Guaranteed Payments for Capital (Section 707 C) Analyzed (2024)

Walter D. Schwidetzky

Walter D. Schwidetzky is a professor of law at the University of Baltimore School of Law. He thanks Fred Brown and Monte Jackel for their exceptionally helpful comments.

In this report, Schwidetzky explains why section 707(c), governing partnership guaranteed payments, was misguided from the outset and made even worse by the enactment of section 707(a)(2)(A).

Copyright 2023 Walter D. Schwidetzky.
All rights reserved.

I. Introduction

In general, transactions between partnerships and their partners fall into one of three categories for federal income tax purposes1: (1) sections 704(b) and 731(a), which usually will give tax-free distribution treatment (the section 731(a) part) when made from a partner’s distributive (that is, allocable) share of partnership income (the section 704(b) part); (2) section 707(a)(1), which covers transactions between a partner and a partnership when the partner is acting in a third-party capacity, that is, not in the partner’s capacity as a partner; and (3) section 707(c), the subject of this report, which covers guaranteed payments to a partner for the use of capital or for services when, at least historically, the partner is acting in a partner capacity.

For items that are otherwise deductible, these provisions can generate comparable outcomes. An allocation of income to a partner means less income is allocated to other partners, generating a deduction equivalent. A payment under section 707(a) or section 707(c) can be deductible to the partnership.2 In principle, the three categories are not optional. If, for example, a partner is acting in a non-partner capacity, section 707(a)(1) applies, and the other two categories cannot apply. However, sometimes it can be unclear which category a given transaction falls into, especially in light of 1984 law changes.

Section 707(c) has been consistently interpreted to apply to payments to partners in their capacity as partners.3 Thus, a critical, historical distinction between section 707(a)(1) and section 707(c) was whether the partner is acting in a partner capacity. That distinction was intended. The provisions are meant to be mutually exclusive,4 though this distinction was undermined with the enactment of section 707(a)(2)(A) in 1984. As I will discuss, section 707(a)(2)(A) and its proposed regulations place certain payments for services that lack “entrepreneurial risk” in section 707(a), even if historically they would have been within section 707(c), to that extent making section 707(c) redundant.

Guaranteed payments were an odd, relatively late addition to section 707 and have never made much sense. Over the years, many have called for the repeal of section 707(c).5 In September 2021 Senate Finance Committee Chair Ron Wyden, D-Ore., released a draft proposing what would be the most substantial changes to subchapter K since 1954.6 The Wyden proposals again recommend repealing section 707(c). With this new impetus, I thought this would be a good time to take a fresh look at section 707(c). This report is not intended to be a comprehensive review of the entire world of guaranteed payments but rather a focused look on whether section 707(c) should be repealed and, if so, what other changes need to be made to section 707.7

II. Guaranteed Payments Basics

Guaranteed payments have become something of a moving target. I will first lay out the basic rules. Section 707(c) is a short code subsection, so I quote it in full:

Guaranteed payments. — 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(a) (relating to gross income) and, subject to section 263, for purposes of section 162(a) [relating to trade or business expenses].

Right out of the gate there are several curiosities. The term “guaranteed payment” is contained only in section 707(c)’s title and is not itself defined in the statute, regulations, or legislative history. As already noted, guaranteed payments have historically been viewed as payments that are made to a partner, in a partner’s capacity as a partner, though this is not explicitly stated in the statute or the regulations. Neither the statute nor the legislative history explicate what it means to have an amount be “determined without regard to the income of the partnership.” But presumably, this phrase means the guaranteed payment should be fixed in amount. It must be payable in all events but, paradoxically, need not actually be paid in order for the partner to have income. Under reg. section 1.707-1(c), the payment is taken into income by the partner based on the accounting method of the partnership rather than the accounting method of the partner. Consequently, a partner must include the guaranteed payment in income for her tax year within which, or with which, ends the partnership tax year in which the partnership deducted that payment as paid or accrued under its method of accounting, even if the guaranteed payment was not in fact made.

