factor is not necessarily indicative of whether or not an arrangement
is treated as a payment for services.
(1) The arrangement lacks significant entrepreneurial risk. Whether
an arrangement lacks significant entrepreneurial risk is based on the
service provider's entrepreneurial risk relative to the overall
entrepreneurial risk of the partnership. Paragraphs (c)(1)(i) through
(v) of this section provide facts and circumstances that create a
presumption that an arrangement lacks significant entrepreneurial risk
and will be treated as a disguised payment for services unless other
facts and circumstances establish the presence of significant
entrepreneurial risk by clear and convincing evidence:
(i) Capped allocations of partnership income if the cap is
reasonably expected to apply in most years;
(ii) An allocation for one or more years under which the service
provider's share of income is reasonably certain;
(iii) An allocation of gross income;
(iv) An allocation (under a formula or otherwise) that is
predominantly fixed in amount, is reasonably determinable under all the
facts and circumstances, or is designed to assure that sufficient net
profits are highly likely to be available to make the allocation to the
service provider (e.g. if the partnership agreement provides for an
allocation of
[[Page 43659]]
net profits from specific transactions or accounting periods and this
allocation does not depend on the long-term future success of the
enterprise); or
(v) An arrangement in which a service provider waives its right to
receive payment for the future performance of services in a manner that
is non-binding or fails to timely notify the partnership and its
partners of the waiver and its terms.
(2) The service provider holds, or is expected to hold, a
transitory partnership interest or a partnership interest for only a
short duration.
(3) The service provider receives an allocation and distribution in
a time frame comparable to the time frame that a non-partner service
provider would typically receive payment.
(4) The service provider became a partner primarily to obtain tax
benefits that would not have been available if the services were
rendered to the partnership in a third party capacity.
(5) The value of the service provider's interest in general and
continuing partnership profits is small in relation to the allocation
and distribution.
(6) The arrangement provides for different allocations or
distributions with respect to different services received, the services
are provided either by one person or by persons that are related under
sections 707(b) or 267(b), and the terms of the differing allocations
or distributions are subject to levels of entrepreneurial risk that
vary significantly.
(d) Examples. The following examples illustrate the application of
this section:
Example 1. Partnership ABC constructed a building that is
projected to generate $100,000 of gross income annually. A, an
architect, performs services for partnership ABC for which A's
normal fee would be $40,000 and contributes cash in an amount equal
to the value of a 25 percent interest in the partnership. In
exchange, A will receive a 25 percent distributive share for the
life of the partnership and a special allocation of $20,000 of
partnership gross income for the first two years of partnership's
operations. The ABC partnership agreement satisfies the requirements
for economic effect contained in Sec. 1.704-1(b)(2)(ii), including
requiring that liquidating distributions are made in accordance with
the partners' positive capital account balances. Under paragraph (c)
of this section, whether the arrangement is treated as a payment for
services depends on the facts and circumstances. The special
allocation to A is a capped amount and the cap is reasonably
expected to apply. The special allocation is also made out of gross
income. Under paragraphs (c)(1)(i) and (iii) of this section, the
capped allocations of income and gross income allocations described
are presumed to lack significant entrepreneurial risk. No additional
facts and circumstances establish otherwise by clear and convincing
evidence. Thus, the allocation lacks significant entrepreneurial
risk. Accordingly, the arrangement provides for a disguised payment
for services as of the date that A and ABC enter into the
arrangement and, pursuant to paragraph (b)(2)(ii) of this section,
should be included in income by A in the time and manner required
under applicable law as determined by applying all relevant sections
of the Internal Revenue Code to the arrangement.
Example 2. A, a stock broker, agrees to effect trades for
Partnership ABC without the normal brokerage commission. A
contributes 51 percent of partnership capital and in exchange,
receives a 51 percent interest in residual partnership profits and
losses. In addition, A receives a special allocation of gross income
that is computed in a manner which approximates its foregone
commissions. The special allocation to A is computed by means of a
formula similar to a normal brokerage fee and varies with the value
and amount of services rendered rather than with the income of the
partnership. It is reasonably expected that Partnership ABC will
have sufficient gross income to make this allocation. The ABC
partnership agreement satisfies the requirements for economic effect
contained in Sec. 1.704-1(b)(2)(ii), including requiring that
liquidating distributions are made in accordance with the partners'
positive capital account balances. Under paragraph (c) of this
section, whether the arrangement is treated as a payment for
services depends on the facts and circumstances. Under paragraphs
(c)(1)(iii) and (iv) of this section, because the allocation is an
allocation of gross income and is reasonably determinable under the
facts and circumstances, it is presumed to lack significant
entrepreneurial risk. No additional facts and circumstances
establish otherwise by clear and convincing evidence. Thus, the
allocation lacks significant entrepreneurial risk. Accordingly, the
arrangement provides for a disguised payment for services as of the
date that A and ABC enter into the arrangement and, pursuant to
paragraph (b)(2)(ii) of this section, should be included in income
by A in the time and manner required under applicable law as
determined by applying all relevant sections of the Internal Revenue
Code to the arrangement.
