Business Entities · Partnerships

Partner's dealings with partnership (e.g., exchange of property, guaranteed payments)

Verification 2026 Verified
tax year · reviewed 2026-08-21 · Draft for I. Ohu review

A partner can deal with their partnership in three different capacities, and the tax consequences turn entirely on which one. As a stranger, under IRC § 707(a) — the partnership buys their building, and the transaction is an ordinary purchase. As a partner receiving a fixed payment, under IRC § 707(c) — a guaranteed payment, which is treated as a payment to a stranger for two named purposes and as a distributive share for everything else. Or as a partner simply taking their share, under IRC § 704. Most errors in this area come from applying the consequences of one capacity to a transaction that belongs in another.

The rule

Dealing as a stranger. where a partner engages in a transaction with the partnership other than in their capacity as a member of it, the transaction is treated as occurring between the partnership and a non-partner (IRC § 707(a)(1))^TY2026

When the form is not respected. a performance of services or transfer of property by a partner, together with a related allocation and distribution to that partner, is treated as a transaction with a non-partner where the two viewed together are properly characterised as occurring with a partner acting other than as a member; the same applies to a transfer by a partner and a related transfer back to that or another partner where the two viewed together are properly characterised as a sale or exchange of property (IRC § 707(a)(2)(A), (B))^TY2026

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 are considered as made to one who is not a member of the partnership — but only for the purposes of IRC § 61(a) on gross income and, subject to IRC § 263, IRC § 162(a) on trade or business expenses (IRC § 707(c))^TY2026

When the partner reports it. the partner includes a guaranteed payment as ordinary income for the taxable year within or with which ends the partnership taxable year in which the partnership deducted it under its method of accounting — so the partner recognition follows the partnership year, not the date of payment (Reg. § 1.707-1(c))^TY2026

What a guaranteed payment is for every other purpose. for every purpose other than IRC §§ 61(a) and 162(a), a guaranteed payment is regarded as a partner distributive share of ordinary income. A partner receiving one is not an employee for withholding, deferred compensation or similar purposes, and guaranteed payments do not constitute an interest in partnership profits for IRC §§ 706(b)(3), 707(b) or 708(b) (Reg. § 1.707-1(c))^TY2026

When the partnership may deduct it. for a guaranteed payment to be deductible by the partnership it must meet the same IRC § 162(a) tests it would have to meet if paid to a non-partner, and the IRC § 263 capital expenditure rules must be taken into account (Reg. § 1.707-1(c))^TY2026

Losses between a partnership and its controlling owner. no deduction is allowed for losses from sales or exchanges of property, other than an interest in the partnership, directly or indirectly between a partnership and a person owning directly or indirectly more than 50 percent of its capital or profits interest, or between two partnerships in which the same persons own directly or indirectly more than 50 percent of the capital or profits interests. On a later sale by the transferee, IRC § 267(d) applies as if the loss had been disallowed under § 267(a)(1) (IRC § 707(b)(1))^TY2026

And gains. on a sale or exchange, direct or indirect, of property that in the hands of the transferee is other than a capital asset, between a partnership and a person owning more than 50 percent of its capital or profits interest, or between two partnerships more than 50 percent commonly owned, any gain recognised is ordinary income (IRC § 707(b)(2))^TY2026

Current figures

Item	Rule	Authority
Guaranteed payment defined	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 one who is not a member of the partnership — but only for the purposes of IRC § 61(a) on gross income and, subject to IRC § 263, IRC § 162(a) on trade or business expenses (IRC § 707(c))^TY2026	IRC § 707(c)
Timing of the partner’s inclusion	the partner includes a guaranteed payment as ordinary income for the taxable year within or with which ends the partnership taxable year in which the partnership deducted it under its method of accounting — so the partner recognition follows the partnership year, not the date of payment (Reg. § 1.707-1(c))^TY2026	Reg. § 1.707-1(c)
Treatment for all other purposes	for every purpose other than IRC §§ 61(a) and 162(a), a guaranteed payment is regarded as a partner distributive share of ordinary income. A partner receiving one is not an employee for withholding, deferred compensation or similar purposes, and guaranteed payments do not constitute an interest in partnership profits for IRC §§ 706(b)(3), 707(b) or 708(b) (Reg. § 1.707-1(c))^TY2026	Reg. § 1.707-1(c)
Losses disallowed	no deduction is allowed for losses from sales or exchanges of property, other than an interest in the partnership, directly or indirectly between a partnership and a person owning directly or indirectly more than 50 percent of its capital or profits interest, or between two partnerships in which the same persons own directly or indirectly more than 50 percent of the capital or profits interests. On a later sale by the transferee, IRC § 267(d) applies as if the loss had been disallowed under § 267(a)(1) (IRC § 707(b)(1))^TY2026	IRC § 707(b)(1)
Gains as ordinary income	on a sale or exchange, direct or indirect, of property that in the hands of the transferee is other than a capital asset, between a partnership and a person owning more than 50 percent of its capital or profits interest, or between two partnerships more than 50 percent commonly owned, any gain recognised is ordinary income (IRC § 707(b)(2))^TY2026	IRC § 707(b)(2)

