Partnerships have become the business entity of choice in a growing number of industries. The flexibility offered using this form, both under state law and federal tax law, can offer unique advantages. As use of partnerships grow, however, so do inventive ways to use the tax law in this relatively complex area. The IRS studies many of these aggressive tax techniques.  Recently, the IRS went on record as opposing one of them, involving guaranteed paybacks using appreciated property.

Under the IRS’s new position, a partnership's use of appreciated property to make a distribution to a partner in satisfaction of a legal obligation to make a guaranteed payment will be taxable to the partnership.

A “guaranteed payment” is a fixed amount for the use of capital or services, determined without regard to partnership income. The IRS ruled that the use of appreciated property to satisfy a partnership’s obligation to make a guaranteed payment to a partner qualifies as a sale or exchange under Code Sec. 1001, not as a nontaxable distribution under Code Sec. 731.

The IRS cited two non-partnership court cases concluding that a taxpayer who conveys appreciated property to satisfy an obligation must recognize gain or loss on the difference between the property's value and its basis.

While expectations are that someone will challenge the IRS’s position in court, most tax experts believe that the IRS has the better chance of winning. Stay tuned.

(Rev. Rul. 2007-40)