Structuring guaranteed payments to avoid disguised sale treatment.

• Author: Ellentuck, Albert B.

Facts

Michael and Lisa Marie are forming the MLM Partnership, a general partnership, to operate a recording studio. Michael is contributing a building worth $100,000 and recording equipment worth $4,000. The partnership agreement has a written provision that Michael is to receive a guaranteed payment for three years for the use of his capital. The guaranteed payment is computed at 10% (compounded annually) of the fair market value (FMV) of the property transferred. No other transfers are anticipated that are not classified as operating cash flow distributions in this three-year period.

The applicable Federal rate (AFR) when the partnership agreement is to be signed is 6% for short-term obligations compounded annually. (It is not anticipated to increase anytime soon.

Michael has provided a draft copy of the partnership agreement to his tax adviser for review.

Issue

Considering the disguised sale rules, should the tax adviser suggest changes to the partnership agreement?

Analysis

In general, guaranteed payments for capital are not treated as part of a sale. A payment to a partner that the parties treat as a guaranteed payment is presumed to be a guaranteed payment unless the facts and circumstances establish otherwise. The payment must be reasonable and determined without regard to the partnership's income. It is basically a return on investment and should not be designed to liquidate a partner's interest in the partnership. These payments must be made pursuant to a written provision of a partnership agreement that provides for payment for the use of capital in a reasonable amount. In addition, the payments should be made for the use of capital after the date that this provision is added to the partnership agreement. A reasonable amount as calculated under Regs. Sec. 1.707-4(a)(3)(ii) is determined by multiplying the partner's unreturned capital at the beginning of the year--or at his option, the weighted average of his capital balance for the year--by the safe harbor interest rate for that year. The safe harbor interest rate is 150% of the highest AFR, at the appropriate compounding period in effect at any time beginning when the right to the guaranteed payment for capital is first established through the end of the tax year.

MLM does have the provision for making the payments to Michael for the use of his capital in writing. To estimate if the payments are reasonable, the tax adviser should multiply Michael's beginning-of-the-year...