a) In General. A partnership is allowed to subtract from taxable income any income of the partnership that constitutes personal service income as defined in 26 USC 1348(b)(1) (as in effect December 31, 1981) or a reasonable allowance for compensation paid or accrued for services rendered by partners to the partnership, whichever is greater. (IITA Section 203(d)(2)(H)) Therefore, pursuant to this Section, a partnership is allowed a subtraction modification in an amount equal to the greater of the amount computed under subsection (b) or the amount computed under subsection (c).
1) Purpose
Under the IRC and federal income tax law, a partner is not an employee of the
partnership. Consequently, a partnership generally may not deduct in computing
the taxable income of the partnership amounts paid to a partner for services
rendered to the partnership. (Estate of Tilton, 8 BTA 914 (1927)) Instead
these amounts are considered distributive shares of partnership income (Revenue
Ruling 55-30, 1955-1 C.B. 430). In contrast, a shareholder of a corporation may
also be employed by the corporation. Amounts paid by the corporation to the
shareholder that constitute compensation for services rendered as an employee
may be deducted by the corporation in computing its taxable income under
26 USC
162(a)(1). The purpose of
the subtraction modification under IITA Section 203(d)(2)(H) and this Section
is to allow partnerships, for purposes of computing their liability for the tax
imposed under IITA Section 201(c) and (d) (replacement tax), a deduction for
compensation paid to partners for services rendered to the partnership similar
to the deduction allowed to a corporation for compensation paid a
shareholder-employee for services rendered to the corporation.
2) Amounts that Qualify for Subtraction
A) The amounts computed under subsections (b)
and (c) are comprised of the distributive shares of the partners in the income
of the partnership. Under
26 USC
707(c) to the extent
determined without regard to the income of the partnership, payments to a
partner for services or the use of capital are considered as made to a person
who is not a partner, but only for the purposes of
26 USC
61(a) (relating to gross
income) and, subject to
26 USC 263
for purposes of IRC section 162(a) (relating to trade or business expenses)
26 CFR
1.707-1(c) states that, for
the other purposes of the IRC, a guaranteed payment is regarded as a
distributive share of the ordinary income of the partnership. Accordingly, a
guaranteed payment to a partner may be included in the computation of the
amounts computed under subsections (b) and (c).
B) Under
26 USC
707(a), if a partner engages
in a transaction with the partnership other than in his or her capacity as a
partner, the transaction is generally considered as occurring between the
partnership and one who is not a partner. When a partnership pays or accrues an
amount to a non-partner for services rendered, the partnership is allowed a
deduction in the computation of its taxable income (see, e.g.,
26 USC
162 ). Therefore, a payment to a partner
subject to
26 USC
707(a) may not be included
in the amounts computed under subsections (b) and (c) (see IITA Section 203(g)
and subsection (a)(5) of this Section). A distribution by the partnership
subject to
26 USC
731 is treated as a return of capital and/or
gain from the sale or exchange of the partnership interest of the distributee
partner and, therefore, in no event may a distribution be included in the
amounts computed under subsections (b) and (c). However, an allocation of
partnership income to a partner may be considered compensation for services for
purposes of this Section, whether or not accompanied by a corresponding
distribution under
26 USC
731.
3) Double Deductions Prohibited. IITA Section
203(g) states that nothing in that Section shall permit the same item
to be deducted more than once. A)
Under IITA Section 203(d)(2)(I), a subtraction modification is allowed to the
partnership for income distributable to an entity subject to replacement tax or
to organizations exempt from federal income tax by reason of IRC section
501(a). Therefore, neither a guaranteed payment nor a distributive share of net
income or gain of a partner subject to replacement tax or exempt from federal
income tax under IRC section 501(a) may be included in the subtraction
modification allowed under this Section.
B) In addition, when a partnership pays or
accrues an amount to a non-partner for services rendered, the partnership is
allowed a deduction in the computation of its taxable income. Therefore, a
payment to a partner subject to
26 USC
707(a) because the partner
is not acting in his or her capacity as a partner, whether or not the payment
is currently deducted by the partnership or capitalized, may not be subtracted
under this Section. Similarly, when a person receives a partnership interest
for the provision of services, the partnership's deduction is determined under
26
USC 83(h). Therefore, no
amount may be deducted by the partnership under this Section for the transfer
of a partnership interest in connection with the performance of
services.
b) Personal Service Income. When the personal service income of the partnership, as defined in this subsection (b), is greater than a reasonable allowance for compensation paid or...
