Disguised Payments for Services, 43652-43661 [2015-17828]

Download as PDF 43652 Federal Register / Vol. 80, No. 141 / Thursday, July 23, 2015 / Proposed Rules partnership in its capacity as other than a partner under section 707(a). DEPARTMENT OF THE TREASURY Internal Revenue Service 26 CFR Part 1 [REG–115452–14] RIN 1545–BM12 Disguised Payments for Services Internal Revenue Service (IRS), Treasury ACTION: Notice of proposed rulemaking. AGENCY: 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: mstockstill on DSK4VPTVN1PROD with PROPOSALS SUMMARY: 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 VerDate Sep<11>2014 19:18 Jul 22, 2015 Jkt 235001 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 PO 00000 Frm 00016 Fmt 4702 Sfmt 4702 amount. House Report at 227; Senate Report at 387. In 1956, the Treasury Department and the IRS issued additional guidance under § 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 nonpartner 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 E:\FR\FM\23JYP1.SGM 23JYP1 Federal Register / Vol. 80, No. 141 / Thursday, July 23, 2015 / Proposed Rules mstockstill on DSK4VPTVN1PROD with PROPOSALS 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 VerDate Sep<11>2014 19:18 Jul 22, 2015 Jkt 235001 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 PO 00000 Frm 00017 Fmt 4702 Sfmt 4702 43653 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 § 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 § 1.707–9. I. General Rules Regarding Disguised Payments for Services A. Scope Consistent with the language of section 707(a)(2)(A), § 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 E:\FR\FM\23JYP1.SGM 23JYP1 mstockstill on DSK4VPTVN1PROD with PROPOSALS 43654 Federal Register / Vol. 80, No. 141 / Thursday, July 23, 2015 / Proposed Rules 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 VerDate Sep<11>2014 19:18 Jul 22, 2015 Jkt 235001 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 PO 00000 Frm 00018 Fmt 4702 Sfmt 4702 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 E:\FR\FM\23JYP1.SGM 23JYP1 mstockstill on DSK4VPTVN1PROD with PROPOSALS Federal Register / Vol. 80, No. 141 / Thursday, July 23, 2015 / Proposed Rules 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, VerDate Sep<11>2014 19:18 Jul 22, 2015 Jkt 235001 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 § 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 PO 00000 Frm 00019 Fmt 4702 Sfmt 4702 43655 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 E:\FR\FM\23JYP1.SGM 23JYP1 43656 Federal Register / Vol. 80, No. 141 / Thursday, July 23, 2015 / Proposed Rules mstockstill on DSK4VPTVN1PROD with PROPOSALS 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 § 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 12month 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. VerDate Sep<11>2014 19:18 Jul 22, 2015 Jkt 235001 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-tomarket 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 PO 00000 Frm 00020 Fmt 4702 Sfmt 4702 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 E:\FR\FM\23JYP1.SGM 23JYP1 43657 Federal Register / Vol. 80, No. 141 / Thursday, July 23, 2015 / Proposed Rules 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. mstockstill on DSK4VPTVN1PROD with PROPOSALS 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 VerDate Sep<11>2014 19:18 Jul 22, 2015 Jkt 235001 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 § 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 §§ 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 PO 00000 Frm 00021 Fmt 4702 Sfmt 4702 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 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). * * * Par. 2. Section 1.707–0 is amended by revising § 1.707–2 to read as follows: ■ § 1.707–0. * Table of contents. * § 1.707–2. services. * * * Disguised payments for (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. E:\FR\FM\23JYP1.SGM 23JYP1 43658 Federal Register / Vol. 80, No. 141 / Thursday, July 23, 2015 / Proposed Rules (ii) Timing of inclusion. (3) Application of disguised payment rules. (c) Factors considered. (d) Examples. * * * * * ■ 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. § 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 § 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. * * * * * Par. 4. Section 1.707–2 is added to read as follows: ■ mstockstill on DSK4VPTVN1PROD with PROPOSALS § 1.707–2 services. Disguised payments for (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; VerDate Sep<11>2014 19:18 Jul 22, 2015 Jkt 235001 (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 nonpartner 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 PO 00000 Frm 00022 Fmt 4702 Sfmt 4702 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 E:\FR\FM\23JYP1.SGM 23JYP1 Federal Register / Vol. 80, No. 141 / Thursday, July 23, 2015 / Proposed Rules mstockstill on DSK4VPTVN1PROD with PROPOSALS 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 § 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 VerDate Sep<11>2014 19:18 Jul 22, 2015 Jkt 235001 