GENERAL EXPLANATION
OF THE
REVENUE PROVISIONS OF THE
DEFICIT REDUCTION ACT OF 1984
(H.R. 4170, 98TH CONGRESS;
PUBLIC LAW 98-369)
The Act authorizes the Treasury Department to prescribe such
regulations as may be necessary or appropriate to carry out the
purposes of the provision. In prescribing these regulations, the
Treasury should be mindful that Congress is concerned with trans-
actions that work to avoid capitalization requirements or other
rules and restrictions governing direct payments and not with non-
abusive allocations that accurately reflect the various economic
contributions of the partners. These regulations may apply the pro-
vision both to one-time transactions and to continuing arrange-
ments which utilize purported partnership allocations and distribu-
tions in place of direct payments. Congress specifically intended
that the provision apply to allocations used to pay partnership or-
ganization or syndication fees, subject to the general principles
above.
The regulations will provide, when appropriate, that the purport-
ed partner performing services for or transferring property to the
partnership is not a partner at all for tax purposes. If it is deter-
mined that the service performer or property transferor actually is
a partner (because of other transactions), Congress believed that
the factors described below should be considered in determining
whether the partner is receiving the putative allocation and distri-
bution in his capacity as a partner.
The first, and generally the most important, factor is whether
the payment is subject to an appreciable risk as to amount. Part-
ners extract the profits of the partnership with reference to the
business success of the venture, while third parties generally re-
ceive payments which are not subject to this risk. Thus, an alloca-
tion and distribution provided for a service partner under the part-
nership agreement which subjects the partner to significant entre-
preneurial risk as to both the amount and the fact of payment gen-
erally should be recognized as a distributive share and a partner-
ship distribution, while an allocation and distribution provided to a
service partner under the partnership agreement which involve
limited risk as to amount and payment should generally be treated
as a fee under section 707(a). Examples of allocations that limit a
® Of course, if a partner received an interest in a partnership in exchange for services, he may
recognize income upon that receipt; however, this issue arises only if it is determined that an
amount received is not a fee but relates instead to a partnership interest. See Code sections 61
and 8:^; Diamond v. Commissioner, 492 F.2d 286 (7th Cir. 1974).
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partner's risk include both "capped" allocations of partnership
income (i.e., percentage or fixed dollar amount allocations subject
to an annual maximum amount when the parties could reasonably
expect the cap to apply in most years) and allocations for a fixed
number of years under which the income that will go to the part-
ner is reasonably certain. Similarly, continuing arrangements in
which purported allocations and distributions (under a formula or
otherwise) are fixed in amount or reasonably determinable under
all the facts and circumstances and which arise in connection with
services also shield the purported partner from entrepreneurial
risk. Although short-lived gross income allocations are particularly
suspect in this regard, gross income allocations may, in very limit-
ed instances, represent an entrepreneurial return, which is classifi-
able as a distributive share under section 704. Similarly, although
net income allocations appear generally to constitute distributive
shares, some net income allocations may be fixed as to amount and
probability of payment and should, if coupled with a distribution or
payment from the partnership, be characterized as fees.
The second factor is whether the partner status of the recipient
is transitory. Transitory partner status (which limits the duration
of a purported joint undertaking for profit) suggests that a pay-
ment is a fee or is in return for property. The fact that partner
status is continuing, however, is of no particular relevance in es-
tablishing that an allocation and distribution are received in an in-
dividual's capacity as a partner.
The third factor is whether the allocation and distribution that
are made to the partner are close in time to the partner's perform-
ance of services for or transfer of property to the partnership. An
allocation close in time to the performance of services, or the trans-
fer of property, is more likely to be related to the services or prop-
erty. In the case of continuing arrangements, the time at which
income is scheduled to be allocated to the partner may be a factor
indicating that an allocation is, in fact, a disguised payment. When
the income subject to allocation arises over an extended period or
is remote in time from the services or property contributed by a
partner, the risk of not receiving payment (the first factor de-
scribed above) may also increase.
The fourth factor is whether, under all the facts and circum-
stances, it appears that the recipient became a partner primarily to
obtain tax benefits for himself or the partnership which would not
have been available if he had rendered services to the partnership
in a third party capacity. The fact that a partner also has signifi-
cant non-tax motivations in becoming a partner is of no particular
relevance.
The fifth factor, which relates to purported allocations /distribu-
tions for services, is whether the value of the recipient's interest in
general and continuing partnership profits is small in relation to
the allocation in question (thus suggesting that the purported allo-
cation is, in fact, a fee). This is especially significant if the alloca-
tion for services is for a limited period of time. The fact that the
recipient's interest in general and continuing partnership profits is
substantial does not, however, suggest that the purported partner-
ship allocation/distribution arrangement should be recognized.
