The IRS has issued proposed regulations (REG-115452-14) that will establish a series of tests to determine if an arrangement will be treated as a disguised payment for services under IRC §707(a)(2)(A). The key test, based on the section’s legislative history, will be whether the payment is subject to significant entrepreneurial risk.
The IRS, in the preamble, cites the following with regard to Congress’s view of the importance of such risk in determining if there is a disguised payment for services as opposed to some other arrangement the partnership claims exists:
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.
The IRS in the proposed regulations plans to move these factors explicitly into the regulations. The primary test will be whether entrepreneurial risk does or does not exist pursuant to Reg. §1.707-2(c)(1). The regulations provide, pursuant to Reg. §1.707-2(c)(1)(i)-(iv) that the existence of any of the following factors presumptively establish the lack of entrepreneurial risk:
- Capped allocations of partnership income if the cap is reasonably expected to apply in most years;
- An allocation for one or more years under which the service provider's share of income is reasonably certain;
- An allocation of gross income;
- 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 net profits from specific transactions or accounting periods and this allocation does not depend on the long term future success of the enterprise); or
- 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.
The presumption is not absolute—it can be overcome by facts and circumstances that otherwise establish entrepreneurial risk. But clearly the IRS will likely take the position in the vast majority of cases that these factors serve as nearly absolute evidence of a disguised provision of compensation.
While the above factor is the most significant, the regulations also provide (in Reg. §1.707-2(c)(2)-(6)) that the following additional five factors are to be considered:
- The service provider holds, or is expected to hold, a transitory partnership interest or a partnership interest for only a short duration.
- 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.
- 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.
- The value of the service provider's interest in general and continuing partnership profits is small in relation to the allocation and distribution.
- 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.
The regulations would be effective for any arrangement entered into or modified after the date they are published. While technically arrangements before that are to be tested under current law, advisers should note the IRS claims that this regulation reflects the pre-existing intent of Congress—thus the IRS may very well effectively start enforcing this regulation immediately, including for transactions that were structured prior to the issuance of these regulations.
Finally, the proposed regulations note that the IRS plans to issue additional guidance to modify the provisions of Rev. Proc. 93-27 regarding issuance of a profits interest for services to provide an additional exception from the safe harbor treatment of such arrangements in certain cases.
As the preamble notes:
Further, the Treasury Department and the IRS plan to issue a revenue procedure providing an additional exception to the safe harbor in Rev. Proc. 9327 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, 200524 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 Notice 2005-43 is finalized, it will include the additional exception referenced.