American Bar Association
Section of Taxation
Report to the ABA House of Delegates
RECOMMENDATION
Section 707(a) of the Code provides that, as a general
rule—
"If a partner engages in a transaction with a
partnership other than in his capacity as a member of such partnership, the transaction
shall, except as otherwise provided in this section, be considered as occurring between
the partnership and on who is not a partner."
Section 707(c) provides--
"To the extent determined without regard to the income
of the partnership, payments to a partner for services or the use of capital
shall be considered as made to one who is not a member of the partnership, but only
for the purposes of section 61 (relating to gross. income) and, subject to section 263,
for the purposes of section 162(a)(relating to trade or business expenses)"
Payments under section 707(c) referred to as
"guaranteed payments", although they are not actually guaranteed by anyone. They
are guaranteed only in the sense that they are payable even if the partnership does
not have any income.
Several other provisions of the law refer
to"guaranteed payments" under '707(c), including '736(b)(1) of the Code
(relating to certain payments to a retired or deceased partner) and '1.721-1(b)(2) of the
U.S. Treasury Department's Regulations on Income Tax (1986
Code)("Regulations"(relating to transfers of interest in partnerships capital in
consideration of services).
Over the years, the IRS and the courts have wrestled with
both the definition of a guaranteed payment and the exact consequences of characterizing a
payment a s a guaranteed payment.
Section 707(a) and (c) were added to the code in 1954 in an
attempt to resolve problems that had arisen under prior law when a partner engaged in a
transaction with a partnership in a capacity purportedly other than as a partner.
Applying the aggregate theory of partnerships, the IRS and the courts usually held that a
partner could not be an employee of his partnership.
Therefore, any payments which the parties tried to treat as
salaries or other amounts as compensation for services were recharacterized as
distributions of income. Similarly, it was held that a debtor-creditor relationship could
not exist between a partner and a partnership, and payments of interest were also
recharacterized. The accounting became quite complex in those cases where the payments to
the partners for services or in the nature of interest exceeded the amount of income. In
most cases, however, the final result was identical to the one that would have been
reached had the payments been treated as salaries or interest in the first place.
It was also assumed that, under the 1939 Code, partnerships
could not make special allocations of income to partners. The IRS reversed its position on
this point several years after the 1954 Code was enacted, but, when the draftsman of the
1954 Code wrote ''707(a) and (c) into the statute, they were under the impression that the
law was to the contrary
The courts often reached inconsistent results for
transactions in which the partner was acting more like an independent contractor than an
employee. Sometimes the aggregate theory was applied; in other cases, the entity theory
was applied.
The legislative history to the 1954 Code indicated that
Congress attempted to solve these problems as follows:
(1) Section 707(a) provides that if a person acts ion the
capacity other than as a partner, the transaction should be treated as though the person
were to a partner; and
(2) Section 707(c) provides that payments for services
should be treated the same as salaries.
(3) Section 707(c) also provides that payments for the use
of capital shall be considered as made to one is not a member of the partnership.
Payments are covered be '707(c) only if made "without
regard to the income of the partnership". The statute refers to them as
"guaranteed payments", although they are not in any way guaranteed. Guaranteed
payments are treated as though made to a nonpartner only for purposes of '61 (gross
income) and '162(e)(trade or business expenses).
One of the fundamental problems with '707(c) is the
statutory language, which is drawn from the February, 1954 draft of the ALI's Federal
Income Tax Statute, assumes that it is possible to distinguish situations in which a
partner is acting in his capacity as a partner from those in which he is not. Over the
years, the IRS, the courts and even Congress have attempted to impose an objective set of
rules to determine the issue, but all such efforts have been unsuccessful. The
commentators have long noted that there is no objective test on which such a distinction
can be based. The reasoning in many of the cases and rulings that have attempted to frame
and apply objective criteria is invariably unsatisfactory and the results often appear
capricious.
