IV. Long-Awaited 2015 Proposed Regulations
A. Clarifying Section 707(a)(2)(A)
More than 30 years after enactment of section 707(a)(2)(A), the Treasury Department finally issued proposed regulations to clarify the provision. The proposed regulations were prompted by the need to address abusive fee waivers by private equity managers in exchange for an increased interest in the profits of the partnership for which they provided management services. The goal of management fee waivers is (1) to obtain capital gain treatment for the foregone fees and (2) to defer the taxable event until the service provider receives an allocation of partnership profits to match the foregone fees. By attacking such fee waivers as nonpartner payments for services under section 707(a)(2)(A), the Service sought to deny these tax benefits, without necessarily implicating broader problems of taxing partnership profits interests. The proposed regulations represent a long overdue effort to implement section 707(a)(2)(A). Unfortunately, they fall short of resolving the inherent tension between section 707(a) and section 707(c).
Consistent with the 1984 congressional directive, the 2015 proposed regulations provide a mechanism based on entrepreneurial risk for distinguishing between section 707(a)(2)(A) disguised payments, on the one hand, and bona fide section 704(b) distributive shares, on the other hand. Under this approach, most fee waivers would clearly be recharacterized as section 707(a)(2)(A) payments because they lack entrepreneurial risk: fund managers are generally unwilling to relinquish a nonrisky right to a fee in exchange for a risky offsetting allocation of capital gain. Under the proposed regulations, entrepreneurial risk is the dominant factor in classifying section 707(a)(2)(A) payments. Thus, allocations and distributions that involve SER will generally be recognized as a distributive share of partnership income, whereas nonrisky or limited-risk arrangements that resemble payments to a third party may be recharacterized as a disguised payment for services.
B. Continuing Viability of Section 707(c)
The preamble to the proposed regulations describes the confused relationship between section 707(a) and section 707(c) prior to the 1984 legislation. Congress “revisited the scope of section 707(a) in 1984” and determined that the payment in Revenue Ruling 81-300 should be recharacterized as a section 707(a) payment rather than a section 707(c) payment. In light of the 1984 legislation, the Treasury Department and the Service “have concluded that section 707(a)(2) applies to arrangements in which distributions to the service provider depend on an allocation of income, and section 707(c) applies to amounts whose payments are unrelated to partnership income.” The Treasury Department and the Service believe that “section 707(a)(2)(A) should generally not apply to arrangements that the partnership has reasonably characterized as a guaranteed payment.” The preamble also notes that the existing regulations under section 707(c) must be amended to reflect Congress’s emphasis on entrepreneurial risk. Specifically, the treatment of guaranteed minimum payments in the current section 707(c) regulations is “inconsistent with the concept that an allocation must be subject to substantial entrepreneurial risk to be treated as a distributive share under section 704(b).”
The proposed regulations confirm the continued viability of section 707(c) following enactment of section 707(a)(2)(A), implicitly rejecting the notion that the absence of SER disqualifies a payment as a partner-capacity payment. Example (2) would be modified, however, to treat the entire guaranteed minimum as a section 707(c) payment, regardless of the partnership’s income. Only the amount in excess of the guaranteed minimum would be characterized as a section 704(b) distributive share, consistent with the SER standard. The puzzle is why new Example (2) does not treat the entire guaranteed minimum as falling under section 707(a) rather than section 707(c). In Revenue Ruling 81-300, the services performed by the general partners were clearly performed in their partner capacity, since they were central to the partnership’s business. Nevertheless, the 1984 legislative history treated these Pratt-type fees as section 707(a) nonpartner payments, presumably because of the lack of SER. If partner capacity were based on SER rather than the nature of the service partner’s activities, the entire guaranteed minimum in Example (2) should be classified as a section 707(a) payment, consistent with the approach of the ALI Reporters’ Study. Since the prototypical section 707(c) payment is a fixed payment that bears no SER, all section 707(c) payments for services would be treated as section 707(a) payments. As one commentator noted, “it is difficult to see how Treasury could conclude that the absence of substantial economic risk causes the amount of minimum guaranty to be a § 707(c) payment.”
