Bulletins

Transactions Between Partners and Partnerships

To our clients and friends,

Based on conversations with veteran practitioners, the tax treatment of transactions between partners and partnerships is an ongoing source of confusion. No wonder! The rules are sometimes complicated and counterintuitive. In this Part 1 of our primer on partner/partnership transactions, we will try to dispel some of the confusion.

When Partner Pays Expenses Related to Partnership's Business

It is not unusual for an individual partner to incur unreimbursed expenses related to the partnership's business. This is especially likely to occur in service partnerships such as accounting and law firms. For example, partners in service partnerships may incur unreimbursed entertainment expenses in developing new client relationships. They may also incur auto expenses to get to and from client meetings, expenses for professional publications and continuing education, and home office expenses. As long as the expenses are of the type the partner is expected to pay without reimbursement under the partnership agreement or firm policy (written or unwritten), the partner can deduct the expenses on Schedule E. Conversely, a partner cannot deduct expenses if the partnership would have honored a request for reimbursement.

According to the instructions for Schedule E (2010 version), unreimbursed partnership expenses paid by an individual partner should be reported in Part II of the partner's Schedule E on Line 28 in column (h). Use a separate line for unreimbursed partnership expenses and enter "UPE" in column (a) of that line.

Note: An individual partner's unreimbursed partnership business expenses should also generally be included as deductions in arriving at the partner's net self-employment income on Schedule SE.

Example: Partner pays expenses related to partnership business.

Belinda is a partner in a local law firm. Under the firm's partnership agreement, partners are expected to bear the costs of soliciting potential new clients except in relatively unusual cases where attracting a large potential new client is deemed to be a firm-wide goal. In attempting to attract new clients during the current year, Belinda spends $3,500 of her own money on meal and entertainment expenses. She receives no reimbursements from the firm. On Line 28 of her 2011 Schedule E, Belinda should report a deductible expense item of $1,750 (50% of $3,500) in the manner explained earlier. She should also include the $1,750 as a deduction in calculating her net self-employment income on Schedule SE.

Use of Office in Partner's Home

Subject to the normal deduction limitations under the home office rules, it appears that a partner can deduct expenses allocable to the regular and exclusive use of a home office for partnership business. A partner's home office expenses should be reported on Line 28 Schedule E in the same fashion as other unreimbursed partnership expenses. Apparently, the partner need not file Form 8829 (Expenses for Business Use of Your Home) because that form is only intended for Schedule C filers.

Warning: If the partnership pays the partner rent for the use of the home office, the partner apparently cannot deduct any home office expenses since the partner is apparently treated as an employee for purposes of the "rental-to-an-employer" rule under IRC Sec. 280A(c)(6). This conclusion is based on the Committee Reports to P.L. 99-514 (The Tax Reform Act of 1986), which specify that independent contractors are treated as employees for the purposes of this limitation.

Quick Summary of Rules for Home Office Deductions. Home office deductions can include depreciation of the office part of the home (or rent for the office part in the case of a rented home) plus the allocable portion of expenditures for mortgage interest, property taxes, homeowner association fees, utilities, insurance, maintenance, security, and so forth. However, assuming the only business use of the home office is for partnership business, a partner's home office expenses are only deductible when: (1) the office space is used regularly and exclusively for partnership business and (2) at least one of the following three tests is passed [IRC Sec. 280A(c)(1)].

1. The home office is used as the partner's principal place for conducting partnership business. This principal place of business test can be passed in two ways. First, "the partner can conduct most of his or her partnership income-earning activities in the home office. Second, the partner can pass the principal place of business test if he or she: (a) uses the home office to conduct partnership administrative and management tasks, and (b) does not make substantial use of any other fixed location (such as the partnership's official office) for such administrative and management tasks. [See IRC Sec. 280A(c)(1)]. In many cases, this second way to pass the principal place of business test will be easily accomplished.

2. The home office is used as a place where the partner meets or deals with clients or customers of the partnership in the normal course of business.

3. The home office is a separate structure (such as a converted garage or barn or other stand-alone building) and is used for any purpose in connection with partnership business.

Side Benefits of Deductible Home Office. When a partner has a deductible home office under the preceding rules, the Schedule E home office deduction will deliver multiple tax-saving benefits because it is effectively deducted for both federal income tax and self-employment tax purposes (and maybe for state income tax purposes too in applicable states). In addition, when the partner's deductible home office passes the principal place of business test, commuting mileage from the home office to partnership business temporary work locations (such as client sites) and partnership business permanent work locations (such as the partnership's official office) count as business mileage.

Guaranteed Payments to Partners

A guaranteed payment is a payment to a partner that is: (1) made to a partner acting in the capacity as a partner, (2) in exchange for services performed for the partnership or for the use of capital by the partnership, and (3) not dependent on partnership income. Guaranteed payments made in exchange for services to a partnership are often called partner salaries, which is a bit of misnomer since partners are not considered employees for federal income tax (FIT) withholding and federal employment tax purposes.