For Example, on one leading case, Pratt v. Commissioner,
the IRS persuaded the Tax Court to hold that payments for services and for capital were
not guaranteed payments because the taxpayers were not acting in their capacity as
partners. On appeal, the IRS confessed error on the payment for capital, and the Fifth
Circuit affirmed the IRS's position on the payment for services. In Revenue Ruling 81-301,
the IRS ruled that the appellate division in the Fifth Circuit was incorrect, and that the
partners in the Pratt were, after all, acting in their capacity as partners with
respect to both the interest-type and the service-type payments. In the Committee Reports
to the 1984 amendments to '707, the Senate Finance Committee repudiated a key part of
Revenue Ruling 81-301 and stated that payments for services of the type rendered in Pratt
and described in that ruling would no longer be deemed guaranteed payments, even though
the language of 707(c) on this point was never changed.
In Schneer v. Commissioner, which involved the
question of whether a partner was acting in his capacity as a partner, the Tax Court
issued four different opinions, none of which agreed with the IRS position. One leading
tax journal published articles by three different commentators, each of whom disagreed
either with result in the case or with the opinions of most, if not all of the judges or
both, as well as with each of the other commentators.
The problem is that a partner is acting in his capacity
when the parties themselves agree that he is so acting, and he is not acting in his
capacity as a partner when the parties agree that he is not. If the partnership agreement
says that a person is rendering services qua partner, then he is a partner; if the
partnership agreement or other binding agreement provides otherwise, then he is not acting
qua partner with respect to the activity in question. There is no other objective
test.
The legislative history to the 1954 Code indicated that
Congress wanted to avoid disputes over when a person is acting in his capacity as a
partner and suggests that the application of '707(a) should be elective with the
taxpayers. If both the partnership and partners take consistent positions with respect to
the issue, the IRS should not take a contrary position. At least two courts have opined
that Congress intended the applicability of ''707(a) and (c) to be elective with
taxpayers. At most, the IRS should be entitled to require that the decision to treat a
person with respect to one or more transactions as acting not in his capacity as a partner
must be set forth clearly in the partnership agreement or in other documents which are
binding on all of the parties.
Another problem with '707(c) has been in identifying what
kind of payment is covered. The statute indicates that a payment is covered by Section
707(c) only if it is made without regard to partnership income. The legislative history
indicated that this was intended to cover payments like salaries and interest payments
which had to be made to employees and creditors, respectively, even if the firm lost
money. However, the regulations define guaranteed payments in some situations by reference
to partnership income.
In Pratt, the IRS argued, and the courts agreed that
a payment equal to a percentage of gross income could not qualify as a guaranteed payment
under '707(c). In Revenue Ruling 81-300, 1981-2 C.B. 143, the IRS reversed itself, and
said that it could. As a policy matter, the ruling makes sense, but it is hard to square
with the statute or the case law,
The treatment of payments for the use of capital the same
as interest has been another ongoing puzzle. If a true debtor/creditor relationship
exists, the payments should be treated as interest under '707(a), and '707(c) is
irrelevant. If the payment to the partner providing capital is merely a priority
distribution of income (as is often the case), section 704(b), which authorizes special
allocations of income, including allocations of gross or net income to partners who
provide capital to the partnership, is the appropriate provision. Again, '707(c) is
irrelevant. Section 707(c) seems to applicable only when a person supplies capital in his
capacity as a partner, and not as a creditor, and is entitled to compensation for the use
of that capital regardless of whether the partnership has even $1 of gross income. Whether
or not as a policy matter that type of payment should be treated the same as interest is
unclear.
Another troublesome provision is the limitation that
payments will be treated as guaranteed payments only for the purposes of ''61 and 162. It
is often necessary to determine whether guaranteed payments are distributive shares of
income or interest-type payments for purposes of other selections. For example: do the
limitations on interest deductions in '163 apply? Two private letter rulings held that
they do not apply in determining the nature of the income received by a REIT from a
partnership.
Issues also arise as to whether guaranteed payments are
portfolio income or passive income within the meaning of 469, with no clear pattern or
logic as to result.
In light of these continuing and unsolvable problems, the
question is whether the section provides benefits which offset the problems. The answer is
that the treatment of almost every transaction covered by '707(c) is, or could, be
determined under ''704(b) or 707(a), with far less interpretive ambiguity and uncertainty.
In its recent report on partnership issues, the Staff of
the Joint Committee (AStaff Report@) recommended that section 707(c) be repealed but only
with respect to interest type payments, and not with respect to payments for services.