Critics of the 2015 proposed regulations have defended the prior wait-and-see approach under Example (2) on the ground that the guaranteed minimum represents a contingent payment; as such, no guaranteed payment materializes unless the recipient’s profit share turns out to be less than the minimum amount. In that event, only the payment that exceeds the profit share is “derived from” the guarantee. While this view is certainly supportable, it seems equally plausible to treat the arrangement in Example (2) as consisting, in substance, of a fixed payment up to the amount of the guaranteed minimum governed by section 707, coupled with a right to a section 704(b) distributive share in excess of this amount. Since the substance of the agreement should control, a guaranteed minimum that lacks SER should not be treated as a section 704(b) distributive share. To be sure, the stakes are increased if the service partner would otherwise be entitled to a section 704(b) distributive share of partnership income consisting of capital gain, as in the case of a disguised fee waiver. Under new Example (2), if the entire minimum amount is a guaranteed payment, the service partner will recognize more ordinary income from services, without necessarily increasing the deduction to the other partners.
When the 2015 proposed regulations are finalized, Revenue Ruling 81-300 will become obsolete, along with two further rulings relying on old Example (2). In Revenue Ruling 69-180, the Service applied the methodology of old Example (2) to a situation in which the partnership earned both ordinary income and capital gain. The approach in new Example (2) obviates the complexity that can arise, under Revenue Ruling 69-180, in determining the composition of the guaranteed partner’s distributive share. In Revenue Ruling 66-95, the Service also applied the approach of old Example (2) to a guaranteed minimum with respect to contributed capital. The decision to make Revenue Ruling 66-95 obsolete suggests that the rationale of new Example (2) also extends to GPUCs even though the 2015 proposed regulations focus almost exclusively on payments for services. Given that the treatment of GPUCs is “quite complex and the law is quite unclear,” commentators have urged the Treasury Department to reconsider whether new Example (2) should apply to GPUCs.
C. Gross Income Allocations, Preferred Returns, and Target Arrangements
As the 2015 proposed regulations confirm, the Treasury Department and the Service now agree with Congress that Pratt-type payments contingent on partnership gross income are classified, if they lack SER, as nonpartner payments under section 707(a), not as section 707(c) payments. Contrary to the Service’s pre-1984 position and Revenue Ruling 81-300, section 707(c) no longer applies to payments that are contingent on gross income allocations. Service-related gross income allocations that lack SER will generally be treated as section 707(a) payments. Gross income allocations presumptively lack SER, but the legislative history indicates that this presumption may be overcome “in very limited instances.” Distributive share treatment is not appropriate for service-related gross income allocations unless the taxpayer can establish SER by “clear and convincing evidence.” Capped allocations of partnership income are also suspect if the cap is “reasonably expected” to apply in most years. The Service’s ability to challenge such allocations is limited, however, to recharacterization under section 707(a)(2)(A) and does not extend to section 707(c).
If a fixed payment coupled with a matching allocation of gross income suffices to avoid both section 707(a) and section 707(c), partners may elect to treat GPUCs (but not service-related compensation) as section 704(b) distributive shares, without altering the partners’ economic arrangement. Assume, for example, that partner A is entitled to receive compensation for services equal to the lesser of $5 or 100% of the partnership’s gross income. If the partnership’s income can reasonably be expected to exceed $5 during all years, A’s compensation will be capped at the lower amount. Technically, A’s arrangement can be distinguished from the minimum payment in Example (2) of the section 707(c) regulations since A is entitled to a percentage of partnership profits (100%) subject to a cap ($5) rather than a guaranteed floor. It is difficult, however, to see why that distinction should make a difference. While A’s compensation might appear to be “fixed,” most practitioners believe that the matching gross income allocation renders section 707(c) inapplicable. Because A is receiving compensation for services, A’s specified minimum will almost certainly be treated as a disguised payment under section 707(a)(2)(A) rather than a section 704(b) distributive share. The scope of section 707(a) is restricted, however, to disguised payments for services and certain property transfers.