Guaranteed payments can be made to a partner for services or as a return on capital. Importantly, they are not considered part of a partner’s distributive share. Even though guaranteed payments are made to a partner in his partner capacity, guaranteed payments are considered as made to one who is not a member of the partnership but only for the purposes of sections 61(a) and 162. This enables the partnership to deduct the guaranteed payment if it meets the ordinary and necessary business expense test under section 162. Guaranteed payments for services that do not meet the ordinary and necessary test typically must be capitalized (a 1976 amendment removed any ambiguity in this regard). A guaranteed payment is always ordinary income to the recipient partner regardless of the character of the income earned by the partnership.8

Guaranteed payments for the use of capital (GPUCs) are deductible by the partnership under section 162 if they are reasonable in amount.9 An example would be a guaranteed return of 6 percent on capital invested given to certain partners before allocations are made to any other partners. Unlike “regular” partnership distributions under section 731(a), GPUCs do not typically reduce the recipient partner’s capital account. For purposes of this report, I assume that guaranteed payments arise in a trade or business context. There is some question of how they might be best treated outside that context. GPUCs should not be seen as interest. There is not a bona fide debtor-creditor relationship between a partnership and a partner entitled to a guaranteed payment. The upside of avoiding section 163 is that it also avoids the many restrictions on the deduction of interest under section 163, though the character of the income is the same.10

Why do we have guaranteed payments in the first place? Section 707(c), which was enacted as part of the seminal Internal Revenue Act of 1954, appears to have been late to the party. Previously, the American Law Institute had made a comprehensive proposal for the taxation of partners and partnerships. The 1954 legislation was largely based on the ALI proposal. In the section 707 context, the ALI proposal provided:

Except as provided in subsections (b) and (c) [not here relevant], if a partner either makes payments to the partnership in exchange for property or for services rendered to him by the partnership, or receives payments from the partnership in exchange for services rendered by him to the partnership, or otherwise engages in a transaction with the partnership wherein he is not acting in his capacity as a partner, the transaction shall be treated as occurring between the partnership and one who is not a partner.11

Essentially, this is current section 707(a)(1). The ALI proposal did not contain a provision on guaranteed payments. It discussed partner salaries in the distributive share context without giving genuine guidance in this regard. But the ALI proposal did not discuss payments to partners in a partner capacity in the section 707 context, admittedly an unfortunate omission.

Apparently, what drove section 707(c)’s enactment was a problem that existed before 1954. The courts had consistently held that a partner could not be an employee of a partnership in which he was a partner. Nonetheless, salary payments to partners were made. The salary payments were considered distributive shares of partnership income. This approach worked acceptably as long as the salary payments did not exceed partnership taxable income. When they did, it created problems. Typically, the excess of partners’ salaries over partnership income was treated as paid out of partnership capital. If the payments came out of the payee partner’s capital account, the partner was treated as having received a return of capital. To the extent the capital accounts of other partners were charged with the excess, the salaried partner was held to have received income, and the other partners were entitled to deductions.

Section 707(c) was, as I will discuss, a decidedly imperfect effort to address these complexities. It appears that Congress wanted to follow the judicial lead and not allow partners to be employees of the partnership. It apparently did not occur to the House and Senate to fold any relevant provision into section 707(a), which would have been both possible and, as I will discuss, preferable. The ALI proposal’s lack of guidance in this regard may have contributed to the problem.

Remember, however, that in 1954 subchapter K was something of a backwater, often thought to be relevant only to small businesses. This changed around the 1970s. Causative factors were the advent of the tax shelter industry and changes in individual and corporate rates. Practitioners realized that partnerships offered tax benefits that corporations often could not, and it was off to the races. While section 707(c) did not make much sense from the beginning, likely few anticipated what a substantial role it would eventually play. Had they seen the train coming, Congress (and the preceding ALI proposal) likely would have handled matters differently from the outset.