Example 3. (i) M performs services for which a fee would
normally be charged to new partnership ABC, an investment
partnership that will acquire a portfolio of investment assets that
are not readily tradable on an established securities market. M will
also contribute $500,000 in exchange for a one percent interest in
ABC's capital and profits. In addition to M's one percent interest,
M is entitled to receive a priority allocation and distribution of
net gain from the sale of any one or more assets during any 12-month
accounting period in which the partnership has overall net gain in
an amount intended to approximate the fee that would normally be
charged for the services M performs. A, a company that controls M,
is the general partner of ABC and directs all operations of the
partnership consistent with the partnership agreement, including
causing ABC to purchase or sell an asset during any accounting
period. A also controls the timing of distributions to M including
distributions arising from M's priority allocation. Given the nature
of the assets in which ABC will invest and A's ability to control
the timing of asset dispositions, the amount of partnership net
income or gains that will be allocable to M under the ABC
partnership agreement is highly likely to be available and
reasonably determinable based on all facts and circumstances
available upon formation of the partnership. A will be allocated 10
percent of any net profits or net losses of ABC earned over the life
of the partnership. A undertakes an enforceable obligation to repay
any amounts allocated and distributed pursuant to this interest
(reduced by reasonable allowances for tax payments made on A's
allocable shares of partnership income and gain) that exceed 10
percent of the overall net amount of partnership profits computed
over the life of the partnership (a ``clawback obligation''). It is
reasonable to anticipate that A could and would comply fully with
any repayment responsibilities that arise pursuant to this
obligation. The ABC partnership agreement satisfies the requirements
for economic effect contained in Sec. 1.704-1(b)(2)(ii), including
requiring that liquidating distributions are made in accordance with
the partners' positive capital account balances.
(ii) Under paragraph (c) of this section, whether A's
arrangement is treated as a payment for services in directing ABC's
operations depends on the facts and circumstances. The most
important factor in this facts and circumstances determination is
the presence or absence of significant entrepreneurial risk. The
arrangement with respect to A creates significant entrepreneurial
risk under paragraph (c)(1) of this section because the allocation
to A is of net profits earned over the life of the partnership, the
allocation is subject to a clawback obligation and it is reasonable
to anticipate that A could and would comply with this obligation,
and the allocation is neither reasonably determinable nor highly
likely to be available. Additionally, other relevant factors do not
establish that the arrangement should be treated as a payment for
services. Thus, the arrangement with respect to A does not
constitute a payment for services for purposes of paragraph (b)(1)
of this section.
(iii) Under paragraph (c) of this section, whether M's
arrangement is treated as a payment for services depends on the
facts and circumstances. The most important factor in this facts and
circumstances determination is the presence or absence of
entrepreneurial risk. The priority allocation to M is an allocation
of net profit from any 12-month accounting period in which the
partnership has net gain, and thus it does not depend on the overall
success of the enterprise. Moreover, the sale of the assets by ABC,
and hence the timing of recognition of gains and losses, is
controlled by A, a company related to M. Taken in combination, the
facts indicate that the allocation is reasonably determinable under
all the facts and circumstances and that sufficient net profits are
highly likely to be available to make the priority allocation to the
service
[[Page 43660]]
provider. As a result, the allocation presumptively lacks
significant entrepreneurial risk. No additional facts and
circumstances establish otherwise by clear and convincing evidence.
Accordingly, the arrangement provides for a disguised payment for
services as of the date M and ABC enter into the arrangement and,
pursuant to paragraph (b)(2)(ii) of this section, should be included
in income by M in the time and manner required under applicable law
as determined by applying all relevant sections of the Internal
Revenue Code to the arrangement.
(iv) Assume the facts are the same as paragraph (i) of this
example, except that the partnership can also fund M's priority
allocation and distribution of net gain from the revaluation of any
partnership assets pursuant to Sec. 1.704-1(b)(2)(iv)(f). As the
general partner of ABC, A controls the timing of events that permit
revaluation of partnership assets and assigns values to those assets
for purposes of the revaluation. Under paragraph (c) of this
section, whether M's arrangement is treated as a payment for
services depends on the facts and circumstances. The most important
factor in this facts and circumstances determination is the presence
or absence of entrepreneurial risk. Under this arrangement, the
valuation of the assets is controlled by A, a company related to M,
and the assets of the company are difficult to value. This fact,
taken in combination with the partnership's determination of M's
profits by reference to a specified accounting period, causes the
allocation to be reasonably determinable under all the facts and
circumstances or to ensure that net profits are highly likely to be
available to make the priority allocation to the service provider.
