Pratt v. Commissioner
64 T.C. 203, 1975 U.S. Tax Ct. LEXIS 150 (1975)
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Rule of Law:
Payments to a general partner for services or for the use of capital are only treated as transactions between the partnership and a non-partner under IRC Section 707(a) if the partner is acting in a capacity other than as a partner; for Section 707(c) 'guaranteed payments,' they must be determined without regard to the partnership's income, and if they qualify, cash-basis partners must include them in income in the taxable year the accrual-basis partnership accrues and deducts them.
Facts:
- On August 1, 1966, Edward T., William D., and Jack E. Pratt (the husband-petitioners) formed Parker Plaza Shopping Center, Ltd., a limited partnership, to purchase, develop, and operate a shopping center.
- On March 1, 1968, the husband-petitioners also formed Stephenville Shopping Center, Ltd., a limited partnership, to purchase, develop, and rent a shopping center.
- In both partnerships, the husband-petitioners were general partners and managed the businesses according to the partnership agreements, which stated they would receive a management fee of 5% of gross base lease rentals and 10% of overrides/percentage rentals for their managerial services, with no other compensation for personal services.
- The partnership agreements also stipulated that general partners would contribute their time and managerial abilities and expend their best efforts to the partnership business, and the management fees would be divided equally among them.
- Both Parker Plaza and Stephenville kept their books and filed tax returns on an accrual basis, while each of the petitioners kept their accounts and reported income on a cash basis.
- From 1967-1969, the partnerships accrued and deducted the management fees, which were reasonable and proper, but these fees were not paid to the petitioners, and petitioners did not report them as income.
- On January 6, 1967, petitioners loaned funds to Parker Plaza, and on December 13, 1968, to Stephenville, in return for promissory notes agreeing to repay principal plus 6% interest per annum, without regard to partnership receipts or income.
- From 1967-1969, both partnerships accrued and deducted this interest expense, but the interest was not paid to the petitioners, and petitioners did not report it as income.
- The petitioners could have legally caused the partnerships to pay the management fees and interest to them if they had chosen to do so, and all partners intended these amounts to be expenses to the partnerships.
Procedural Posture:
- Respondent (Commissioner of Internal Revenue) determined deficiencies in the Federal income taxes of Edward T. and Billie R. Pratt, William D. and Anita Pratt, and Jack E. and Crystal A. Pratt for the years 1967, 1968, and 1969.
- The IRS increased the income of each petitioner for the years 1968 and 1969 (and for Edward and William Pratt for 1967) by amounts equal to their portion of management fees and interest credited to their accounts by the partnerships.
- The IRS explained that the claimed management fees and interest were 'not allowed' as partnership deductions, being 'a division of partnership profits,' and that if they were 'guaranteed payments,' petitioners must include them as ordinary income.
- Petitioners filed petitions with the United States Tax Court challenging the determined deficiencies.
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Issue:
Does Internal Revenue Code Section 707 (a) or (c) allow an accrual-basis limited partnership to deduct management fees paid to its cash-basis general partners and interest paid on loans from those general partners, where the fees are based on gross rentals and the interest is fixed, and if so, must the cash-basis general partners include these amounts in their income in the year accrued by the partnership, even if not yet received?
Opinions:
Majority - Scott, Judge
No, the accrual-basis limited partnerships may not deduct the management fees under Section 707(a) or (c), because the general partners were acting in their capacity as partners, and the fees were not 'guaranteed payments' as they were determined with regard to partnership income. However, yes, the interest payments are 'guaranteed payments' under Section 707(c), and the cash-basis general partners must include these amounts in their income in the year the accrual-basis partnerships accrued and deducted them, consistent with Treasury Regulation § 1.707-1(c). The Court first addressed petitioners' argument that IRC Section 267 (disallowing deductions for accrued, unpaid expenses owed to related cash-basis taxpayers by corporations) was inapplicable to partnerships. The Court agreed that Section 267 applies only to corporations, but clarified that this does not automatically entitle petitioners to treat the management fees and interest as if they were not partners. The statutory scheme of Subchapter K of the 1954 Code treats a partnership as an aggregate of its partners, not a separate taxable entity, unless specific statutory provisions (like 707(a) or 707(c)) dictate otherwise. Regarding the management fees, the Court held they were not 'guaranteed payments' under Section 707(c). Section 707(c) requires payments to be 'determined without regard to the income' of the partnership. Since the management fees were based on a fixed percentage of the partnerships' gross rentals, which constitute partnership income, they were determined with regard to income. Therefore, they failed the key criterion for 'guaranteed payments.' Furthermore, the Court found that the management fees were not deductible under Section 707(a) as a transaction with the partnership by a partner acting 'other than in his capacity as a member of such partnership.' The Court emphasized that in managing the shopping centers and receiving fees for these services, the petitioners were performing basic duties within the normal scope of their roles as general partners, pursuant to the partnership agreements. Citing Treasury Regulation § 1.707-1(a) which states that 'the substance of the transaction will govern rather than its form,' the Court distinguished this from cases where a partner engages in a truly separate transaction, like acting as an independent contractor. Thus, the management fees were considered part of the partners' distributive share of partnership income, not deductible expenses. As for the interest payments, the Court agreed with both parties that they were 'guaranteed payments' under Section 707(c) because they were fixed at 6 percent of the principal per annum, 'without regard to partnership receipts or income.' However, the petitioners argued that as cash-basis taxpayers, they should only include these amounts in income when actually received. The Court rejected this, upholding Treasury Regulation § 1.707-1(c) as a reasonable and valid interpretation of Section 707(c). This regulation, supported by legislative history, explicitly states that a partner must include such guaranteed payments as ordinary income for their taxable year within which the partnership's taxable year ends, provided the partnership deducted the payments as paid or accrued. This prevents an income mismatch where the accrual-basis partnership deducts an expense, but the cash-basis partner delays reporting the corresponding income.
Analysis:
This case is significant for clarifying the distinct tax treatments of payments to partners under IRC Sections 707(a) and 707(c). It establishes a strict interpretation of the 'without regard to income' requirement for guaranteed payments, indicating that payments based on gross revenue are still 'with regard to income' and therefore not guaranteed payments. Furthermore, it reinforces that general partners performing routine managerial duties are acting in their capacity as partners, preventing Section 707(a) treatment. Most importantly, Pratt affirmed the validity and enforceability of Treasury Regulation § 1.707-1(c), which mandates that cash-basis partners include guaranteed payments in income in the same taxable year that an accrual-basis partnership deducts them, preventing a timing mismatch and ensuring consistency in tax reporting.