The leading case interpreting guaranteed payments is Pratt.12 In Pratt, the general partners of real estate limited partnerships were entitled to be paid a fee of 5 percent of the gross rentals received by the partnerships in return for managing the partnerships. The fees were not actually paid. The partnerships were on the accrual method of accounting, and the partners were on the cash method. Apparently, the parties were trying to game the accrual and cash accounting systems at a time when section 267(a)(2) and (e), which would have prevented this, had not yet entered the code. The parties unsuccessfully claimed that the regulation, which then and now requires a partner to include a guaranteed payment in income in the year the partnership accrues or deducts it, was an “overextension of [Treasury’s] authority.” That was a decent argument because section 707(c) does not speak to this issue, but the legislative history supports the regulation:

It should be noted that such [guaranteed] payments, whether for services or for the use of capital, will be includible in the recipient’s return for the taxable year with or within which the partnership year in which the payment was made, or accrued, ends.13

The Tax Court thus correctly concluded that the regulation was a reasonable interpretation.

The taxpayers in Pratt contended that the management fees should either be treated as guaranteed payments (relying on the failed overextension argument) or section 707(a) payments to a partner other than in the partner’s capacity as a partner (which at the time would have allowed the accrual/cash game to work). But both the Tax Court and the Fifth Circuit held that the management fees were not deductible. Both courts found that the fees were not payments to a partner other than in the partner’s capacity as a partner, as required by section 707(a), because the general partners (to state the obvious) were acting in their capacities as partners performing basic duties of the partnership business under the partnership agreement.

Guaranteed payments include only amounts that are paid without regard to the income of the partnership. In Pratt, the Tax Court held that this standard was not met because the guaranteed payments were computed as a percentage of gross rental income received by the partnerships. The court reasoned that the gross rental income was income of the partnerships, and thus, the payments were made with regard to partnership income. As such, the Tax Court’s view is undisputable. Whether it was what Congress intended is another question. (For technical reasons, the Fifth Circuit did not address this issue on appeal.) Although this is not an instance of hard cases making bad law, it is worth noting that the decision kept the taxpayers from gaming the system because the payments to them were treated as part of their distributive shares.

The outcome of the Pratt decision was criticized,14 though the criticism perhaps should have been directed at Congress, which chose the language of the statute. The Tax Court’s holding certainly aligns with the statutory mandate that a guaranteed payment be determined without regard to income. It aligns less well with the legislative history, which sought to obviate the need for complex calculations when salary-type payments exceed partnership taxable income, though Congress did not speak to the issue in Pratt directly.15 In Rev. Rul. 81-300, 1981-2 C.B. 143, the IRS ruled that fees based on gross income of a partnership for services performed in a partnership capacity should not be treated as being determined with regard to partnership income, allowing section 707(c) to apply to the payment:

Although a fixed amount is the most obvious form of guaranteed payment, there are situations in which compensation for services is determined by reference to an item of gross income. For example, it is not unusual to compensate a manager of real property by reference to the gross rental income that the property produces. Such compensation arrangements do not give the provider of the service a share in the profits of the enterprise, but are designed to accurately measure the value of the services that are provided. Thus, . . . [in light of the] legislative history and the purpose underlying section 707 of the Code, the term “guaranteed payment” should not be limited to fixed amounts. A payment for services determined by reference to an item of gross income will be a guaranteed payment if, on the basis of all of the facts and circ*mstances, the payment is compensation rather than a share of partnership profits. Relevant facts would include the reasonableness of the payment for the services provided and whether the method used to determine the amount of the payment would have been used to compensate an unrelated party for the services. [Emphasis added.]

The italicized language surely represents a reasonable rule, just not one supported by the language of section 707(c). While the IRS’s position arguably can find support in the legislative history, as noted, there is nothing in the legislative history directly on point. Although the IRS did not state this explicitly, it seems clear that the reason for the agency’s position was that it would be rare for a partnership to not have gross income (as opposed to net profits), making it unlikely that a guaranteed payment would not be payable. Keeping payments based on gross income out of section 707(c) (assuming section 707(a) would not apply and the payments were actually made) could enable the payee partner to avoid ordinary income if the character of partnership income was long-term capital or section 1231 gain. Note that a guaranteed payment’s ordinary income status is decoupled from the economic success or failure of the partnership. Thus, ordinary income treatment applies even if the partnership operates at a net loss. Indeed, if the guaranteed payment is deductible, it could increase the partnership’s loss.16 That still leaves the pesky problem that the statute just uses the word “income” and not “taxable income,” and nowhere does it provide for the use of a facts and circ*mstances test.