If a partner instead receives a matching allocation of gross income as a preferred return on the partner’s capital, section 707(a) does not apply since the payment pertains to partner equity. Because the payment is accompanied by a matching allocation of gross income, section 707(c) is apparently also inapplicable. By structuring the return to fall outside both section 707(a) and section 707(c), the partners can elect more favorable treatment under section 704(b) without significantly altering the economic consequences. Based on section 707(a)(2)(A) principles, it might appear that the allocation and distribution could be collapsed, thereby converting the preferred return into a deemed section 707(c) payment. There is arguably no statutory authority, however, that permits recharacterizing such an arrangement as a section 707(c) payment “merely because there is virtual certainty of payment and the distributee bears little or no significant entrepreneurial risk.” Anticipating the Service’s position under the 2015 proposed regulations, one commentator noted that, while section 707(a)(2)(A) converts most gross income allocations for services into section 707(a) payments, “most (if not all) payments for the use of capital . . . should continue to qualify as distributive shares of firm (gross) income.” In light of the SER standard, the issue is whether the ability of partnerships to elect into section 704(b) distributive share treatment continues to be justified, particularly given the Treasury Department’s elimination of the wait-and-see approach under Example (2) of the 1956 regulations.
The Treasury Department invited comments concerning the tax consequences when a partner is entitled to a cumulative preferred return on its capital investment and the partnership uses target capital accounts to determine the partners’ economic entitlements. Partnership agreements often use target allocations to match a partner’s entitlement on liquidation with the outcome that would occur if the partnership liquidated in accordance with positive capital accounts, as required under the section 704(b) safe harbor. Under a target capital account agreement, a partner may be entitled to receive a preferred return based on a percentage of the partner’s capital account, coupled with a residual share of partnership income in excess of the preferred return. If a partner is entitled to a priority allocation of the first dollars of the partnership’s net income but the partnership has insufficient profits in a particular year, these arrangements may give rise to an inchoate guaranteed payment under section 707(c).
Assume, for example, that A and B each contribute $100 to the accrual-method AB partnership. Under AB’s target capital account agreement, A is entitled to a 10% preferred return (cumulative if unpaid) on A’s capital of $100; any remaining income is shared 50/50. Over the life of the partnership, distributions are made in three tiers: first to A in the amount required to return A’s capital plus a 10% preferred return on that capital, then to B in the amount required to return B’s capital, and then equally to A and B to reflect their residual share of profits. If the partnership earns at least $10 of net income each year, the target allocations produce the same economic result as if A were entitled to a section 707(c) guaranteed payment of $10 annually. However, if A’s preferred return is contingent on the partnership’s net income, the entire amount will likely be treated as a section 704(b) distributive share rather than a GPUC.
If AB earns net income of $10 in Year 1, A’s target capital account will be $110 and B’s will be $100 at year end. If the $10 is treated as a distributive share, A’s capital account and outside basis will increase by $10, and A can receive a tax-free section 731 distribution of $10, reducing A’s capital account and outside basis correspondingly. By contrast, if the $10 is treated as a GPUC taxable to A when accrued, it affects the partners’ capital accounts only to the extent of their shares of the partnership’s corresponding deduction. Even though A is not entitled to any fixed payment for A’s capital, the allocation and distribution provisions accomplish the same result, provided the partnership has at least $10 of income to allocate to A. If the $10 is treated as a distributive share, B excludes the income allocated to A. If the amount is instead treated as a GPUC, B should generally be allocated the corresponding income, coupled with an offsetting deduction. Depending on the characterization of the payment to A, B thus receives a deduction or a deduction equivalent.
If the partnership earns insufficient net income to pay A’s preference, A may nevertheless be required to include the accreting return of $10 annually if it is classified as a section 707(c) guaranteed payment. The 2015 proposed regulations frame the issue as whether a partnership that uses target capital accounts “must allocate income or a guaranteed payment” to a partner who is entitled to a net income preferred return and receives an increased right to a distribution when the partnership has “no, or insufficient, net income” for a particular year. The Treasury Department evidently believes that the existing capital account rules under section 704(b) adequately address this situation “by requiring partner capital accounts to reflect the partner’s distribution rights as if the partnership liquidated at the end of the taxable year.” The preamble’s reference to “distribution rights” upon a deemed liquidation implies that A must report income in the year of any shortfall in profits. To the extent the partnership has sufficient gross income to make up the shortfall, A’s income would be treated as a section 704(b) distributive share and otherwise as a GPUC. Notwithstanding the Treasury Department’s position, sophisticated practitioners generally consider that A has “no income at all” in this situation. Under the wait-and-see approach, no GPUC will arise in the year of the shortfall because A’s future share of profits may eliminate the earlier shortfall. Also, no GPUC will arise in the year of payment as long as A’s profit share is sufficient to cover the payment.
