Rev. Rul. 56-675

Advice has been requested with respect to the treatment for Federal income tax purposes of amounts received by a member of a partnership under the circumstances described below.

Each of the three members of a partnership contributed equally to its capital for a one-third interest in the partnership capital and in partnership profits and losses. Additional working capital was attributable to amounts paid by the United States, which fall within the provisions of section 621 of the Internal Revenue Code of 1954. One of the partners was selected as manager and was paid guaranteed payments for his services during a taxable year in which the partnership had no income. Such payments resulted in an operating loss to the partnership. Under the partnership agreement, such losses were to be shared by all partners.

Section 707(c) of the 1954 Code, which has no counterpart in the 1939 Code, provides, with respect to guaranteed payments to a member of a partnership, as follows:

(c) GUARANTEED PAYMENTS.-To the extent determined without regard to the income of the partnership, payments to a partner for services or the use of capital shall be considered as made to one who is not a member of the partnership, but only for the purposes of section 61(a) (relating to gross income) and section 162(a) (relating to trade or business expenses).

Section 1402 of the Self-Employment Contributions Act of 1954 (chapter 2, subtitle A of the 1954 Code) provides in part as follows:

(a) NET EARNING FROM SELF-EMPLOYMENT.-The term `net earnings from self-employment' means the gross income derived by an individual from any trade or business carried on by such individual, less the deductions allowed by this subtitle which are attributable to such trade or business, plus his distributive share (whether or not distributed) of income or loss described in section 702(a)(9) from any trade or business carried on by a partnership of which he is a member; * * *

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(c) TRADE OR BUSINESS.-The term `trade or business', when used with reference to self-employment income or net earnings from self-employment, shall have the same meaning as when used in section 162 (relating to trade or business expenses), * * *.

Senate Report No. 1622 to accompany H.R. 8300, 83d Cong., at pages 94 and 387, contains the following pertinent explanations of the purposes of section 707(c).

In the case of guaranteed salary payments your committee followed the House bill but made it clear that such income is to be reported for tax purposes at the end of the partnership year in which it is paid and that this treatment is only provided for purposes of the reporting of the income by the partner and the deducting of the payments by the partnership. Your committee also extended this treatment to guaranteed interest payments on capital.

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Subsection (c) provides a rule with respect to guaranteed payments to members of a partnership. A partner who renders services to the partnership for a fixed salary, payable without regard to partnership income, shall be treated, to the extent of such amount, as one who is not a partner, and the partnership shall be allowed a deduction for a business expense. The amount of such payment shall be included in the partner's gross income, and shall not be considered a distributive share of partnership income or gain. A partner who is guaranteed a minimum annual amount for his services shall be treated as receiving a fixed payment in that amount.

Section 1.707-1(c) of the Income Tax Regulations, implementing section 707 of the Code, provides in part as follows:

* * * Guaranteed payments are considered as made to one who is not a member of the partnership, only for the purposes of section 61(a) (relating to gross income) and section 162(a) (relating to trade or business expenses). They do not constitute an interest in partnership profits for purposes or sections 706(b)(3), 707(b) and 708(b). For the purposes of other provisions of the internal revenue laws, guaranteed payments are regarded as a partner's distributive share of ordinary income. * * *

In general, under the provisions of section 707(c) of the Code the amount of a guaranteed payment to a member of a partnership is deductible as a business expense in determining the taxable income of the partnership and it is includible in the recipient partner's gross income without regard to the source of the cash which may be disbursed. Furthermore, in the circumstances specified in section 1.707-1(c) of the regulations, guaranteed payments are regarded as a partner's distributive share of ordinary income.

Since the partnership had no gross income during the partnership taxable year in which the guaranteed payments were made to the partner, the partnership realized a loss for that year which was deductible by the partners to the extent of their distributive shares thereof, as provided in section 702(a)(2) of the Code. Under section 705(a)(2), each partner's capital account and the basis of his partnership interest were decreased by the amount of his distributive share of such loss.

In view of the provisions of section 707(c), it is concluded that the instant guaranteed payments are includible in the recipient's gross income. Under section 1.1402(a)-1(a)(2) of the regulations, guaranteed payments are treated as gross income subject to self-employment tax. However, where a partner's distributive share includes a loss resulting from the operation of the partnership business, including the deduction for guaranteed payments treated as a business expense under section 162, the self-employment income is the net amount computed by applying to the guaranteed payment the distributive share of loss. Likewise, where a partner's distributive share is a profit resulting from the operation of the partnership business, including the deduction for guaranteed payments treated as a business expense under section 162, the self-employment income is the aggregate amount computed by adding to the guaranteed payment the distributive share of profit. Accordingly, it is held that, for income and self-employment tax purposes, the instant recipient partner is taxable upon the guaranteed payments to the extent that such payments exceed his distributive share of the partnership losses resulting therefrom.