At the same time it issued Rev. Rul. 81-300, the IRS issued Rev. Rul. 81-301, 1981-2 C.B. 144. The latter ruling describes a limited partnership that has two classes of general partners. The first class partner (director general partners) had complete control over the management, conduct, and operation of partnership activities. The second class (consisting of a single adviser general partner) rendered to the partnership services that were substantially the same as those that the adviser general partner rendered to other persons as an independent contractor. The adviser general partner received 10 percent of daily gross income in exchange for the management services it provided to the partnership. Rev. Rul. 81-301 concluded that the adviser general partner received its gross income allocation in a non-partner capacity and fell within section 707(a) because it provided similar services to its general clients, was subject to removal by the director general partners, was not personally liable to the other partners for any losses, and its management was supervised by the director general partners. Unlike Rev. Rul. 81-300, this revenue ruling aligns well with section 707(a).

One more piece to the puzzle is relevant to this discussion. Example 2 of reg. section 1.707-1(c), adopted in 1956,17 provides:

Partner C in the CD partnership is to receive 30 percent of partnership income as determined before taking into account any guaranteed payments, but not less than $10,000. The income of the partnership is $60,000, and C is entitled to $18,000 (30 percent of $60,000) as his distributive share. No part of this amount is a guaranteed payment. However, if the partnership had income of $20,000 instead of $60,000, $6,000 (30 percent of $20,000) would be partner C’s distributive share, and the remaining $4,000 payable to C would be a guaranteed payment [guaranteed minimum payment].

See Also

Schedule K-1 (Form 1065) - Guaranteed PaymentsWhat is a Guaranteed Payment? | SC&HQualified Business Income Deduction (QBI): What It Is - NerdWalletTax Treatment of Guaranteed Payments to Partners: Impact of IRC 199A, Section 707 Payments, Priority Allocations

Thus, Example 2 treats a guaranteed minimum payment as a guaranteed payment to the extent the payment is not matched by an allocation of income. As I discuss in more detail below, proposed regulations, not under section 707(c) but under section 707(a)(2)(A), would change the result of this example so that the guaranteed minimum amount (in Example 2, $10,000) would always be a guaranteed payment.18

Guaranteed payments were odd ducks from the outset. Further, the only real tax difference between subsections (a) and (c) of section 707 is that for section 707(a) purposes, the payee partner’s method of accounting typically controls the timing of the payee’s income inclusion, whereas for section 707(c) purposes, the payee is bound by the partnership’s method of accounting. I am unaware of any hard data on point, but few partners will put up with income without the associated payment, so most likely this difference in treatment is of little practical significance. The origin of the special accounting provision is not entirely clear. Most likely, it relates to the fact that the partner is receiving a payment in her capacity as a partner. An alternative (or supplemental) explanation is that it was created to prevent partnerships from gaming the accrual- or cash-basis accounting rules as was tried in Pratt. If the latter, one wonders why it was not also applied in the section 707(a) context, in which the same issue exists. In 1984 Congress mooted this question with the enactment of section 267(a)(2) and (e), which explicitly prohibits gaming cash and accrual accounting in the partner/partnership context, thereby eliminating a distinction between section 707(a) and section 707(c) and making the existence of the latter even more dubious.

III. Section 707(a)(2)(A) Problems

The interaction of section 707(c) and section 707(a)(2)(A) is an example of an irresistible force meeting an immovable object.

