Accounting for the value of a partner's services.

Facts

On January 1, Colin gave his son, Boris, a 50% interest in Colin's sole proprietorship hardware business. Colin and Boris then contributed their interests in the business to Shelley Hardware, a general partnership. Boris and Colin were credited with equal capital accounts. Under the partnership agreement, income, losses and other items are allocable 50% to each partner. Colin worked full-time in Shelley Hardware's business during the partnership's first year, but was not compensated for his services, other than through his share of partnership income. Boris was not actively involved in the business. During the year, Shelley Hardware had net income of $70,000, which was allocated $35,000 to each partner.

Issue

Will Shelley Hardware's allocation of partnership net income be respected for tax purposes?

Analysis

Because Boris is the owner of a capital interest in a partnership in which capital is a material income-producing factor, he is a partner in Shelley Hardware. As such, he normally would be taxed on his distributive share of the partnership's income, as determined in accordance with the partnership agreement. This result, however, is subject to two exceptions. One exception prohibits allocations to a donee disproportionately high in relation to the donee's capital interest. The other provides that income allocated to a donee is not includible in his gross income to the extent it is determined without an allowance for reasonable compensation for services rendered to the partnership by the donor. Income allocated to the donee is taxed to the donor, to the extent necessary to reflect reasonable compensation for the donor's services.

When partnership agreement allocations do not comply with this reasonable compensation requirement, the distributive shares of the donor and the donee must be adjusted by making reasonable allowances for each's respective services. The balance of the partnership's income is allocated to the donor and the donee in proportion to their capital. Apparently, the rules contemplate reallocations of income only. There appears to be no requirement that deductions or other loss items be reallocated to the donee.

Shelley Hardware made no allowance for Colin's services. Consequently, the allocations of income between Colin and Boris will not be fully respected for income tax purposes. If Colin's services were found to have a reasonable value of $20,000, Shelley Hardware's $70,000 of income would be reallocated, with Colin receiving a total allocation of income of $45,000, and Boris $25,000.

Because this tax reallocation would not legally affect the allocations under the partnership agreement, this reallocation also could have gift and income tax consequences in future years.

In situations such as these, the tax adviser should ensure that the donor partner is reasonable compensated for his services. The practitioner can assist the partners by providing for a guaranteed payment to reflect the value of the donor's services. If the partners explicitly provide for such an allocation and can in good faith argue that the allocation is reasonable (even if it may be at the low end of the range of compensation that might be expected for such services), the likelihood of avoiding or overcoming an IRS challenge is significantly enhanced.

Conclusion

If a donor of a partnership interest performs services for the partnership, and the donee's distributive share of partnership income does not reflect a reasonable allowance for the donor's services (taking into account any services performed by the donee), income must be reallocated for tax purposes. Consequently, income allocated to Boris under the partnership agreement would be taxed to Colin to the extent necessary to reflect reasonable compensation for Colin's services.