Both the House’s and Senate’s budget bills would clarify that certain rules applicable to disguised payments for services and disguised sales of property between a partner and a partnership under Section 707(a)(2) are self-executing in the absence of regulations.  Specifically, Section 707(a)(2) is prefaced by the phrase “under regulations prescribed by the Secretary,” which some have argued indicates that the statute is not self-executing in the absence of directly applicable Treasury regulations.  The bills would revise this language to “except as provided by the Secretary,” thereby clarifying that Section 707(a)(2) is self-executing with respect to services performed by a partner and property transferred to a partnership after the date of enactment.  

No explanation was provided for the proposed legislation, which was added as a last-minute amendment to the House bill and was not discussed in the House committee reports.  Historically, the IRS and many practitioners have viewed Section 707(a)(2) as self-executing.  That said, the proposed legislation has been scored as revenue-generating by the Joint Committee on Taxation, i.e., the change is expected to result in more tax revenues than the status quo.  It is unclear whether the budget scoring resulted from the anticipated increased compliance with Section 707(a)(2) following the self-executing clarification or a perceived substantive expansion of Section 707(a)(2). 

While not discussed in the legislative history of the bills, the proposed legislation could be an attempt to target so-called disguised sales of partnership interests.  For example, a third party contributes cash to an existing partnership in exchange for a partnership interest, and immediately thereafter, the partnership distributes the cash to the legacy partners.  The IRS issued proposed regulations in 2004 addressing the disguised sales of partnership interests but withdrew them in 2009 after receiving criticism that they were overly broad.  In this regard, the proposed legislation mirrors earlier legislation introduced by Senator Ron Wyden (OR) in 2021, which specifically targeted disguised sales of partnership interests.  If Section 707(a)(2) is self-executing, the IRS could challenge disguised sales of partnership interests even in the absence of regulations.

Regarding disguised payments for service transactions, the IRS issued proposed regulations in 2015 but never finalized them.  The proposed regulations incorporate various factors from the legislative history of Section 707(a)(2) to determine whether a payment to a partner should be treated as a distribution, or alternatively, as a disguised payment for services.  One of the most significant factors indicative of a distribution rather than a disguised payment for services is that the payment is tied to the entrepreneurial risk of the partnership.  As noted in the preamble, the proposed regulations also specifically target certain arrangements whereby fund investment managers would waive their management fees (taxable as ordinary income) in exchange for an increased percentage of the fund’s profits (potentially taxable under preferential capital gains rates).  If Section 707(a)(2) is self-executing, the IRS could challenge these types of disguised payments for services transactions even in the absence of finalized regulations.