Before reaching a final conclusion as to whether '707(c)
should be repealed, the Task Force reviewed the impact of repeal under Code sections. For
example. If '707(c) is repealed with respect to interest-type payments, the Staff Report
does not indicate how payments for the use of capital which do not meet the traditional
definitions of interest (because of the lack of a true indebtedness) and which exceed the
income of the partnership will be treated.
Another issue that the repeal raises is the treatment of
income from foreign sources. Section 707(c) is often used by partnerships which engage in
business both in the United States and outside the United States to allocate income to the
partners located abroad to permit them to utilize the full foreign tax credit. There is
some question whether guaranteed payments in the form typically used for this purpose
meets the statutory definition (Awithout regard to the income of the partnership@) or
whether an allocation of part of the balance of the partnership=s net income to the
foreign based partner has economic effect. In many cases, the amount of the guaranteed
payment is determined or readjusted after the amount of the foreign source income is
known. In other cases, the guaranteed payment for a particular year may not be changed,
but the adjustment is made to the amount of the guaranteed payment for the following year,
it being the intention of the parties that the guaranteed payment in fact be equal to the
amount that the foreign based partner would have received had he received his normal
distributive share of the firm=s earnings from all source. Regardless of whether such
practices are proper or valid as a matter of law, it is questionable whether they are
consistent with the concepts and purposes of either '707(c) or '707(b).
The view of the Task Force is that the typical allocation
of foreign source income primarily to foreign based partners has economic effect and
should be recognized as valid under '704(b). This type of allocation was recognized by the
IRS prior to 1954, even when no other special allocations were recognized, so they have
always had a preferred status, at least prior to 1954. There is no indication that
Congress, in adopting the 1954 Code, intended to make it more difficult to make this type
of allocation after 1954. A normal allocation of foreign source income to foreign based
partners is economically realistic and should be recognized under '704(b). If Treasury is
willing to recognize the validity of such allocations, by either a ruling or an amendment
to the regulations, artificially pegged and recalculated guaranteed payments to foreign
based partners can become a thing of the past. If Treasury is unable or unwilling to
recognize the validity of such allocations, any repeal of '707(c) should be accompanied by
an explicit statutory amendment to '704(b) to permit them.
Repeal will require changes to be made to a number of other
sections of the Code, but it is believed that conforming changes will not be a serious
problem. For example, although '736 states that certain payments made to retired or
deceased partners should be treated as guaranteed payments under section 707(c), that
cross reference is unnecessary. In fact, that section would probably make more sense of
the type of payment in question were treated as a pension, annuity, or other form of
deferred compensation. Similarly, the reference in Regulations '1.721-1(b)(2) to the
treatment of a transfer of capital as a guaranteed payment is unnecessary. The transfer of
capital to a partner for services is taxable as ordinary income, without regard to the
applicability of section 707(c); nor does the reference to guaranteed payments help with
the analysis of whether such transfer should be deductible by the transferors.
Finally, rules would have to be adopted to alleviate
transitional problems created by partnership agreements which call for guaranteed payments
under current law. In general, it is anticipated that such payments in future years would
be treated, depending upon their substance, under either '707(a) or '704(b).
There is one type of transaction which is presently covered
by '707(c) which would not be directly covered by any other section if '707(c) were
repealed. Payments made to partners for the use of capital would come within '707(a),
because there is no indebtedness as that term is usually defined for tax purpose and,
therefore, the payment cannot be treated as interest. Where the payment is payable solely
out of income (including gross income), it can be treated as an allocation of gross
income, as the pre-1954 cases held. But to the extent that such a payment exceeds the
gross income out of which it is payable, there would be no specific provision of
subchapter to cover it. In this case, the law would revert to the pre-1954 case authority.
Although the computations required by these cases were deemed complex at the time those
decisions were rendered, the complexity of those computations pale in comparison to the
normal subchapter K computations encountered everyday by practitioners currently. In any
event, such transactions occur rarely, and the Task Force does not believe that the issue
justifies retention of an otherwise complex section of the Code. On balance, the amount of
complexity that would be eliminated be repeal far outweighs the problem of dealing with
interest-type payments under pre-1954 Code.