How it works in practice

The defining feature of a guaranteed payment is in five words of IRC § 707(c): determined without regard to the income of the partnership. A payment that varies with profits is not a guaranteed payment however the agreement labels it; a payment fixed in amount is one however the agreement labels it. A partner entitled to the greater of a fixed sum or a stated share of profits has a guaranteed payment equal to the fixed sum and a distributive share for anything above it — the two halves are analysed separately.

The consequence of that is the point clients find surprising: the payment is made whether or not the partnership earns anything. A partnership with a loss still owes and still deducts its guaranteed payments, which deepens the loss allocated to the other partners. The recipient reports ordinary income in a year the partnership had none.

The limitation in IRC § 707(c) is exact and repays reading twice. The payment is treated as made to a non-partner only for IRC § 61(a) and IRC § 162(a) — that is, only for including it in the recipient’s gross income and deducting it at the partnership. For every other provision of the Code it is a distributive share of ordinary income. That single sentence answers a series of questions that otherwise look separate. The partner is not an employee, so no income tax or FICA is withheld. There is no Form W-2. The payment cannot be excluded under provisions available to employees. And it is self-employment income, because a partner’s distributive share of ordinary income from a trade or business is.

Timing follows the partnership rather than the payment. The partner includes the guaranteed payment for their taxable year within or with which ends the partnership taxable year in which the partnership deducted it. A cash-basis partner does not report on receipt; an accrual-basis partnership that accrues a payment in one year and pays it in the next has fixed the partner’s year of inclusion by the accrual.

The deduction is not automatic either. Reg. § 1.707-1(c) requires the payment to satisfy IRC § 162(a) as it would if made to a stranger — ordinary, necessary and reasonable — and requires IRC § 263 to be taken into account. A guaranteed payment for services in constructing a building is capitalised, not deducted, and the partner still includes it.

The IRC § 707(b) rules are the subchapter K version of IRC § 267 and they are stricter in one respect and looser in another. Stricter: the ownership threshold reaches indirect ownership and applies to profits interests as well as capital interests, and paragraph (2) converts gain to ordinary income where the property is not a capital asset in the transferee’s hands. Looser: they apply only above more than 50 percent, so a partner with exactly half is outside them.

Note what happens to a disallowed loss. It is not extinguished. IRC § 707(b)(1) applies IRC § 267(d) as if the loss had been disallowed under IRC § 267(a)(1), so on a later sale by the transferee, gain is recognised only to the extent it exceeds the disallowed loss. The benefit passes to the buyer rather than disappearing.

Scenarios

The payment in a loss year

A three-partner design partnership agrees that Marguerite receives $90,000 a year for running the studio, fixed and payable regardless of results. In 2026 the partnership has revenues of $410,000 and expenses of $470,000 before that payment, and the partners share profits and losses equally.

The payment is made and deducted. Ordinary business income for 2026 is negative $150,000 after the guaranteed payment, allocated $50,000 of loss to each of the three partners. Marguerite reports $90,000 of ordinary income from the guaranteed payment and a $50,000 loss from her distributive share, subject to her outside basis under IRC § 704(d). The other two partners each report a $50,000 loss and nothing else. The partnership's inability to pay out of profits is irrelevant: IRC § 707(c) turns on the payment being determined without regard to income, and a loss year is the clearest case of that.

The greater of a fixed sum or a share

A partnership agrees to pay Nikola "the greater of $60,000 or 15 percent of partnership net profits" for his services. In 2026 partnership net profits before the payment are $700,000, so 15 percent would be $105,000 and he receives that.

