Avoiding taxation of income earned by a partner.

• Author: Ellentuck, Albert B.

Frequently, partnerships engaged in rendering personal services require partners to remit income earned outside the entity (e.g., book royalties earned by a partner in a CPA firm). Both the IRS and the courts have held that such income is taxable to the partnership, not the individual, if it is for services that the partnership could perform (Rev. Rul. 64-90). Such income would be treated similarly if the services were within the range of those generally undertaken by the partnership, even though it could not legally perform them; see Rev. Rul. 80-338 and Stephen Schneer, 97 TC 643 (1991).

What Are "Similar Services"?

Even though a partnership might require its partners to submit fees received for similar services performed in their individual capacities, the IRS might disagree with the definition of "similar services." In Letter Ruling 9514008, it determined that an attorney serving on a client's board of directors did so in his individual capacity, not as a law firm partner; thus, the income he received for those services was includible in his individual gross income.

The reasoning? Under local law, only a natural person may be a director of the client company; because of limitations contained in the partnership's professional liability insurance coverage, only lawyers other than the one serving on the client's board could provide legal advice on board actions. According to the IRS, services provided as a director must be conceptually distinguishable from those that the individual performs as a partner when rendering services the law firm is authorized to perform for the client.

Example

Dick is a general partner in Charley Brown & Co., a general partnership with an April 30 tax year-end. (Dick has a December 31 year-end.) The partnership is engaged in the practice of public accounting. Its tax year-end has been approved by the IRS under post-Tax Reform Act of 1986 rules. During calendar-year 2005, Dick personally received the following cash payments:

March 2005--Executor's fee for services to a deceased friend's estate: $5,000

July 2005--Honorarium for teaching a tax course: $2,000

December 2005--Salary as a member of the Golden Hills City Council: $4,000

The partnership agreement requires partners to promptly remit all fees, salaries, honoraria and book royalties. Dick complies with those terms by promptly remitting each of the above payments to the partnership.

Dick's distributive share of the partnership's taxable income (including his...