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The sixth factor, which relates to purported allocations/distribu-
tions for property, is whether the requirement that capital ac-
counts be respected under section 704(b) (and the proposed regula-
tions thereunder) makes income allocations which are disguised
payments for capital economically unfeasible and therefore unlike-
ly to occur. This generally will be the case unless (i) the valuation
of the property contributed by the partner to the partnership is
below the fair market value of such property (thus improperly un-
derstating the amount in such partner's capital account), or (ii) the
property is sold by the partner to the partnership at a stated price
below the fair market value of such property, or (iii) the capital ac-
count will be respected at such a distant point in the future that its
present value is small and there is to be no meaningful return on
the capital account in the intervening period.
Congress anticipated that the Treasury Department may describe
other factors that are relevant in evaluating whether a purported
allocation and distribution should be respected. In applying these
various factors, the Treasury and the courts should be careful not
to be misled by possibly self-serving assertions in the partnership
agreement as to the duties of a partner in his partner capacity but
should instead seek to determine the substance of the transaction.
In the case of allocations which are only partly determined to be
related to the performance of services for, or the transfer of proper-
ty to, the partnership, the provision applies to that portion of the
allocation which is reasonably determined to be related to the
property or services provided to the partnership. Finally, it was an-
ticipated that Treasury regulations will provide for the coordina-
tion of this provision with the preexisting rules of section 707 and
other provisions of subchapter K such as section 736.
Congress did not intend to create any inference regarding the tax
treatment of the transactions described above under prior law.
The principles of this provision can be illustrated by the follow-
ing examples.
Example 1
A commercial office building constructed by a partnership is pro-
jected to generate gross income of at least $100,000 per year indefi-
nitely. Its architect, whose normal fee for such services is $40,000,
contributes cash for a 25-percent interest in the partnership and
receives both a 25-percent distributive share of net income for the
life of the partnership, and an allocation of $20,000 of partnership
gross income for the first two years of partnership operations after
lease-up. The partnership is expected to have sufficient cash avail-
able to distribute $20,000 to the architect in each of the first two
years, and the agreement requires such a distribution.
The purported gross income allocation and partnership distribu-
tion in this example should be treated as a fee under section 707(a),
rather than as a distributive share because as to those payments
the architect is insulated from the risk of the joint enterprise. Fac-
tors which contribute to this conclusion are (1) the special alloca-
tion to the architect is fixed in amount and there is a substantial
probability that the partnership will have sufficient gross income
and cash to satisfy the allocation/distribution; (2) the distribution
relating to the allocation is fairly close in time to the rendering of
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the services; and (3) it is not unreasonable to conclude from all the
facts and circumstances that the architect became a partner pri-
marily for tax reasons.
If, on the other hand, the agreement allocates to the architect 20
percent of gross income for the first two years following construc-
tion of the building, a question arises as to how likely it is that the
architect will receive substantially more or less than his imputed
fee of $40,000. If the building is pre-leased to a high credit tenant
under a lease requiring the lessee to pay $100,000 per year of rent,
or if there is low vacancy rate in the area for comparable space, it
is likely that the architect will receive approximately $20,000 per
year for the first two years of operations. Therefore, he assumes
limited risk as to the amount or payment of the allocation and, as
a consequence, the allocation/distribution should be treated as a
disguised fee. If, on the other hand, the project is a "spec building,"
and the architect assumes significant entrepreneurial risk that the
partnership will be unable to lease the building, the special alloca-
tion might (even though a gross income allocation), depending on
all the facts and circumstances, properly be treated as a distribu-
tive share and a genuine partnership distribution.
Example 2
In certain instances, allocation /distribution arrangements that
are contingent in amount may nevertheless be recharacterized as
fees. Generally, these situations should arise only when (1) the
partner in question normally performs, has previously performed,
or is capable of performing similar services for third parties, and
(2) the partnership agreement provides for an allocation and distri-
bution to such partner that effectively compensates him in a
manner substantially similar to the manner in which the partner's
compensation from third parties normally would be computed.
For example, suppose that a partnership is formed to invest in
stock. The partnership admits a stock broker as a partner. The
broker agrees to effect trades for the partnership without the
normal brokerage commission. In exchange for his partnership in-
terest, the broker contributes 51 percent of partnership capital and
receives a 51 percent interest in residual partnership profits and
losses. In addition, he receives an allocation of gross income that is
computed in a manner which approximates his foregone commis-
sions. It is expected that the partnership will have sufficient gross
income to make this allocation. The agreement provides that the
broker will receive a priority distribution of cash from operations
up to the amount of the gross income allocation. In this case, even
though the broker/ partner's special allocation appears contingent
and not substantially fixed as to amount, it is computed by means
of a formula like a normal brokerage fee and effectively varies
with the value and amount of services rendered rather than with
the income of the partnership. Thus, this contingent gross income
allocation along with the equivalent priority distribution should be
treated as a fee under section 707(a), rather than as a distributive
share and partnership distribution.
In addition to these examples, Congress intended that the provi-
sion lead to the conclusions contained in Revenue Ruling 81-300,
1981-2 C.B. 143, and Revenue RuUng 81-301, 1981-2 C.B. 144, except
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that the transaction described in Revenue Ruling 81-300 would be
treated as a transaction described in section 707(a) (rather than sec-
tion 707(c)).