For example, assume the accrual-method AB partnership above makes no distributions in Year 1 and has only $8 of net income in Year 2, consisting of gross income of $12 and deductions of $4. At the end of Year 2, A’s target capital account is increased to $118 ($110 capital account at the end of Year 1 increased by $8 allocation of net income in Year 2), and B’s target capital account ($100) is unchanged. Because A should be entitled to a liquidating distribution of $120 ($100 capital contribution increased by $20 preference in Years 1–2), the target allocation leaves a shortfall of $2. The Treasury Department’s approach would apparently require the partnership to allocate income or “items thereof” to A to the extent necessary to satisfy A’s preference and eliminate the economic mismatch. Allocating gross income of $10 to A would cause B to report a net loss of $2 (the partnership’s remaining gross income of $2 less deductions of $4). A’s ending capital account balance would be $120 ($110 capital account at the end of Year 1 increased by $10 allocation of gross income for Year 2) and B’s would be $98 ($100 capital account at the end of Year 1 reduced by $2 net loss for Year 2). This approach achieves the right economic result: if the partnership were liquidated at the end of Year 2, the cash of $218 would be distributed $120 to A and $98 to B.
Under the 1956 regulations, Example (2)’s “wait-and-see” approach furnished support for the position that a preferred partner such as A should be permitted to “earn its way out of” guaranteed payment treatment. If the partnership expected to have ample profits over its life and the preferred return were payable on a deferred basis, the transaction would be held open. There would be no GPUC, either annually as the preferred return accreted or in the year of actual payment, provided the partnership had sufficient income in the later year. By contrast, under the Treasury Department’s approach, both the existence and the timing of any gross income allocation or imputed guaranteed payment would seem to depend on the partnership’s method of accounting, including the “economic performance” rules in the case of an accrual-method partnership. Proponents of the wait-and-see approach argue that the “fundamental flaw” in the Treasury Department’s position is “the assumption that the partners know that the preferred return will be paid, and a partnership will always have sufficient assets to pay the preferred return.”
The counterargument is that the annual net income cap on A’s preference constitutes merely a timing contingency that does not affect whether A’s preference will ultimately be paid. Under this view, the full amount of the accreting preferred return (not just any shortfall) should be treated as a GPUC; indeed, A may be treated as not entitled to a share of partnership profits in the first place. As a result, A should be required to include the preferred return of $10 annually as a guaranteed payment, even if the partnership has no net (or gross) profits and makes no distributions. Consistent with new Example (2), only A’s profit share (if any) in excess of the GPUC would be treated as a distributive share. If the partners truly intend that A’s preference will be satisfied under all circumstances, any shortfall in income will be satisfied from B’s capital. Because B’s capital will be repaid only after return of A’s capital and accreting preference, the partnership’s distribution priorities are structured to ensure that A’s interest-equivalent return will be paid “no matter how unsuccessful the partnership effort may be.” Somewhat surprisingly, the Treasury Department seems to have implicitly assumed that such a preferred return subject to a net income cap necessarily falls outside section 707(c). If the “goal . . . is to capture preferred returns that resemble interest,” the Treasury Department may need to reconsider the impact of revised Example (2), particularly in light of incentives to elect out of GPUC status under current law.
