Revenue Service (IRS) issued proposed regulations on July 22 that address when
a disbursement from a partnership is a disguised payment for services that must be taxed as ordinary income instead of
as a capital gain. Under the proposed regulations, if a payment to a partner is
treated as a disguised payment for services, it is taxed as ordinary income up
to the maximum rate of 39.6 percent. Otherwise, a partnership distribution may
be taxed at lower capital gains tax rates of up to 20 percent.
This proposal seems to be in response to transactions in the private equity arena where management fees - taxed today at ordinary income rates - are re-characterized as partnership interests that are taxed at lower capital gains rates. The main question in such so-called “fee waiver” situations is whether the re-characterized income is placed at risk.
That is, if there is no entrepreneurial risk (i.e. a guarantee that money won’t be lost) or if the re-characterized management fee income is likely to be provided to the partner, the income is treated as a disguised payment for services and taxed at ordinary rates. If, on the other hand, the income is put at risk, it may be treated as investment income and taxed as a capital gain.
The proposal establishes a six-part facts and circumstances based test to determine whether an arrangement should be treated as a disguised payment for services. Importantly, the only factor that must be present for a payment not to be treated as a disguised sale is entrepreneurial risk.
NMHC/NAA are evaluating this IRS proposal to determine its impact on the industry.
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