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IRS Issues Proposed Partnership Regulations Under §1.707-2


9/24/15

Synopsis

The IRS has issued proposed regulations [REG-115452-14] under §1.707-2 which provide guidance to partnerships and partners on whether an arrangement will be treated as a disguised payment for services.

Issue
Congress has indicated that the most important factor in determining whether or not an arrangement constitutes a payment for services is that the allocation and distribution of partnership income or gain is subject to significant entrepreneurial risk.  Generally, an arrangement lacks entrepreneurial risk when there is a high likelihood that the service provider will receive an allocation regardless of the success of the business operation.  Under the proposed regulations, an arrangement that lacks significant entrepreneurial risk constitutes a disguised payment for services.  The proposed regulations provide several examples of arrangements that lack significant entrepreneurial risk.

The proposed regulations also describe additional factors of secondary importance that may indicate an arrangement constitutes a payment for services:

  1. The service provider holds, or is expected to hold, a transitory partnership interest for only a short duration
  2. 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
  3. 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
  4. The value of the service providers’ interest in general and continuing partnership profits is small relative to the allocation and distribution
  5. 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 §707 or §267(b), and the terms of the differing allocations or distributions are subject to levels of entrepreneurial risk that vary significantly

Additionally, the proposed regulations address 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 that is valued at the approximate amount of waived fee.  According to the preamble to the proposed regulations, the Treasury Department and the IRS have determined that the safe harbor under Rev. Proc. 93-27 does not apply to such transactions.
 
Rev. Proc. 93-27 provides a safe harbor whereby a person receiving a profits interest in a partnership for providing services would not have a taxable event provided the transaction does not fall under one of three exceptions:

  1. The profits interest does not relate to a guaranteed stream of income
  2. The profits interest is not disposed of within two years of receipt
  3. The profits interest is not a limited partnership interest in a publicly traded partnership. 

The preamble of the proposed regulations indicates that the Treasury Department and IRS plan to issue a new revenue procedure. It will add an additional exception for profits interests issued in conjunction with a partner forgoing payment of a fixed amount that is for the performance of services.  The new revenue procedure will be issued in conjunction with the publication of the final §1.707-2 regulations.

Note: Management fee waiver arrangements are often used to avoid New York City unincorporated business tax (UBT). The UBT is a 4% tax imposed on net income and is assessed on every individual or unincorporated entity carrying on a trade or business in New York City. Fund managers subject to UBT reduce taxable income by having a related party receive a profits interest in a partnership in lieu of a management fee. These arrangements may need to be reconsidered under the new guidance.

The proposed regulations will be effective on the date the final regulations are published and will apply to any arrangement entered into, or modified on or after, the date of the final regulations. Taxpayers that are contemplating this type of arrangement may want to consider executing it before the regulations become final.

Contact
For more information, please contact Thomas Nice, Partner, at thomas.nice@cohnreznick.com or at 301-961-5542, or Daniel King, Senior Manager, at daniel.king@cohnreznick.com or at 301-280-3069.


Any advice contained in this communication, including attachments and enclosures, is not intended as a thorough, in-depth analysis of specific issues. Nor is it sufficient to avoid tax-related penalties. This has been prepared for information purposes and general guidance only and does not constitute professional advice. You should not act upon the information contained in this publication without obtaining specific professional advice. No representation or warranty (express or implied) is made as to the accuracy or completeness of the information contained in this publication, and CohnReznick LLP, its members, employees and agents accept no liability, and disclaim all responsibility, for the consequences of you or anyone else acting, or refraining to act, in reliance on the information contained in this publication or for any decision based on it.

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