Transactions Between a Partner and Partnership (Services, Sales, Property)

21.4 Transactions Between a Partner and Partnership (Services, Sales, Property)

Transactions between a partner and a partnership encompass a complex array of legal, financial, and tax considerations. Partners may provide services to the partnership, sell or exchange property with the partnership, or otherwise engage in complex transactions that trigger specialized rules. It is crucial to understand how these interactions differ from standard third-party transactions, as the Internal Revenue Service (IRS) often imposes special rules to mitigate potential abuse and ensure the correct income tax treatment. This section covers key topics such as disguised sales, compensatory partnership interests, and self-employment tax considerations.

Overview of Partner-Partnership Transactions

Broadly, transactions between a partner and the partnership can be separated into these categories:

• Provision of services in exchange for partnership interests or compensation.
• Sales and exchanges of property between a partner and the partnership.
• Special circumstances, including “disguised sales” of property.
• Miscellaneous transactions that influence self-employment tax and other tax attributes.

Partnerships are “flow-through” entities, meaning tax attributes generally flow to the partners. However, special rules under the Internal Revenue Code (IRC) sections—particularly IRC §§ 704, 707, and 721—address how these transactions are taxed to both the partner and the partnership.

Compensation for Services and Compensatory Partnership Interests

When a partner provides services to the partnership, the partnership may compensate that partner by:

1. Paying the partner a salary or guaranteed payment.
2. Granting a partnership interest, which could be a capital interest, a profits interest, or both.

Guaranteed Payments vs. Partnership Interests

• Guaranteed Payments
A guaranteed payment is compensation to a partner for services or use of capital that is determined without regard to the partnership’s income. Guaranteed payments are generally deductible by the partnership (unless they must be capitalized) and are includible in the partner’s ordinary income. Additionally, guaranteed payments often constitute self-employment income subject to self-employment tax, even if the partnership reports a loss.

• Compensatory Partnership Interests
Compensatory partnership interests are partnership interests transferred to a service provider in exchange for services. These interests can be:

• Capital Interest: An interest that gives the holder a share in the partnership’s existing capital and retained earnings. Its fair market value (FMV) at grant is generally includible in the service provider’s taxable income on the grant date (unless subject to a substantial risk of forfeiture).
• Profits Interest: An interest that confers the right to future profits and appreciation in value but not a share of existing capital. If certain conditions are met, a profits interest may have zero FMV on the grant date, thus causing no immediate taxable event.

Example: Compensatory Capital Interest

Assume that Partner A provides accounting and management services to the ABC Partnership. In exchange, ABC grants A a 10% capital interest in the partnership. If the FMV of that 10% interest is $100,000 at the time of grant, Partner A recognizes $100,000 of ordinary compensation income for that tax year. The partnership, if eligible, may claim a deduction of $100,000.

Example: Compensatory Profits Interest

Suppose the ABC Partnership wants to incentivize Partner B by awarding her a 10% profits interest, which only entitles B to future profits. Because this type of interest has no immediate liquidation value (assuming it meets the IRS “safe harbor” conditions), B may have no income on receipt. The key factor is that the interest must not represent an interest in the partnership’s established capital.

Sales, Exchanges, and Distinguishing Transactions Under Section 707

Transactions between a partner and a partnership often fall under IRC § 707, which creates two broad categories:

• Section 707(a)(1): Transactions Between Partners and Partnerships as if Between Strangers
If a partner engages in a transaction with a partnership other than in their capacity as a partner, the transaction is treated “as if” between the partnership and a third party. For instance, if a partner leases property to the partnership on terms unrelated to the partnership agreement, this is treated as if it were a lease between two unrelated parties.

• Section 707(c): Guaranteed Payments
When a partner is entitled to a fixed or guaranteed amount for services or for the use of capital, the payment is taxed as ordinary income to the partner and is often deductible by the partnership.

Example: Property Sale

Partner X sells a piece of machinery to the partnership for $80,000, which is its FMV. Partner X treats the gain or loss on the sale according to standard sales principles. However, if there are certain conditions (like the property being contributed initially and quickly “redeemed” by the partnership), the IRS might reclassify the transaction as a disguised sale.

Disguised Sales Under IRC Section 707(a)(2)(B)

A “disguised sale” occurs when a partner contributes property to a partnership and, in what is effectively a prearranged, reciprocal transaction, receives a distribution in return—either immediately or soon thereafter. The IRS can recharacterize such contribution-and-distribution transactions as a sale. This prevents taxpayers from disguising what is essentially a property sale by structuring it as a tax-free contribution under IRC § 721.

Basic Tests for a Disguised Sale

1. Timing of Contributions and Distributions: If a partner contributes property and receives a distribution of cash or other property within two years, there is a presumption of a disguised sale.
2. Non-Tax Business Purpose: If the facts indicate the contributions and distributions are linked, with no meaningful change in ownership risk, the transaction could be deemed a disguised sale.

Example: Disguised Sale Scenario

1. Partner M transfers a building with an FMV of $500,000 to MNO Partnership.
2. Within six months, the partnership “distributes” $500,000 in cash to M.
3. Absent a compelling non-tax reason, the IRS may treat this arrangement as Partner M “selling” the building to the partnership for $500,000.