Partnerships can be tempted to convert capital expenditures into ordinary deductions using section 704(b) allocations. Assume, for example, that an attorney is a partner in a real estate partnership. He advises the partnership on the acquisition of a new apartment building. His normal fee for this service is $15,000. If the partnership pays him the $15,000 and treats it as a section 707(a) payment, like acquisition costs generally, the $15,000 may not be deducted currently and is capitalized into the cost of the property.19 More appealing would be for the partnership to allocate an “extra” $15,000 of the partnership’s income to the attorney-partner. The tax consequence to the attorney is the same, assuming ordinary income is allocated. But the partnership, by having $15,000 less income to allocate to the partners, is given the equivalent of a deduction. Thus, if allowed, by using partnership allocations, the partnership can turn a capital item into an ordinary deduction. Further, the section 162 limits on current deductions do not apply to allocations. While allocations can have the effect of deductions, they are not deductions, as such, and thus cannot fall within section 162.

Unsurprisingly, Congress was unenthusiastic about this result. To deal with this and similar abuses, it enacted section 707(a)(2)(A). Section 707(a)(2)(A) provides that if a partner performs services for a partner or transfers property to a partnership and there is a related direct or indirect allocation and distribution to that partner — and the performance of services and the allocation and distribution, when viewed together, are properly characterized as occurring between the partnership and a person acting other than in his capacity as a partner — that is how it will be treated. Thus, in the above example, the purported allocation/distribution to the attorney-partner will not be respected, and the partnership will be considered to have made a $10,000 payment to a non-partner and be required to capitalize that amount. The “transfers property” language in section 707(a)(2)(A) typically refers to a disguised lease or similar transaction and not a disguised sale, which is covered by other code provisions.20 As a consequence, it is of no real relevance to this report and will not be the subject of further discussion. Note that section 707(a)(2)(A) applies to services only, not GPUCs, a subject to which I will return.

The legislative history makes clear that whether a payment is subject to section 707(a)(2)(A) depends on whether the payment is subject to significant entrepreneurial risk. If it is not, section 707(a)(2)(A) applies. Fatefully, and unnecessarily, the legislative history specifies that the fees in Pratt and Rev. Rul. 81-300 should have come within section 707(a), not section 707(c).21 It is not apparent why. Congress could have easily noted that Rev. Rul. 81-300 represents a correct interpretation of the law. Instead, it created a mess.

The focus on entrepreneurial risk represents a sea change, though it may not leap off the page on a first reading. Before the enactment of section 707(a)(2)(A), one asked whether the partner was acting in a partner capacity. According to the proposed regulations (discussed below), now one must ask to what risk is the payment subject. If it is not subject to sufficient entrepreneurial risk while also being tied to partnership income, it will come within section 707(a)(2)(A), irrespective of the capacity in which the partner was acting, another topic to which I will return.22

A whopping 31 years after section 707(a)(2)(A) was enacted, proposed regulations, which largely mirror the legislative history, were promulgated in July 2015.23 This delay in promulgating the regulations occurred even through, arguably, the implementation of section 707(a)(2)(A), by its terms, requires Treasury to promulgate regulations, though the IRS claims otherwise.24 To my knowledge, there is no case law on section 707(a)(2)(A). The possible driver for the proposed regulations was the problems created when fund managers waived fees in a manner that could covert ordinary income into long-term capital gains. For example, a manager might waive a 2 percent fee (which would be ordinary income) in exchange for a larger profit share (which could be long-term capital gain).25

The effective date of the proposed regulations will generally be after the publication of the final regulations in the Federal Register. It has been about eight years since these regulations were proposed, but still we wait. Sadly, in the partnership taxation universe, this is more the norm than the exception. That said, when they are the only game in town (aside from the legislative history), practitioners tend to rely on proposed regulations. To some extent, these proposed regulations contemplate that reliance.26

Somewhat disingenuously, the preamble to the proposed regulations provides that Treasury and the IRS believe that section 707(a)(2)(A) generally should not apply to arrangements that the partnership has reasonably characterized as a guaranteed payment under section 707(c).27 In fact, as I will discuss, the proposed regulations would change the section 707(c) universe. Still, both section 707(a)(2)(A) and section 707(c) are on the books, and it makes sense to promulgate regulations under one code subsection that, as much as possible, do not obviate a different subsection. But keeping both on the books will only add to existing confusion while accomplishing no great (or even non-great) policy objective.