The only issue that should be clarified, however, is the
nature of the income to the recipient, and the allowability of the deduction. It is the
view of the Task Force that these payments are sufficiently similar in nature to interest
that they should be so treated by both the recipients and the transferors. The
clarification could be included in the legislative history to the repeal provisions, or in
regulations to be issued by the IRS.
In conclusion, it is recommended that '707(c) be repealed
in its entirety.
Respectfully Submitted,
Stefan F. Tucker, Chair
February, 1999
EXECUTIVE SUMMARY
1. Summary of the Recommendation
To repeal section 707(c) in the Internal Revenue
Service Code of 1986 to eliminate the special rules dealing with Aguaranteed payments:.
2. Summary of the issues which the Recommendation
Addresses
The Partnership Committee's Task Force on the
Simplification of Subchapter K has been formed and is operating for the purpose of
promoting the simplification of the Internal Revenue Service Code. Simplification can be
accomplished in part by repealing statutory provisions which have proved unadministerable
and confusing, and which offer no administrative benefits.
Section 707(c) meets all of these criteria
The treatment of payments to partners for either the use of
capital or for services can be adequately addressed by other applicable provisions of the
Code.
3. Please explain how the proposed policy position will
address the issue.
Repeal will eliminate the long-standing confusion in
the law, as reflected by judicial decisions, administrative rulings and legislative
history, over the determination as to when a person is or is not acting in his capacity as
a partner. There is no present need in the law to continue to provide special treatment
for these types of payments and, therefore, no need to continue the futile attempts to
define when a partner is acting qua partner.
4. Summary of any minority views of oppositions which
have been identified.
The Staff of the Joint Committee has proposed repeal,
but only with respect to interest-type guaranteed payments.
GENERAL INFORMATION FORM
Submitting entity: Section of Taxation
Submitted by: Stefan F. Tucker, Chair, Section of Taxation
1. Summary of Recommendation
The resolution proposes the repeal of section 707(c) of
the internal Revenue Code. The purpose is to simplify subchapter K of the Code, which
deals with the taxation of partnerships
Section 707(c) provides that certain payments to partners
should be treated as though made to persons who are not partners. Such payments are
denominated by the statute as "guaranteed payments" (although not actually
guaranteed by either the partnership or any of the partners).
The meaning and proper application of this section has been
unclear and it is the source of much litigation often with inconsistent results, It is
also superfluous, because the treatment of payments to partners is adequately covered by
other provisions of subchapter K.
2. Approval by Submitting Entity.
This is submitted contingent on Section of Taxation
approval at its January 15-16, 1999 Midyear Meeting.
3. Has this or a similar recommendation been submitted
to the House or Board previously?
No
4. What existing Association policies are relevant to
this recommendation and how would they be affected by its adoption?
None
5. What urgency exists which requires action at this
meeting of the House?
None
6. Status of Legislation.
None
7. Cost to the Association.
None
8. Disclosure of Interest.
No member of the originating Committee or the Council
of the Section of Taxation is known to have material interest in the Resolution by virtue
of specific employment or engagement to obtain the results of the Resolution.
9. Referrals.
All Sections and Divisions
10. Contact Persons
James P. Holden
Steptoe & Johnson, LLP
1330 Connecticut Avenue, NW
Washington, DC 20036
202/ 429-6407
Jere D. McGaffey
Foley & Lardner
777 East Wisconsin Avenue, Suite 3600
Milwaukee, WI 53202
414/297-5729
Christine A. Brunswick
Director, Section of Taxation
American Bar Association
740 15th Street, NW
Washington, DC 20005
202/662-8675
11. Contact persons (who will present report to the
House)
James P. Holden
Steptoe & Johnson, LLP
1330 Connecticut Avenue, NW
Washington, DC 20036
202/ 429-6407
Jere D. McGaffey
Foley & Lardner
777 East Wisconsin Avenue, Suite 3600
Milwaukee, WI 53202
12. Contact persons regarding amendments to this
recommendation.
James P. Holden
Steptoe & Johnson, LLP
1330 Connecticut Avenue, NW
Washington, DC 20036
202/ 429-6407
Jere D. McGaffey
Foley & Lardner
777 East Wisconsin Avenue, Suite 3600
Milwaukee, WI 53202 |