Proposed regulations were issued under Section 707(a)(2)(A) of the Internal Revenue Code of 1986, as amended (the “Code”), that address circumstances when certain arrangements between partnerships and their partners will be re-characterized as disguised payments for services (the “Proposed Regulations”).1The Proposed Regulations, issued on July 22, 2015, contain “conforming modifications” to the current regulations issued under Section 707(c) of the Code, relating to guaranteed payments. Importantly, as a result of the Proposed Regulations, certain preferred equity investments in entities treated as partnerships may result in “guaranteed payments,” which could have an adverse effect on the taxation of the income from such investment for certain investors. The Proposed Regulations technically do not take effect until published in final form, but the preamble to the Proposed Regulations (the “Preamble”) states that Treasury and the IRS view the Proposed Regulations as generally reflecting Congressional intent as to when arrangements are appropriately treated as disguised payments for services.

Guaranteed payments are payments made to a partner that are considered as made to one who is not a member of the partnership only for purposes of the gross income rules under Section 61 of the Code and for the deductibility of business expenses under Section 162(a) of the Code. The Code and the Treasury Regulation describe guaranteed payments as payments for services or for the use of capital to the extent the payments are determined without regard to the income of the partnership.

The treatment of a distributive share is clear (it provides for a share of the income, loss, gains and losses of the partnership). When a non-U.S. partner is allocated its share of a partnership’s capital gain (such as when a partnership has sold a portfolio company that is a corporation), the partner is generally not subject to U.S. income tax. The treatment of a guaranteed payment for the use of capital (i.e., to a financial partner) is less clear. A common concern is that a guaranteed payment made to a non-U.S. financial partner should be treated as interest, which would not qualify as “portfolio interest,” or other forms of U.S. source payments that would be subject to a 30% withholding tax. Accordingly, for a financial partner, the characterization of their share of income as a “distributive share” of income rather than a guaranteed payment is a critical determination, and certainty (or at least a perception of a reasonably low level of risk) that a partnership interest will not result in a guaranteed payment can be a very important deal point to a foreign investor providing capital to a partnership.

Proposed Regulation 1.707-2 is a proposal of a full regulation dealing with disguised payments for services, but the proposals for Treasury Regulation 1.707-1 (dealing generally with transactions between partners and partnerships) are not substantial in length. One of these changes is to example 2 of Treasury Regulation 1.707-1(c). In the example, a partner in a partnership is entitled to the greater of (a) 30 percent of partnership income or (b) US$10,000. The example, without these modifications, concludes that the partner has a guaranteed payment only to the extent that US$10,000 exceeds 30% of the partnership income. The modification to the example in the Proposed Regulations, however, concludes that the partner has a US$10,000 guaranteed payment in all events (regardless of the amount of the partnership’s income). An interesting question is whether the Proposed Regulations, and specifically this example 2, applies to a payment to a partner in a partnership that is not a service provider, such as the holder of a “preferred” interest that is entitled to a minimum payment with respect to its economic investment in the partnership.

The Preamble and the Proposed Regulations both generally refer only to the treatment of payments to partners for services, and refer to the proposed changes in Treasury Regulation 1.707-1 as “conforming.” While there is no explicit discussion in the Preamble of how or whether the Proposed Regulations apply to payments for the use of capital, Section 707(c) of the Code and Treasury Regulation 1.707-1(c) apply both to payments to a partner for services as well as payments for the use of capital. Examples 1, 3 and 4 of Treasury Regulation 1.707-1(c) (which are not changed by the Proposed Regulation) refer specifically to payments to partners for services; but example 2 does not explain the reason for the payment to the partner. (Interestingly, when example 2 was in proposed form in 1955, it was drafted to refer to a payment for services, and we have not found any explanation for the changes to this example).

Even without the Proposed Regulations, there has been some lack of certainty around the proper treatment of a partnership interest that provides a partner with a “greater of” return that is not measured in some way by the net income of the partnership. Under current law and regulations, many advisors have reasoned that a partnership interest could have certain features resembling example 2 and still have “distributive share” treatment, or at the very least that while a preferred return is accruing and is not paid, one could “wait and see” how the partnership performs before concluding whether or not there would be a “guaranteed payment.” The change to example 2 further clouds this issue, and may lead an investor to structure a preferred investment in a manner that does not include a specific minimum payment amount. Although it is not clear when the Proposed Regulations will become effective, or whether the IRS may assert the principles of the Proposed Regulation even before effectiveness, careful consideration should be given to the potential effects of the Proposed Regulations when designing a preferred equity investment in a partnership, especially for a non-U.S. investor.