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 § 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 PO 00000 Frm 00023 Fmt 4702 Sfmt 4702 43659 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 § 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 E:\FR\FM\23JYP1.SGM 23JYP1 mstockstill on DSK4VPTVN1PROD with PROPOSALS 43660 Federal Register / Vol. 80, No. 141 / Thursday, July 23, 2015 / Proposed Rules 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 § 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-tomarket 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 VerDate Sep<11>2014 19:18 Jul 22, 2015 Jkt 235001 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 § 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 PO 00000 Frm 00024 Fmt 4702 Sfmt 4702 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 § 1.704–1(b)(2)(ii), including requiring that E:\FR\FM\23JYP1.SGM 23JYP1 Federal Register / Vol. 80, No. 141 / Thursday, July 23, 2015 / Proposed Rules 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 § 1.704–1(b)(2)(iv) and to revalue partner capital accounts under § 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. 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: ■ mstockstill on DSK4VPTVN1PROD with PROPOSALS § 1.707–9. 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 19:18 Jul 22, 2015 Jkt 235001 § 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 § 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 ENVIRONMENTAL PROTECTION AGENCY 40 CFR Part 52 [EPA–R06–OAR–2015–0189; FRL–9931–02– Region 6] Effective dates and transitional VerDate Sep<11>2014 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). * * * * * ■ Par. 6. Section 1.736–1 is amended by adding a sentence at the end of paragraph (a)(1)(i) to read as follows: Approval and Promulgation of Implementation Plans; Arkansas; Regional Haze and Interstate Visibility Transport Federal Implementation Plan; Reopening of Comment Period Environmental Protection Agency (EPA). ACTION: Proposed rule, reopening of comment period. AGENCY: The Environmental Protection Agency (EPA) is reopening the comment period for a proposed rule to establish a Clean Air Act (CAA) Federal Implementation Plan (FIP) to address regional haze and visibility transport requirements for the State of Arkansas. The EPA is reopening the public comment period for the proposed rule for an additional 15 days from the date of today’s publication. The reopening of the comment period is in response to a request submitted by the Domtar Ashdown Mill to extend the comment period. DATES: The comment period for the proposed rule published on April 8, 2015 (80 FR 18944), extended on May SUMMARY: PO 00000 Frm 00025 Fmt 4702 Sfmt 4702 43661 1, 2015 (80 FR 24872), is reopened. Written comments must be received on or before August 7, 2015. ADDRESSES: Submit your comments, identified by Docket No. EPA–R06– OAR–2015–0189, by one of the following methods: • Federal e-Rulemaking Portal: http://www.regulations.gov. Follow the online instructions for submitting comments. • Email: R6AIR_ARHaze@epa.gov. • Mail: Guy Donaldson, Chief, Air Planning Section (6PD–L), Environmental Protection Agency, 1445 Ross Avenue, Suite 1200, Dallas, Texas 75202–2733. • Hand or Courier Delivery: Guy Donaldson at the address above. Such deliveries are accepted only between the hours of 8 a.m. and 4 p.m. weekdays, and not on legal holidays. Special arrangements should be made for deliveries of boxed information. • Fax: Guy Donaldson at (214) 665– 7263. Instructions: Direct your comments to Docket No. EPA–R06–OAR–2015–0189. Our policy is that all comments received will be included in the public docket without change and may be made available online at www.regulations.gov, including any personal information provided, unless the comment includes information claimed to be Confidential Business Information (CBI) or other information whose disclosure is restricted by statute. Do not submit information that you consider to be CBI or otherwise protected through www.regulations.gov or email. The www.regulations.gov Web site is an ‘‘anonymous access’’ system, which means we will not know your identity or contact information unless you provide it in the body of your comment. If you send an email comment directly to us without going through www.regulations.gov your email address will be automatically captured and included as part of the comment that is placed in the public docket and made available on the Internet. If you submit an electronic comment, we recommend that you include your name and other contact information in the body of your comment and with any disk or CD–ROM you submit. If we cannot read your comment due to technical difficulties and cannot contact you for clarification, we may not be able to consider your comment. Electronic files should avoid the use of special characters, any form of encryption, and be free of any defects or viruses. Docket: The index to the docket for this action is available electronically at www.regulations.gov and in hard copy E:\FR\FM\23JYP1.SGM 23JYP1

Agencies

[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