No additional facts and circumstances establish otherwise by clear
and convincing evidence. Accordingly, the arrangement provides for a
disguised payment for services as of the date M and ABC enter into
the arrangement and, pursuant to paragraph (b)(2)(ii) of this
section, should be included in income by M in time and manner
required under applicable law as determined by applying all relevant
sections of the Internal Revenue Code to the arrangement.
Example 4. (i) The facts are the same as in Example 3, except
that ABC's investment assets are securities that are readily
tradable on an established securities market, and ABC is in the
trade or business of trading in securities and has validly elected
to mark-to-market under section 475(f)(1). In addition, M is
entitled to receive a special allocation and distribution of
partnership net gain attributable to a specified future 12-month
taxable year. Although it is expected that one or more of the
partnership's assets will be sold for a gain, it cannot reasonably
be predicted whether the partnership will have net profits with
respect to its entire portfolio in that 12-month taxable year.
(ii) Under paragraph (c) of this section, whether the
arrangement is treated as a payment for services depends on the
facts and circumstances. The most important factor in this facts and
circumstances determination is the presence or absence of
entrepreneurial risk. The special allocation to M is allocable out
of net profits, the partnership assets have a readily ascertainable
market value that is determined at the close of each taxable year,
and it cannot reasonably be predicted whether the partnership will
have net profits with respect to its entire portfolio for the year
to which the special allocation would relate. Accordingly, the
special allocation is neither reasonably determinable nor highly
likely to be available because the partnership assets have a readily
ascertainable fair market value that is determined at the beginning
of the year and at the end of the year. Thus, the arrangement does
not lack significant entrepreneurial risk under paragraph (c)(1) of
this section. Additionally, the facts and circumstances do not
establish the presence of other factors that would suggest that the
arrangement is properly characterized as a payment for services.
Accordingly, the arrangement does not constitute a payment for
services under paragraph (b)(1) of this section.
Example 5. (i) A is a general partner in newly-formed
partnership ABC, an investment fund. A is responsible for providing
management services to ABC, but has delegated that management
function to M, a company controlled by A. Funds that are comparable
to ABC commonly require the general partner to contribute capital in
an amount equal to one percent of the capital contributed by the
limited partners, provide the general partner with an interest in 20
percent of future partnership net income and gains as measured over
the life of the fund, and pay the fund manager annually an amount
equal to two percent of capital committed by the partners.
(ii) Upon formation of ABC, the partners of ABC execute a
partnership agreement with terms that differ from those commonly
agreed upon by other comparable funds. The ABC partnership agreement
provides that A will contribute nominal capital to ABC, that ABC
will annually pay M an amount equal to one percent of capital
committed by the partners, and that A will receive an interest in 20
percent of future partnership net income and gains as measured over
the life of the fund. A will also receive an additional interest in
future partnership net income and gains determined by a formula (the
``Additional Interest''). The parties intend that the estimated
present value of the Additional Interest approximately equals the
present value of one percent of capital committed by the partners
determined annually over the life of the fund. However, the amount
of net profits that will be allocable to A under the Additional
Interest is neither highly likely to be available nor reasonably
determinable based on all facts and circumstances available upon
formation of the partnership. A undertakes a clawback obligation,
and it is reasonable to anticipate that A could and would comply
fully with any repayment responsibilities that arise pursuant to
this obligation. The ABC partnership agreement satisfies the
requirements for economic effect contained in Sec. 1.704-
1(b)(2)(ii), including requiring that liquidating distributions are
made in accordance with the partners' positive capital account
balances.
(iii) Under paragraph (c) of this section, whether the
arrangement relating to the Additional Interest is treated as a
payment for services depends on the facts and circumstances. The
most important factor in this facts and circumstances determination
is the presence or absence of significant entrepreneurial risk. The
arrangement with respect to A creates significant entrepreneurial
risk under paragraph (c)(1) of this section because the allocation
to A is of net profits, the allocation is subject to a clawback
obligation over the life of the fund and it is reasonable to
anticipate that A could and would comply with this obligation, and
the allocation is neither reasonably determinable nor highly likely
to be available. Additionally, the facts and circumstances do not
establish the presence of other factors that would suggest that the
arrangement is properly characterized as a payment for services.
Accordingly, the arrangement does not constitute a payment for
services under paragraph (b)(1) of this section.