The proposed regulations have been covered in detail by other efforts,28 and I will cover only the basics here. Whether an arrangement constitutes a disguised payment for services (in whole or in part) depends on all the facts and circ*mstances.29 The proposed regulations include six nonexclusive factors that may indicate that an arrangement constitutes a disguised payment for services. Of these factors, the first five generally track the facts and circ*mstances identified in the legislative history as relevant in applying section 707(a)(2)(A)30:

1. whether the payment is subject to appreciable entrepreneurial risk (the most important factor, according to the legislative history, which calls it “appreciable risk”);

2. whether the partner status of the recipient is transitory;

3. whether a distribution to a partner is close in time to the partner’s performance of services for, or transfers of property to, the partnership;

4. whether the recipient of a distribution became a partner primarily to obtain tax benefits for himself or the partnership, such as the avoidance of capitalization requirements, which would not have been available if the recipient had rendered services to the partnership in a third-party capacity (a factor that would be challenging to apply in practice); and

5. whether the value of the recipient’s interest in partnership profits is generally small in relation to the allocation in question.

The sixth factor, which was not included in the legislative history, provides factual elements that indicate that an allocation/distribution is tied to particular services, rather than the business of the partnership as a whole, implicitly with reduced entrepreneurial risk.31 This sixth factor could permit an allocation of net profits — which normally would be thought of as subject to ample entrepreneurial risk — to come within section 707(a)(2)(A) if it is unlikely that the net profits will not be generated from a certain subset of partnership activities, such as high-quality bonds.32

The existence of significant entrepreneurial risk can be thought of as a superfactor and is accorded more weight than the other factors. The other factors, which the preamble calls “secondary factors,”33 will tend to arise when there is reduced entrepreneurial risk and can be thought of as providing support for the entrepreneurial risk factor. The bottom line is that under the proposed regulations, an arrangement with an allocation and distribution that lacks significant entrepreneurial risk is generally treated as a disguised payment for services.34 An arrangement in which allocations and distributions to the service provider are subject to significant entrepreneurial risk will generally be recognized as a distributive share.35 Gross income allocations presumptively lack sufficient entrepreneurial risk, though the legislative history indicates that this presumption can be rebutted “in very limited circ*mstances.”36 The proposed regulations would require clear and convincing evidence in this regard.37

A. But What About Section 707(c)?

If the purpose of section 707(a)(2)(A) is to put non-risky payments between a partner and a partnership under section 707(a)(1), why is a non-risky payment to a partner also covered by section 707(c)? Before the proposed regulations, the two subsections could be read to apply to different circ*mstances: section 707(a)(2)(A) when a partner is acting in a third-party capacity and section 707(c) when the partner is acting in a partner capacity. As noted above, that hardly justified section 707(c). In a services context, in either case, there is ordinary income to the recipient partner and either a deduction or capital item to the partnership. And in either case, the payment is non-risky. Why have two different provisions applying to what is substantively the same type of transaction? But at least it was clear how to distinguish between the two subsections. Now the waters are muddied.

Be that as it may, Treasury cannot read section 707(c) out of the code. But did it have to obviate partner capacity? Perhaps. It was clear that Congress wanted Pratt-type allocations of gross income to come within 707(a) even though the partner is acting in a partner capacity.38 While one can have sympathy for the problematic situation in which Congress put Treasury, it is awkward for regulations to effectively contradict a historical basis of a statute for no purpose other than complying with an ill-informed wish of Congress. But, in light of the legislative history, it would have been bold for Treasury to finesse Pratt-type allocations into section 707(c), notwithstanding that the congressional mandate was fundamentally misguided.39 The critical issue is whether payments come within section 704(b). If not, whether they are classified under section 707(a)(2)(A) or section 707(c) is of no great import. By insisting that Pratt-type transactions come within section 707(a)(2)(A), Congress at best muddied the waters and at worst risked making section 707 and its regulations incoherent.

