Partnership payments to partners are sometimes disguised payments for services and should be reported by the partner as income.
The IRS explained in proposed regulations in July how to tell when that is the case.
There are three labels that the US tax authorities may put on a payment by a partnership to a partner. The payment may simply be a distribution of the partner’s share of cash out of partnership earnings. It may be a “guaranteed payment,” meaning a payment, like interest for use of the partner’s capital, that is not tied to partnership earnings. It may be compensation for services that the partner provided to the partnership. The last two types of payments must be reported as taxable income. Cash distributions, on the other hand, are not usually taxed to a partner until the partner has received more cash than his “basis” in his partnership interest.
The IRS said it will treat a payment to a partner as compensation for services if the partner does something for the partnership, even in anticipation of becoming a partner, and receives cash distributions from the partnership that are not tied in amount to partnership earnings or where there is a high likelihood the partner will receive an expected amount regardless of how well the partnership performs.
Other factors that are less important, but that may point to a disguised payment for services, are whether the person’s status as a partner is temporary, whether the distributions are made closely in time to when the services are performed, whether the person’s interest in the partnership is small in relation to the cash distributions, whether the person became a partner “primarily to obtain tax benefits for itself” that would not otherwise have been available, and whether two related partners provide services and the distributions to them are “subject to different levels of entrepreneurial risk.” An example of the last factor is where a management company partner receives priority cash distributions, and distributions to a related general partner are subject to being clawed back if the cash is needed to make the priority distributions to the management company partner.
The IRS said that payments will be treated as “guaranteed payments” rather than disguised payments for services if the partner performs services in his capacity as a partner as opposed to performing them as if he were a third party. An example of the latter is where the partner provides the same services to multiple customers and not just the partnership.
Depending on the services, the partnership may be able to deduct any amounts treated as payment for services, or it may have to add the amounts to basis in a project owned by the partnership and recover them through depreciation.
The IRS has taken 31 years to propose how to sort out labels in this area. Congress directed that some partnership distributions should be treated as disguised payments to partners for services in 1984.