V. Section 707 Payments After the 2017 Act
In 2017, Congress enacted section 199A which generally allows noncorporate taxpayers to deduct up to 20% of qualified business income (QBI). Section 199A was intended to preserve parity between corporations taxed at 21% after the 2017 Act and passthrough businesses taxed at higher individual income tax rates. To be eligible for the section 199A deduction, income must be derived from a qualified trade or business, which generally excludes a specified service trade or business. For individuals with taxable income above specified threshold amounts, additional limitations also may reduce the maximum QBI deduction. When the maximum deduction is fully available, passthrough income of high earners is taxed at 29.6% (80% × 37%).
Consistent with the notion that the passthrough deduction was intended to benefit only capital (and not labor) income, section 199A(c)(4)(A) excludes from QBI any reasonable compensation paid to a passthrough owner for services. Importantly, the regulations restrict the reasonable compensation standard to owner-shareholders of S corporations. Expanding the concept beyond S corporations would violate the long-standing principle, set forth in Revenue Ruling 69-184, that a partner cannot be an employee of a partnership. Section 199A(c)(4)(B) also excludes from the definition of QBI all section 707(c) guaranteed payments for services, while section 199A(c)(4)(C) authorizes the Treasury Department to exclude section 707(a) payments for services. The final regulations exclude section 707(a) and section 707(c) payments alike from QBI; the exclusion extends to GPUCs but only if they are classified as guaranteed payments.
A. Section 707 Payments for Services
The preamble to the proposed regulations explains that “[w]ithin the context of section 199A,” section 707(a) payments for services “are similar to, and therefore should be treated similarly as, guaranteed payments, reasonable compensation, and wages—none of which are includible in QBI.” The proposed regulations also requested comments on whether, in certain circumstances, it would be appropriate to permit certain section 707(a) payments to be included in QBI. Commentators argued that not all section 707(a) payments resemble wages and that section 707(a) payments should be included in QBI if they are received in connection with a partner’s own qualified trade or business separate from the partnership. The final regulations generally do not adopt these comments. Given the difficulty of distinguishing between section 707(a) and section 707(c) payments for services, “creating such a distinction would be difficult for both taxpayers and the IRS to administer.” Under the final regulations, some payments classified as section 707(a) payments may not be treated as QBI even though similar payments for services rendered by a third party might have constituted QBI. Thus, services rendered in a nonpartner capacity by a partner may receive less favorable QBI treatment than the same services performed by a third party.
The final regulations categorically exclude from QBI payments for services, whether classified as section 707(a) or section 707(c) payments, in the hands of the recipient. The seeming simplicity of this approach belies the uncertainty concerning the classification of section 707 payments generally. Under the 2017 Act, service partners have an enhanced incentive to classify payments as falling entirely outside section 707, thereby increasing their section 704(b) distributive shares of QBI (and section 199A deductions). Given the porousness of the different categories and the enhanced classification stakes, the purported guardrails under section 199A to prevent labor income from masquerading as capital income are likely to prove hopelessly inadequate. Unlike S corporations, which are subject to a reasonable compensation constraint, partnerships are not required to compensate their partners separately for services rendered to the partnership. Thus, section 707 represents the only opportunity for the Service to prevent partners from disguising payments for services as capital income.
Guaranteed payments for services are disfavored from the perspective of both the recipient partner (since they are not QBI) and the payor partnership (since they reduce entity-level QBI). Guaranteed payments to a partner for services reduce the partnership’s QBI but, unlike reasonable compensation paid to S corporation owner-employees, such payments are not W-2 wages. Assume, for example, that A and B are equal partners in the AB partnership, which has $1,000 of net income (comprised entirely of qualified items under section 199A) before taking into account a $400 deduction for a section 707(c) payment for A’s services. A and B share all partnership items equally, except for the partnership’s payment of $400 to A. Under a pure aggregate approach, the partnership would have total QBI of $1,000; A would have QBI of $700 ($400 salary plus $300 distributive share) and B would have QBI of $300. Assuming the 20% of QBI limit is binding, A’s section 199A deduction would be $140 (20% × $700) and B’s would be $60 (20% × $300), or a total of $200 (20% × $1,000 QBI). By comparison, under the entity approach of section 199A, no portion of A’s salary of $400 is treated as QBI; nevertheless, the partnership’s deduction for A’s compensation reduces overall QBI from $1,000 to $600 (allocated $300 to A and $300 to B); each partner would have a section 199A deduction of $60 (20% × $300). The total section 199A deduction is reduced from $200 to $120, a reduction of $80 (20% × $400 section 707(c) payment). For purposes of section 199A, the result would be identical if A were instead treated as receiving a section 707(a) payment for services, rather than a section 707(c) payment.
