Structuring guaranteed payments to avoid disguised sale treatment.

Facts

Michael and Lisa Marie are forming the MLM Partnership, a general partnership, to operate a recording studio. Michael is contributing a building worth $100,000 and recording equipment worth $4,000. The partnership agreement has a written provision that Michael is to receive a guaranteed payment for three years for the use of his capital. The guaranteed payment is computed at 10% (compounded annually) of the fair market value (FMV) of the property transferred. No other transfers are anticipated that are not classified as operating cash flow distributions in this three-year period.

The applicable Federal rate (AFR) when the partnership agreement is to be signed is 6% for short-term obligations compounded annually. (It is not anticipated to increase anytime soon.

Michael has provided a draft copy of the partnership agreement to his tax adviser for review.

Issue

Considering the disguised sale rules, should the tax adviser suggest changes to the partnership agreement?

Analysis

In general, guaranteed payments for capital are not treated as part of a sale. A payment to a partner that the parties treat as a guaranteed payment is presumed to be a guaranteed payment unless the facts and circumstances establish otherwise. The payment must be reasonable and determined without regard to the partnership's income. It is basically a return on investment and should not be designed to liquidate a partner's interest in the partnership. These payments must be made pursuant to a written provision of a partnership agreement that provides for payment for the use of capital in a reasonable amount. In addition, the payments should be made for the use of capital after the date that this provision is added to the partnership agreement. A reasonable amount as calculated under Regs. Sec. 1.707-4(a)(3)(ii) is determined by multiplying the partner's unreturned capital at the beginning of the year--or at his option, the weighted average of his capital balance for the year--by the safe harbor interest rate for that year. The safe harbor interest rate is 150% of the highest AFR, at the appropriate compounding period in effect at any time beginning when the right to the guaranteed payment for capital is first established through the end of the tax year.

MLM does have the provision for making the payments to Michael for the use of his capital in writing. To estimate if the payments are reasonable, the tax adviser should multiply Michael's beginning-of-the-year unreturned capital ($104,000, the FMV of the property he contributed) by the safe harbor interest rate (1.5 X 0.06). (Since this is an estimation and no other distributions are anticipated, the weighted average capital balance for the year should be the same as the beginning-of-the-year balance.) Thus, the amount estimated to be reasonable is $9,360.

As the partnership agreement is currently drafted, Michael is entitled to a guaranteed payment of 10% (compounded annually) of the FMV of the transferred property in each of the three years following the transfer. In the initial year, the amount would be $10,400 ($104,000 X 10%).

Based on this estimate, the guaranteed payment Michael is entitled to receive under the partnership agreement is not a reasonable amount. Unless the facts and circumstances clearly establish that the transfer is a guaranteed payment for capital, the transfer may run afoul of the disguised sale rules under Regs. Sec. 1.707-3.

Given this situation, it might be appropriate to revise the payment structure. The rules apply to guaranteed payments made within two years of the date of the property's contribution. Guaranteed payments made outside of this two-year period are assumed not to be part of a disguised sale. Extending payments over a longer period, and thereby reducing the annual payment, would help ensure that the amounts would be reasonable in the first two years.

If the payments are recharacterized as a disguised sale, Michael will be treated as if he sold a portion of each of the properties he transferred to the partnership. Under Prop. Regs. Sec. 1.707-3(e), if a partner transferred more than one property to the partnership pursuant to a plan (as Michael is doing), the amount realized from the consideration received would be allocated between the properties transferred based on their relative FMVs. However, this rule has been deleted from the final regulations and no further guidance has been issued.

Conclusion

To avoid any disguised sale problems, Michael should change the partnership agreement to provide for a smaller guaranteed payment over more years.

Editor's note: This case study has been adapted from PPC Tax Planning Guide--Partnerships, 9th edition, by Grover A. Cleveland, William D. Klein, Terry W. Lovelace, Sara S. McMurrian, Linda A. Markwood and Richard D. Thorsen, published by Practitioners Publishing Company, Fort Worth, Tex., 1995.