Avoiding Taxation of Income Earned by a Partner

Editor:
Albert B. Ellentuck, Esq.
Of Counsel
King & Nordlinger, L.L.P.
Arlington, VA

Editors note: This case study has been adapted from PPC Tax Planning GuidePartnerships, 18th Edition, by James A. Keller, William D. Klein, Sara S. McMurrian and Linda A. Markwood, published by Practitioners Publishing Company, Fort Worth, TX, 2004 ((800) 3238724; ppc.thomson.com).

Frequently, partnerships engaged in rendering personal services require partners to remit income earned outside the entity (e.g., book royalties earned by a partner in a CPA firm). Both the IRS and the courts have held that such income is taxable to the partnership, not the individual, if it is for services that the partnership could perform (Rev. Rul. 64-90). Such income would be treated similarly if the services were within the range of those generally undertaken by the partnership, even though it could not legally perform them; see Rev. Rul. 80-338 and Stephen Schneer, 97 TC 643 (1991).

What Are Similar Services?

Even though a partnership might require its partners to submit fees received for similar services performed in their individual capacities, the IRS might disagree with the definition of similar services. In Letter Ruling 9514008, it determined that an attorney serving on a clients board of directors did so in his individual capacity, not as a law firm partner; thus, the income he received for those services was includible in his individual gross income.

The reasoning? Under local law, only a natural person may be a director of the client company; because of limitations contained in the partnerships professional liability insurance coverage, only lawyers other than the one serving on the clients board could provide legal advice on board actions. According to the IRS, services provided as a director must be conceptually distinguishable from those that the individual performs as a partner when rendering services the law firm is authorized to perform for the client.

Example

Dick is a general partner in Charley Brown & Co., a general partnership with an April 30 tax year-end. (Dick has a December 31 year-end.) The partnership is engaged in the practice of public accounting. Its tax year-end has been approved by the IRS under  post-Tax Reform Act of 1986 rules. During calendar-year 2005, Dick personally received the following cash payments:

March 2005Executors fee for services to a deceased friends estate: $5,000

July 2005Honorarium for teaching a tax course: $2,000

December 2005Salary as a member of the Golden Hills City Council: $4,000

The partnership agreement requires partners to promptly remit all fees, salaries, honoraria and book royalties. Dick complies with those terms by promptly remitting each of the above payments to the partnership.

Dicks distributive share of the partnerships taxable income (including his share of the outside income he remitted to the partnership) is $100,000 for the year ended April 30, 2005, and $125,000 for the year ended April 30, 2006. How much income from sources outside the partnership does Dick report on his 2005 and 2006 returns?

Executors fee: The $5,000 executors fee Dick remitted to the partnership is excludible from his income and includible in the partnerships income for the tax year ended April 30, 2005. Those services depend on the exercise of his expertise and are similar to the services he provides to the partnership in accordance with the partnership agreement. Thus, even though Charley Brown & Co. cannot legally be named as an executor, the function is within the range of services undertaken by accountants.

Honorarium: The same treatment is accorded the $2,000 teaching honorarium. This amount is included in the partnerships taxable income for the year ending April 30, 2006.

Council salary: As to the $4,000 City Council salary, the partnership could not legally be appointed or elected to the City Council. In addition, Dicks services to the City Council are not similar to the services he renders to the partnership. Accordingly, the $4,000 salary must be included in Dicks gross income on his own return; see Rev. Rul. 54-167, amplified by Rev. Rul. 64-90.

The IRS requires individual partners who receive income not normally earned by the partnership to include it on their return in the year received. The individual partner must include in gross income his or her distributive share of all partnership income, less the outside income the partner remitted and included in partnership income. Although this treatment results in the partner reporting the same amount of income, when the partnership has a tax year different from the partners, the income timing differs.

Dick reports the $4,000 City Council salary on his 2005 return. In 2006, he reports $121,000 of partnership income (his partnership distributive share of $125,000 $4,000 previously reported on his 2005 return). The IRS has ruled that if the amount remitted by the partner exceeds his or her distributive share of partnership taxable income, the excess is deductible as a loss; see Rev. Rul. 64-90.

Planning tip: Alternatively, the tax adviser could recommend that the partnership agreement permit partners to keep all outside earned income, but reduce their distributive shares of partnership income dollar-for-dollar. Even though such a provision generally produces the same result as described in the preceding paragraph, there is greater certainty as to when the income is includible in a partners taxable income.