In response to this conundrum, Treasury and the IRS concluded that Congress “revisited the scope of section 707(a) in 1984 and further concluded that section 707(a)(2) applies to arrangements in which distributions to the service provider depend on an allocation of an item of income, and section 707(c) applies to amounts whose payments are unrelated to partnership income.”40 (Emphasis added.) Thus, despite the well-established and reasonable basis for applying section 707(c), the proposed regulations appear to create a new dividing line for section 707(c): Partner capacity is out; whether a payment is related to partnership income is in — sort of.41

The preamble notes that Congress’s emphasis on entrepreneurial risk requires changes to existing regulations under section 707(c). Treasury’s hands (for all but the most intrepid) tied, the preamble obsoletes Rev. Rul. 81-300.42 Treasury also had to tackle Example 2 of reg. section 1.707-1(c), discussed above.43 The preamble insists that Example 2 is inconsistent with the concept that an allocation must be subject to significant entrepreneurial risk to be treated as a distributive share under section 704(b), even though Treasury also said section 707(c) applies to amounts whose payments are unrelated to partnership income. In the example, the payments are related to partnership income. Nonetheless, the proposed regulations modify Example 2 but keep it within section 707(c). The proposed regulations provide that the entire minimum amount ($10,000) is treated as a guaranteed payment under section 707(c) regardless of the amount of the income allocation.44 This is probably the right result, but the reasoning is tortured. Given that Treasury felt bound by the legislative history of section 707(a)(2)(A), it would have made more sense to move the example into section 707(a)(2)(A).45 It would have made even more sense to have stuck with the capacity dividing line and to have only applied the proposed regulations to as narrow a set of facts as possible. And, of course, it would have made the most sense for Congress not to have insisted that Pratt-type transactions come within section 707(a) instead of section 707(c).

B. Guaranteed Returns on Capital

Nothing in the legislative history or the statute suggests that section 707(a)(2)(A) was meant to apply to preferred returns on capital.46 A GPUC could conceivably meet the requirements of section 707(a)(2)(A)(i) and (ii) (transfer of property to a partnership and related direct or indirect allocation and distribution to the partner) but fails subdivision (iii) (properly characterized as a transaction occurring between the partnership and a partner acting other than in his capacity as a member of the partnership).47 A return on capital, of course, is paid to a partner in his partner capacity.48 Thus, an uncomplicated GPUC of say 5 percent of contributed capital now falls within section 707(c), as it has since 1954. Could it just have easily been placed in section 707(a)? Of course, but at least in this case the rules remain coherent.

What if it is not so simple? What if a partner is entitled to a GPUC equal to 25 percent of gross income but not more than 5 percent of that partner’s contributed capital? If it is not covered by section 707(a)(2)(A), and it is not as that code provision applies only to services, does that mean that the allocation falls within section 707(c)? Not if one applies the Treasury rule in the proposed regulations that section 707(c) applies to amounts whose payments are unrelated to partnership income49 because here the payments obviously are related to partnership income. By dint of adding in a gross income allocation, GPUCs could be pulled out of section 707(c), and thus entirely out of section 707, leaving only section 704(b). In other words, if the partnership earns only long-term capital gains, an ordinary income GPUC payment under section 707(c) could be converted into long-term capital gain allocation by adding a gross income component to the GPUC. And, of course, any associated distribution could be tax free under section 731(a).50

Obviously, end-running section 707(c) should not be this easy, but it is not apparent how this outcome is avoided, at least if Treasury sticks to its proposed regulation-guns when a payment falls within section 707(c). Would it be possible to shoehorn the transaction into section 707(c) through a substance-over-form argument? It would not seem so because the transaction has substance, and income in part controls the outcome. It would be necessary to ignore the income allocation entirely — a heavy lift, though perhaps possible in an extreme case — say, an allocation of 100 percent of income up to 5 percent of capital or when a large company with vast amounts of gross income is involved. The McKee treatise, on the other hand, insists that “there is no statutory basis for applying [section] 707(a)(2)(A) principles to convert a putative distribution/allocation arrangement into a section 707(c) guaranteed payment merely because there is a virtual certainty of payment and the distributee-partner bears little or no significant entrepreneurial risk.”51

Another, decidedly aggressive, option would be to finesse Pratt and claim that Congress’s concern was the ultimate tax consequence and not the governing code section — heavily glossing over (truly flat-out ignoring parts of) the legislative history. Pratt would be left under section 707(c). That would permit Treasury to continue to distinguish section 707(a)(2)(A) and section 707(c) based on the relevant partner capacity, and GPUCs would no longer be easily convertible into a section 704(b) distributive shares. One could argue that Treasury has, in fact, ignored Congress’s mandate for many years by not promulgating regulations for a code provision that arguably requires them for implementation and by failing to finalize the proposed regulations. Treasury has, thus, made a sort of end-run around Congress. But doing so implicitly is one thing; doing so explicitly very much another.

