IRS proposes rules on disguised payments for services.

• Author: Schreiber, Sally P.

The IRS issued proposed regulations that require the application of a nonexclusive six-factor test to determine whether payments from a partnership to a partner are disguised payments for services that are not rendered in the partner's capacity as a partner in the partnership (REG-115452-14).

Under the partnership rules, an allocation or distribution between a partnership and a partner for the provision of services can be treated in one of three ways: (1) as a Sec. 704(b) distributive share; (2) as a Sec. 707(c) guaranteed payment; or (3) as a transaction under Sec. 707(a) in which a partner has rendered services to the partnership in a capacity other than as a partner.

A disguised payment occurs when a partner performs services for a partnership, but the payment for the services is treated as an allocation or distribution of partnership income, even though the performance of services and allocation or distribution, when viewed together, would properly be characterized as a transaction occurring between the partnership and a partner acting other than in its capacity as a partner. In those cases, the transaction will be treated as occurring between the partnership and one who is not a partner.

Under the proposed regulations, an arrangement will be treated as a disguised payment for services if (1) a service provider, either as a partner or in anticipation of being a partner, performs services (directly or through its delegate) to or for the benefit of the partnership; (2) there is a related direct or indirect allocation and distribution to the service provider; and (3) the performance of the services and the allocation and distribution are properly characterized as a transaction occurring between the partnership and a person acting other than in that person's capacity as a partner.

An arrangement that is treated as a disguised payment for services is treated as a payment for services for all purposes of the Code. Therefore, the partnership must treat the payments as payments to a nonpartner in determining the remaining partners' shares of taxable income or loss and must capitalize the payments or otherwise treat them consistently.

Whether an arrangement constitutes a payment for services (in whole or in part) depends on all of the facts and circumstances, and six nonexclusive factors may indicate that an arrangement is a payment for services. The most important of the six factors is the absence of significant entrepreneurial risk, as to both...