Example 6. (i) A is a general partner in limited partnership
ABC, an investment fund. A is responsible for providing management
services to ABC, but has delegated that management function to M, a
company controlled by A. The ABC partnership agreement provides that
A must contribute capital in an amount equal to one percent of the
capital contributed by the limited partners, that A is entitled to
an interest in 20 percent of future partnership net income and gains
as measured over the life of the fund, and that M is entitled to
receive an annual fee in an amount equal to two percent of capital
committed by the partners. The amount of partnership net income or
gains that will be allocable to A under the ABC partnership
agreement is neither highly likely to be available nor reasonably
determinable based on all facts and circumstances available upon
formation of the partnership. A also undertakes a clawback
obligation, and it is reasonable to anticipate that A could and
would comply fully with any repayment responsibilities that arise
pursuant to this obligation.
(ii) ABC's partnership agreement also permits M (as A's
appointed delegate) to waive all or a portion of its fee for any
year if it provides written notice to the limited partners of ABC at
least 60 days prior to the commencement of the partnership taxable
year for which the fee is payable. If M elects to waive irrevocably
its fee pursuant to this provision, the partnership will,
immediately following the commencement of the partnership taxable
year for which the fee would have been payable, issue to M an
interest determined by a formula in subsequent partnership net
income and gains (the ``Additional Interest''). The parties intend
that the estimated present value of the Additional Interest
approximately equals the estimated present value of the fee that was
waived. However, the amount of net income or gains that will be
allocable to M is neither highly likely to be available nor
reasonably determinable based on all facts and circumstances
available at the time of the waiver of the partnership. The ABC
partnership agreement satisfies the requirements for economic effect
contained in Sec. 1.704-1(b)(2)(ii), including requiring that
[[Page 43661]]
liquidating distributions are made in accordance with the partners'
positive capital account balances. The partnership agreement also
requires ABC to maintain capital accounts pursuant to Sec. 1.704-
1(b)(2)(iv) and to revalue partner capital accounts under Sec.
1.704-1(b)(2)(iv)(f) immediately prior to the issuance of the
partnership interest to M. M undertakes a clawback obligation, and
it is reasonable to anticipate that M could and would comply fully
with any repayment responsibilities that arise pursuant to this
obligation.
(iii) Under paragraph (c) of this section, whether the
arrangements relating to A's 20 percent interest in future
partnership net income and gains and M's Additional Interest are
treated as payment for services depends on the facts and
circumstances. The most important factor in this facts and
circumstances determination is the presence or absence of
significant entrepreneurial risk. The allocations to A and M do not
presumptively lack significant entrepreneurial risk under paragraph
(c)(1) of this section because the allocations are based on net
profits, the allocations are subject to a clawback obligation over
the life of the fund and it is reasonable to anticipate that A and M
could and would comply with this obligation, and the allocations are
neither reasonably determinable nor highly likely to be available.
Additionally, the facts and circumstances do not establish the
presence of other factors that would suggest that the arrangement is
properly characterized as a payment for services. Accordingly, the
arrangements do not constitute payment for services under paragraph
(b)(1) of this section.
0
Par. 5. Section 1.707-9 is amended by:
a. Redesignating paragraph (b) as paragraph (c);
b. Redesignating paragraph (a) as paragraph (b); and
c. Adding new paragraph (a).
The addition reads as follows:
Sec. 1.707-9. Effective dates and transitional rules.
(a) Section 1.707-2--(1) In general. Section 1.707-2 applies to all
arrangements entered into or modified after the date of publication of
the Treasury decision adopting that section as final regulations in the
Federal Register. To the extent that an arrangement permits a service
provider to waive all or a portion of its fee for any period subsequent
to the date the arrangement is created, then the arrangement is
modified for purposes of this paragraph on the date or dates that the
fee is waived.
(2) Arrangements entered into or modified before final regulations
are published in the Federal Register. In the case of any arrangement
entered into or modified that occurs on or before final regulations are
published in the Federal Register, the determination of whether the
arrangement is a disguised fee for services under section 707(a)(2)(A)
is to be made on the basis of the statute and the guidance provided
regarding that provision in the legislative history of section 73 of
the Tax Reform Act of 1984 (Pub. L. 98-369, 98 Stat. 494). See H.R.
Rep. No. 861, 98th Cong., 2d Sess. 859-2 (1984); S. Prt. No. 169 (Vol.
I), 98th Cong., 2d Sess. 223-32 (1984); H.R. Rep. No. 432 (Pt. 2), 98th
Cong., 2d Sess. 1216-21 (1984).
* * * * *
0
Par. 6. Section 1.736-1 is amended by adding a sentence at the end of
paragraph (a)(1)(i) to read as follows:
Sec. 1.736-1. Payments to a retiring partner or a deceased partner's
successor in interest.
(a) * * *
(1)(i) * * * Section 736 does not apply to arrangements treated as
disguised payments for services under Sec. 1.707-2.
* * * * *
John Dalrymple,
Deputy Commissioner for Services and Enforcement.
[FR Doc. 2015-17828 Filed 7-22-15; 8:45 am]
BILLING CODE 4830-01-P