If partners can structure compensatory payments for services to fall outside section 707, aggregate-versus-entity treatment may be largely elective under section 199A. By substituting priority cash flow distributions coupled with priority income allocations, a partnership can generally replicate the economic effect of a guaranteed payment. Nevertheless, such payments should generally escape treatment as section 707(c) guaranteed payments. While section 707(a) could recharacterize the priority income allocation/cash distribution as a disguised payment for services, a sufficiently risky arrangement should also fall entirely outside section 707. Even if such an arrangement fails to accomplish an identical economic result, the tax advantage of the section 199A deduction is likely to outweigh any detriment.
The 2017 Act enhances the incentive for limited partners and LLC members to structure compensation for services as a section 704(b) distributive share rather than a section 707(c) guaranteed payment, thereby minimizing self-employment taxes and maximizing the section 199A deduction. Under section 1402(a)(13), state-law limited partners are exempt from self-employment taxes on their distributive share, but the exclusion does not apply to section 707(c) guaranteed payments for services. The limited-partner exception under section 1402(a)(13), originally intended to prevent passive investors from qualifying for Social Security benefits, has given rise to a widening gap in self-employment taxes driven by the rise of LLCs. Exploiting uncertainty concerning the definition of a limited partner, members of LLCs and other limited liability entities have aggressively used the exception to avoid self-employment taxes. In the case of general partners, distributive share treatment reduces income taxes under section 199A even if self-employment taxes are unchanged. Distributive share treatment also reduces employment taxes and the section 1411 tax on net investment income to the extent that a general partner can bifurcate a profits interest into a general and a limited interest.
B. Section 707 Payments for Capital
Section 199A does not explicitly exclude guaranteed payments for capital from QBI. Nevertheless, such payments may often be economically indistinguishable from interest income which is specifically excluded from QBI. The proposed regulations under section 199A provided that GPUCs “are not considered attributable to a trade or business” (and hence do not constitute QBI) because they are necessarily “determined without regard to the income of the partnership.” Although the statute is silent concerning GPUCs, only income from a qualified trade or business is eligible for the section 199A deduction. Excluding GPUCs from the definition of qualified trade-or-business income allowed the Treasury Department to sidestep whether GPUCs in fact constitute interest (or an interest equivalent).
Given the lack of clarity in the 2017 Act, GPUCs clearly represented a “hard case” under section 199A. Commentators argued that section 199A(c)(4)(B)’s specific reference to guaranteed payments for services gave rise to a negative inference that GPUCs should be included in QBI. In enacting section 199A, Congress understandably focused primarily on excluding section 707(c) payments for services without addressing interest-like GPUCs also described in section 707(c). While GPUCs are treated as third-party payments for purposes of inclusion and deduction (or capitalization), they are regarded as distributive shares for all other purposes. Given their hybrid debt-equity nature, commentators argued that GPUCs should constitute QBI to the recipient, at least if the recipient is also entitled to a distributive share of partnership net income. The Treasury Department mostly rejected these comments, while allowing QBI treatment for GPUCs that are properly allocable to the recipient’s separate qualified trade or business.
Even though GPUCs generally do not constitute QBI in the recipient’s hands, they reduce the partnership’s QBI if they are properly allocable to the partnership’s trade or business and otherwise deductible. Thus, the section 199A deduction at the partner level is automatically reduced by 20% of the amount treated as a GPUC, increasing the tax burden on this income from 29.8% to 37% for high-bracket partners. Preferred returns that resemble interest will reduce QBI only if they are classified as GPUCs, however. If partners can easily elect out of GPUC status by restructuring preferred returns as section 704(b) distributive shares, unfavorable QBI treatment is essentially meaningless. While arguably a feature of the existing rules, such electivity is inconsistent with the notion that classification of section 707(c) payments should be based on substance. Particularly if non-GPUC status confers a distinct tax advantage, it seems unlikely that Congress intended to allow partners to elect the most favorable tax consequences without significantly altering their economic arrangement.
