Partnerships are flow‑through entities, but certain transactions between a partnership and a partner are treated as if the partner were not a partner. These rules prevent partners from disguising sales, wages, or exchanges as partnership allocations.
When a partner is treated as a non‑partner
Under IRC §707, a partner is treated as not acting in the capacity of a partner when:
- Services or property are provided to the partnership and
- There is a related allocation or distribution, and
- The overall transaction resembles a deal between the partnership and an outsider
- Transfers of money or property occur with a related transfer back to the partner, and
- The combined transfers are properly characterized as a sale or exchange
These rules prevent disguised compensation and disguised sales.
Guaranteed Payments
Guaranteed payments are amounts paid to a partner without regard to partnership income.
Key rules
- Treated as if paid to a non‑partner for purposes of gross income and deductions
- Deductible by the partnership (unless capitalized)
- Taxable to the partner as ordinary income
- Included in the partner’s income in the year the partnership year ends
- Not subject to withholding
- May create or increase a partnership loss, but the partner still reports the full guaranteed payment
Health insurance
Partnership‑paid health insurance for a partner is treated as a guaranteed payment, deductible by the partnership and taxable to the partner.
Sales or Exchanges Between Partners and Partnerships
Under IRC §707(b) and §267, special rules apply to prevent loss shifting.
Loss disallowance
Losses are not allowed on sales or exchanges between:
- A partnership and a person owning >50% of capital or profits
- Two partnerships if the same person owns >50% of each
The partner’s basis is reduced by the disallowed loss.
Ordinary income treatment
Gain is ordinary income (not capital gain) if:
- The same person owns >50% of the partnership(s), and
- The property is not a capital asset in the transferee’s hands
- Accounts receivable
- Inventory
- Stock‑in‑trade
- Depreciable or real property used in business
Attribution rules
Ownership is attributed from:
- Corporations, partnerships, estates, trusts → to owners
- Individuals → to family (spouse, ancestors, lineal descendants, siblings)
Contribution of Property
Under IRC §721(a), no gain or loss is recognized when a partner contributes property to a partnership in exchange for a partnership interest.
Exception: Investment company
Under §721(b), nonrecognition does not apply if the partnership would be treated as an investment company under §351.
Inside basis
The partnership takes a carryover basis equal to:
- Contributing partner’s adjusted basis
- Plus any gain recognized
Liabilities
If the partnership assumes a partner’s liability:
- The partner’s basis is reduced by the share of liability assumed by other partners
- If liabilities assumed exceed basis, the partner recognizes gain
Disguised Sales
A contribution followed by a distribution may be treated as a sale, not a contribution, if:
- The distribution would not have occurred but for the contribution
- The partner’s right to the distribution does not depend on partnership performance
This is governed by IRC §707(a)(2)(B).
Pre‑Contribution Gain (7‑Year Rule)
Under IRC §704(c)(1)(B):
- If a partner contributes appreciated property
- And the partnership distributes that property to another partner within 7 years
- The contributing partner must recognize built‑in gain
Gain equals:
- FMV of property
- Minus adjusted basis of the partner’s interest
- Reduced by any money received
Built‑In Gain or Loss Allocations (704(c))
When contributed property has a basis different from FMV:
- The partnership must allocate income, gain, loss, and depreciation to reflect the built‑in difference
- Methods must be reasonable and applied consistently
- Total allocations cannot exceed the partnership’s actual depreciation or gain/loss
Contribution of Services
A partner may receive:
Capital interest
Taxable at FMV when:
- Transferable, or
- No longer subject to substantial risk of forfeiture
Profits interest
Generally not taxable, unless:
- It relates to predictable income streams
- Disposed of within 2 years
- It is an interest in a publicly traded partnership
Summary
Transactions between partnerships and partners are governed by strict rules to prevent disguised sales, disguised compensation, and improper loss shifting. Key principles:
- Guaranteed payments are ordinary income
- Losses between related parties are disallowed
- Certain gains become ordinary
- Contributions are generally tax‑free unless liabilities exceed basis or investment company rules apply
- Built‑in gain rules protect pre‑contribution appreciation
- Capital interests for services are taxable; profits interests usually are not
These rules come directly from IRC §707, §721, §704(c), §267, and IRS partnership guidance.