The partnership deducts or capitalizes the amount of a guaranteed payment based on the nature of the payment and the partnership's accounting methods. If the payment is deducted, it is generally reported on Line 10 of Page 1 of Form 1065. Guaranteed payments are reported to the recipient partner on Line 4 of that partner's Schedule K -1.

When the partner's tax year-end coincides with the partnership's tax year-end (the usual case because both typically have December 31 year-ends for tax purposes), the partner reports the guaranteed payment income in the same year the partnership claims a deduction or additional basis for the guaranteed payment. When the tax year-ends do not coincide, the partner reports the guaranteed payment as income in the tax year that includes the end of the partnership tax year in which the payment is deducted or capitalized by the partnership.

Note: Guaranteed payments to an individual partner from a partnership that is considered to be engaged in a trade or business are considered self-employment income 'and should be reported as such on the Line 14 of the partner's Schedule K-l (Code A), and included as self-employment income on the partner's Schedule SE.

Individual Partners Who Provide Services Are Treated as Self-employed Persons for Most Federal Tax Purposes

As a general rule, self-employed status rather than employee status applies to an individual who in the capacity as a bona fide partner provides services to a partnership. This general rule applies to payments received by partners for FIT withholding and federal employment tax purposes. In other words, a partner's allocable share of partnership business income is subject to self-employment (SE) tax, but there is no withholding for FIT or FICA tax. Similarly, guaranteed payments received in exchange for services provided by a partner are also subject to SE tax, but not to FIT or FICA tax withholding.

Fringe Benefits. The general rule (self-employed status rather than employee status) also applies for purposes of determining the federal tax treatment of most partnership-provided fringe benefits, including health insurance premiums and HSA contributions, up to $50,000 of group-term life insurance, and qualified transportation fringe benefits. The partnership deducts the costs as guaranteed payment expenses, and the guaranteed payments represent taxable income to the partners for whom the benefits are provided. Unless the amounts qualify as medical expenses or other specifically deductible items at the partner level, the partners cannot deduct them on their individual Forms 1040.

There are a few exceptions to the general rule. For example, partners are treated as employees for purposes of determining the tax treatment of certain partnership-provided fringe benefits, such as working-condition fringes, educational assistance, dependent care assistance plans, and de minimus fringe benefits. These fringe benefits are not treated as guaranteed payments. For these benefits, partners are treated the same as employees, meaning a deduction for the partnership and no taxable income for the partners for whom these benefits are provided (assuming the relevant qualification rules are met for each benefit).

Section 199 Deductions. Because a partnership's Section 199 domestic production activities deduction is limited to 50% of W-2 wages paid by the partnership, there has been some speculation that perhaps payments to partners for services could be characterized as W-2 wages for Section 199 deduction purposes. The IRS has defined W-2 wages for Section 199 purposes as wages subject to FIT withholding, certain employee elective deferral contributions to retirement plans, and employee designated Roth contributions. Allocable shares of partnership income paid to partners and guaranteed payments made to partners do not meet this definition. In addition, the longstanding precedent of Rev. Rul. 69-184 seems to add weight to the notion that payments to partners do not meet the definition of W-2 wages for Section 199 purposes. Therefore treating payments to partners as W-2 wages for Section 199 purposes does not appear to be a supportable position at this time.

Partner Acting as Third Party (Nonpartner)

When a partner is considered to be acting as a third party in a transaction with the partnership, the partner is treated like a non-partner. Therefore, the "standard" non-partnership tax rules apply to the transaction. An example would be when a partner sells property to a partnership (as opposed to contributing property to a partnership). In this scenario, the partner's accounting methods control the timing of the partner's recognition of any income or deductions from the transaction, and the partnership's accounting methods control the timing of its recognition of any income or deductions.

Partner Acting as Partner

When a partner is considered to be acting in the capacity of a partner in a transaction with the partnership, the "standard" partnership tax rules, found in Subchapter K of the Internal Revenue Code, determine the transaction's tax treatment. Under these rules, for example, partner contributions to the partnership are usually tax-free and so are partnership distributions to the partner.

Warning: In some cases, what initially appears to be a normal partner/partnership transaction can be re-characterized as transaction with a non-partner under the so-called disguised sale rules [IRC Sec. 707(a)(2) and related regulations]. An example would be when a partner makes what initially appears to be a property contribution to a partnership and then receives a cash distribution from the partnership within two years. Under the disguised sale rules, this chain of events can be re-characterized as a taxable sale or partial sale of the property to the partnership. We will summarize the disguised sale rules in Part II of our primer.

Related Party Rules

Special (and unfavorable) rules found in IRC Sec. 707(b) apply to the treatment of gains and losses from sales between partners and controlled partnerships. In addition, IRC Sec. 267 can partially disallow losses from sales between partners and partnerships.

Conclusion

There you have it: Part 1 of our primer on partner/partnership transactions. We will have more to say on this subject in future issues. Please stay tuned.