C. GPUCs as Interest-Equivalents
The 2017 Act imposes a new limitation on business interest expense (BIE) applicable to passthrough entities. Under section 163(j), a taxpayer may generally deduct business interest only up to the sum of the taxpayer’s business interest income (BII) plus 30% of the taxpayer’s adjusted taxable income (ATI) for the year. ATI is defined as the amount of a taxpayer’s taxable income without taking into account items such as BIE and BII and the section 199A deduction. Any disallowed BIE may be carried forward and deducted in future years (subject to the section 163(j) limitation). For partnerships and S corporations, the interest limitation applies to the entity, with the consequences of that determination passing through to the entity’s owners.
In implementing section 163(j), the proposed regulations adopted a broad definition of interest that included items not treated as interest under other Code provisions. Thus, some items that were previously deductible as trade-or-business expenses under section 162 without limitation would be tested under section 163(j). Specifically, the proposed regulations included GPUCs within the definition of interest. This treatment, if confirmed in final regulations, would have effectively eliminated, for purposes of section 163(j), the distinction between section 707(a) payments for partner loans and section 707(c) payments for contributed equity: both types of payments would have been treated as interest. GPUCs would be required to run the gauntlet of section 163(j), notwithstanding the express language of the section 707(c) regulations treating such payments as deductible under section 162, not section 163. Commentators argued that treating GPUCs as interest was inconsistent with existing authority and the congressional policy underlying section 707(c).
Under the proposed regulations, a preferred return on a partner’s capital would be subject to section 163(j) only if it were treated as a section 707(c) guaranteed payment; otherwise, the preferred return would be treated as a section 704(b) distributive share and would not be subject to the interest limitation. If GPUC treatment applied, the net result would be to convert an otherwise deductible section 707(c) payment into a potentially nondeductible interest expense. Assume, for example, that the AB partnership has $110 of income and pays $10 to partner A as a section 707(a) payment or a section 707(c) payment. Except for the guaranteed payment, A and B share profits and losses equally. As long as the amount is deductible, A has a $10 payment and the partnership has $100 of income divided between A and B. If the GPUC is treated as nondeductible interest by virtue of section 163(j), the partners must report total income of $110 (rather than $100), allocable $55 each to A and B. A is effectively taxed twice on a portion of the $10 payment, once under section 707(c) as a guaranteed payment and again on A’s distributive share of income under section 705. By contrast, if the preferred return escapes GPUC treatment, section 163(j) does not apply and the special allocation to A is equivalent to a deduction for B.
The preamble to the final regulations notes that GPUCs “have both equity and debt characteristics” because the partner “who provided capital is an owner of the business, but also receives payments that are similar to interest.” Rather than automatically treat GPUCs as interest, the final regulations provide an anti-abuse rule that may characterize a GPUC as interest expense (and interest income) for purposes of section 163(j). Example (5) of the regulations illustrates the anti-abuse rule. In the example, partner A agrees to make an additional capital contribution, in exchange for a GPUC, to the ABC partnership, which already has significant debt and interest expense. The example concludes that the payment is economically equivalent to interest that the partnership would otherwise be obliged to pay to obtain additional third-party borrowing. Because a “principal purpose” for the GPUC was to reduce the interest expense that the partnership would otherwise incur, the guaranteed payment to A is treated as interest expense for purposes of section 163(j). The anti-abuse rule is intended to prevent a partnership that would otherwise be unable to deduct business interest by virtue of section 163(j) from restructuring debt as equity capital for which the contributor receives an interest-like return in the form of a GPUC. The anti-abuse approach may also discourage partners from taking advantage of section 163(j) by using GPUCs to create BII that would shelter partner-level BIE dollar-for-dollar.