In such a case:
• Partner M recognizes gain or loss as if the property were sold.
• The partnership takes a cost basis in the building.

Diagram: Potential Disguised Sale Structure

Below is a simplified mermaid diagram illustrating a potential disguised sale scenario:

    flowchart LR
	    A["Partner M Contributes Building"] --> B["MNO Partnership"]
	    B["MNO Partnership"] --> A["Distribution to M (Cash)"]

In this structure, the temporal link and the equivalence in value between the contributed building and the subsequent distribution may indicate a disguised sale under IRC § 707(a)(2)(B).

Self-Employment Tax Considerations

Unlike corporate shareholders who may receive wages subject to Federal Insurance Contributions Act (FICA) taxes, general partners typically pay self-employment (SE) tax on their distributive share of partnership income. Here are critical factors:

1. General Partners: Generally, all trade or business income allocated to general partners is subject to SE tax.
2. Limited Partners: Traditionally, limited partners do not pay SE tax on distributive shares, except for guaranteed payments for services. However, classification of LLC members under IRS rules can be complicated; certain active LLC members could be treated similarly to general partners for SE tax.
3. Guaranteed Payments: Guaranteed payments for services rendered are subject to SE tax.
4. Partnership Interest Received for Services: If the partner receives a capital interest that is included in ordinary compensation income, it is also subject to SE tax to the extent it constitutes compensation for services.

Example: Calculating Self-Employment Tax for a General Partner

• Mundy is a 40% general partner in an active trade or business partnership.
• The partnership has net income of $300,000 for the year (after guaranteed payments).
• Mundy’s distributive share is 40% × $300,000 = $120,000.
• Mundy must generally include the $120,000 in the computation of her SE tax.

Special Rules and Pitfalls

• Inventory and Unrealized Receivables: Special rules exist under IRC § 751 for sales or exchanges of partnership interests (or distributions) that include “hot assets” such as substantially appreciated inventory or unrealized receivables.
• Holding Period: Partners should keep careful records of when contributions and distributions occur to avoid unintended disguised sale classification within the two-year presumption window.
• Income Allocation: Transactions that appear unrelated may inadvertently shift income or losses. Special allocations must adhere to the substantial economic effect rules under IRC § 704(b).
• Economic Substance: The IRS will recharacterize transactions lacking economic substance or business purpose.

Best Practices for Mitigating Risks

1. Document Business Purposes: Where property is contributed shortly before or after a distribution, furnish clear documentation supporting independent business reasons.
2. Obtain Appraisals: For property sales or swaps between partners and the partnership, use qualified appraisers to substantiate FMV.
3. Institute Safe Harbor Procedures for Profits Interests: Follow the IRS guidelines for “profits interests” to avoid immediate taxable events.
4. Consult with Experts: Because rules on disguised sales and self-employment tax can be nuanced, professional advice is crucial to structuring transactions correctly.

Practical Case Study

Facts

• Partner J wants to join the JK Partnership. The partnership is profitable. J offers to contribute a patent valued at $200,000.
• As part of the contribution arrangement, the partnership agrees to “distribute” $150,000 to J within six months.
• The partnership also grants J a 15% profits interest for services rendered (expected FMV at grant is zero).

Analysis

1. Contribution and Distribution: The near-simultaneous contribution of the patent and distribution of $150,000 raises the possibility of a disguised sale. The question becomes whether the distribution is effectively payment for the patent. If deemed a disguised sale, J recognizes $150,000 of proceeds minus any adjusted basis.
2. Profits Interest: If the 15% interest meets the safe harbor for profits interests, it may not trigger immediate taxation. However, J must pay self-employment tax on his distributive share once the partnership realizes profits.
3. Partnership Operations: JK Partnership would treat the $150,000 payment as part of the purchase price of the patent if it triggers disguised sale treatment, adjusting the basis accordingly.

Diagrams: Summarizing Service and Property Contribution Flows

Below is a mermaid diagram emphasizing both service compensation and potential property contributions:

    flowchart TB
	    A["Partner J (Services + Patent)"] --> B["JK Partnership"]
	    B["JK Partnership"] --> A["Cash Distribution/Compensation"]
	    B["JK Partnership"] --> A["Profits Interest"]

The partnership confers both a cash distribution and a profits interest to Partner J. If the arrangement effectively functions as a purchase of the patent (disguised sale) plus a compensatory interest for services, the tax treatment may differ significantly from a standard partnership contribution.

References for Further Exploration

• IRC §§ 707, 704, 721 – Statutory authority on partner-partnership transactions, disguised sales, and contributions.
• Treasury Regulations § 1.707-3 – Comprehensive guidelines and examples to identify disguised sales.
• IRS Revenue Procedures 93-27 and 2001-43 – Guidance on taxation of partnership profits interests.
• Professional Publications: “Federal Taxation of Partnerships and Partners” by leading tax publishers.

Test Your Knowledge: Disguised Sales & Compensatory Partnership Interests

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