But in truth, what section 707(a)(2)(A) paradoxically brings into sharper focus is the illogic of section 707(c), illogic that in some form has been there since the beginning. That makes the solution straightforward.

IV. The Way Out

Section 707(c) caused problems before section 707(a)(2)(A) was enacted. Going forward, the tension between sections 707(a)(2)(A) and 707(c) (particularly if one factors in the proposed regulations) are likely to create problems in the future. The solution, happily, is not unduly complex. Step one is to follow the lead of the Wyden proposals on section 707(c):

Under current law, such payments are generally treated as a payment between the partnership and one who is not a partner under section 707(a) or, alternatively, as a payment to a partner that is determined without regard to the income of the partnership under section 707(c). Section 707(c) has created confusion and uncertainty since its enactment. Furthermore, taxpayers can choose to treat certain payments to partners as a distributive share or as a section 707(c) payments under current law. The provision repeals section 707(c). Section 707(a) would govern any such payments by the partnership that are not actual or in substance distributions under section 731, treating them as payments to a partner not acting in its capacity as a partner.

I have been critical of some of the Wyden proposals, but this one makes eminent sense.

But simply repealing section 707(c) would not be sufficient. Some adjustment to section 707(a) is required, particularly for GPUCs with an associated gross income allocation, which should not allowed to avoid section 707(a). GPUCs that are tied to net income (for example, the lesser of 10 percent of net income or a 5 percent return on capital) normally would continue to fall within sections 704(b) and 731, as they should, because a payment based on net income is hardly assured. A possible exception is the concern that Treasury expressed in the section 707(a)(2)(A) context:

An allocation (under a formula or otherwise) that is predominantly fixed in amount, is reasonably determinable under all of the facts and circ*mstances, or is designed to assure that sufficient net profits are highly likely to be available to make the allocation to the service provider (for example, if the partnership agreement provides for an allocation of net profits from specific transactions or accounting periods and this allocation does not depend on the overall success of the enterprise).52

This issue can be addressed through a regulatory antiabuse rule.

A. Proposed Statutory Language

Keeping the noted considerations in mind, section 707(a) could be simplified to read:

All fixed payments made by a partnership to a partner for services or the use of capital shall be considered as occurring between the partnership and one who is not a partner. Fixed payments shall include payments that are a function of gross income. Under regulations prescribed by the Secretary, certain non-fixed payments will also be considered as occurring between the partnership and one who is not a partner [the antiabuse rule].53

There would no longer be a need for section 707(a)(2)(A) because section 707(a) would cover the relevant waterfront. Section 707(a)(2)(B) (dealing with disguised sales) would still be necessary, albeit with some renumbering.

V. Conclusion

Section 704(c), it is plain, never made much sense when it was added to the code, and it makes even less sense now in light of section 707(a)(2)(A). But there are other arguments for the repeal of section 707(c), beyond the illogic of the provision. The current confused state of the law can encourage practitioners to engage in more aggressive planning than might be possible otherwise. Further, while not a focus of this report, there are many questions on how section 704(c) applies to other parts of the code. Beyond sections 162 and 263, the regulations state that guaranteed payments are to be “regarded as” a distributive share of ordinary income for purposes of other provisions of the code.54 Numerous code sections could come into play. The list is a long one: section 199A, related-party rules, and passive loss rules, to name but a few.55 These issues go away with section 707(c)’s repeal. Thus, though section 707(c) is a short provision, its repeal will strike a surprisingly large blow for simplification.