The character of GPUCs as interest to both the payor and payee has long been unsettled. Indeed, one commentator has suggested that “the classification of GPUCs is at best confused, and at worst, seemingly schizophrenic.” Although it is not entirely clear why Congress included GPUCs in section 707(c), the intent was apparently to allow such payments to be deducted under section 162, similarly to payments for services. The reference in the 1954 legislative history to “guaranteed interest payments on capital” may support the Service’s historical position that GPUCs should be treated as interest by the recipient partner under section 61(a)(4). Although the Service has described GPUCs as interest payments on “fictional indebtedness,” such payments lack the normal indicia of debt. In treating GPUCs as interest income to the recipient, the Service was apparently not troubled by the fact that the section 707(c) regulations explicitly provide a section 162 deduction for such amounts. More recent rulings have treated GPUCs as a distributive share of partnership income in some situations, but in other contexts the Service has treated GPUCs as interest to both the payor and the payee. In the recent regulations concerning allocation and apportionment of foreign tax credits, the Treasury Department indicated that a GPUC need not be “indebtedness” to be treated as an interest equivalent.
Clearly, the notion that GPUCs are a return on partner equity should not preclude interest-like treatment for guaranteed payments that share many characteristics of interest payments that a partnership would normally make to a lender. The Service’s approach would appear to determine whether GPUCs are equivalent to interest based on a case-by-case analysis of specific provisions. In theory, it would be desirable to determine when the characteristics of a fixed preferred return are sufficiently debt-like to warrant treating such returns as interest rather than a distributive share, regardless of whether they constitute GPUCs under current law. As experience with sections 199A and 163(j) illustrates, however, the electivity of the existing rules allows taxpayers to draft around unfavorable treatment for GPUCs without significantly altering the partners’ economic arrangement. Regardless of whether GPUCs should be classified as a “new category of interest expense,” classification should not be elective as under current law.
VI. Conclusion
Section 707(a)(2)(A) imposes a risk-based standard for determining whether a purported allocation and related distribution should be treated as disguised compensation for services. Guaranteed payments for partner-capacity services, governed by section 707(c), are generally devoid of entrepreneurial risk. Following enactment of section 707(a)(2)(A), commentators suggested that section 707(c) should be repealed since the provision no longer served any useful purpose. The 2015 proposed regulations revise Example (2) under the 1956 regulations, eliminating the existing wait-and-see approach to classification. Unfortunately, the proposed regulations classify guaranteed minimum payments under section 707(c) rather than section 707(a), thereby perpetuating long-standing confusion over the scope of the two provisions. A preferable approach would treat all nonrisky payments for services as subject to section 707(a), regardless of the capacity in which they are rendered.
If nonrisky payments for services are no longer governed by section 707(c), that provision would apply only to GPUCs, a category that Congress failed to adequately conceptualize in 1954. In the absence of section 707(c), the current category of GPUCs could be treated either as section 707(a) payments or as section 704(b) distributive shares. Since GPUCs are subject to significantly less entrepreneurial risk than a distributive share of partnership income, there is a strong argument for treating such payments as section 707(a) payments even if they lack the normal indicia of debt. If Congress were writing on a clean slate, section 704(b) might seem adequate to prevent the potential abuses that section 707(c) invites. While section 704(b) is clearly sufficiently flexible to deal with the computational complexity that prompted enactment of section 707(c), differential treatment of GPUCs and partner loans would invite further gaming opportunities. In light of section 707(a)(2)(A), allowing taxpayers to elect to treat most guaranteed payments for capital as distributive shares is no longer a viable approach.
Repealing the intermediate category of section 707(c) payments would restore the ALI’s 1954 version of section 707 and finally render the “capacity” issue moot. The entrepreneurial risk standard would provide a basis for consistent tax treatment of payments for services and capital, as recommended by the ALI’s 1999 proposals. It may seem surprising that section 707(c) has survived virtually unchanged since 1954, despite repeated calls for its repeal. One possible explanation is that differential tax treatment may have seemed relatively unimportant, at least prior to 2017. The 2017 Act, however, has raised the tax stakes while creating perverse incentives for taxpayers to choose the most favorable tax treatment under the current classification scheme. Section 707(c) is no longer an innocuous anomaly but a source of continuing confusion and uncertainty. It serves no useful purpose, and its repeal is long overdue.