The payment splits. The $60,000 minimum is determined without regard to the income of the partnership and is a guaranteed payment under IRC § 707(c): ordinary income to Nikola, deductible by the partnership, self-employment income, no withholding. The excess of $45,000 varies entirely with profits and is not determined without regard to income, so it is a distributive share allocated under IRC § 704 rather than a payment. The practical difference is not the rate but the character: the distributive share carries the character of the underlying partnership items, while the guaranteed payment is ordinary income regardless.

The building sold at a loss

Aurelio owns a 60 percent profits interest in a partnership. He sells it a warehouse he has held for eleven years, with an adjusted basis of $1,200,000, for its fair market value of $850,000. The partnership holds the warehouse as a rental property. Three years later the partnership sells it to a stranger for $1,050,000.

Aurelio's $350,000 loss is disallowed under IRC § 707(b)(1), because he owns directly more than 50 percent of the profits interest. It is not lost. On the partnership's later sale, IRC § 267(d) applies as if the loss had been disallowed under IRC § 267(a)(1), so the partnership's $200,000 of realised gain is recognised only to the extent it exceeds Aurelio's disallowed loss — and it does not, so the partnership recognises nothing. The remaining $150,000 of Aurelio's disallowed loss simply disappears; IRC § 267(d) shelters gain but does not create a deduction.

The equipment sold at a gain to a dealer partnership

Perpetua owns a 70 percent capital interest in a partnership that buys and resells construction plant as inventory. She sells it an excavator she has used in a separate business for eight years, with a basis of $40,000, for its market value of $115,000.

The $75,000 of gain is ordinary income. Under IRC § 707(b)(2) a sale between a partnership and a person owning directly or indirectly more than 50 percent of its capital or profits interest produces ordinary income where the property, in the hands of the transferee, is other than a capital asset — and the excavator is inventory to this partnership. The character in Perpetua's own hands is irrelevant, which is the whole point of the paragraph: without it, she could convert what the partnership would earn as ordinary income into her own capital gain by selling in before the resale.

Traps

The label does not decide. IRC § 707(c) turns on whether the payment is determined without regard to partnership income, not on what the agreement calls it.
Guaranteed payments are paid in loss years. They deepen the loss allocated to the other partners.
Non-partner status is for two purposes only. IRC §§ 61(a) and 162(a). For everything else the payment is a distributive share of ordinary income.
No W-2, no withholding, and self-employment income. All three follow from that limitation.
Timing follows the partnership's deduction year. Not the date of payment, even for a cash-basis partner.
The deduction can be denied. IRC § 162(a) reasonableness applies, and IRC § 263 can require capitalisation while the partner still includes the payment.
Exactly 50 percent is outside IRC § 707(b). Both paragraphs require more than 50 percent.
Character under IRC § 707(b)(2) is tested in the transferee's hands. Not the seller's.

How this has changed

IRC § 707 has been stable in its essentials, and the guaranteed payment rules in particular have not moved. What has changed around them is the significance of the self-employment consequence. Because a guaranteed payment is a distributive share of ordinary income for every purpose other than IRC §§ 61(a) and 162(a), it is self-employment income, and it is expressly carved back into self-employment income for a limited partner by IRC § 1402(a)(13). As the boundary of the limited partner exclusion has become contested, the guaranteed payment has become the one component of a limited partner’s return that is not in doubt — which in turn makes the allocation between guaranteed payment and distributive share a more consequential drafting decision than it once was.

IRC § 707(a)(2) is the newer part of the section. Paragraph (2)(A) addresses a services or property transfer paired with a related allocation and distribution, and paragraph (2)(B) addresses a transfer in paired with a related transfer out, in each case where the two viewed together are properly characterised as a transaction with a non-partner or a sale. Both are anti-abuse provisions aimed at arrangements that used the flexibility of subchapter K allocations to disguise what were in substance sales or fees. Their existence is the reason a question describing an unusually neat pairing of a contribution and a distribution is rarely testing IRC § 731.

Exam focus

The commonest computation gives guaranteed payments to some partners, an ordinary income figure, and profit-sharing percentages, and asks what a partner includes. Two things decide it. First, read whether the income figure is stated before or after the guaranteed payments — “ordinary partnership income” is the residual figure and is normally already net of them, and the alternative reading is usually offered as a distractor. Second, a partner who receives no guaranteed payment includes only their share of that residual figure.

The second recurring shape asks whether a guaranteed payment depends on profitability. It does not, and every distractor that conditions it on profits or on profits exceeding the payment is wrong for the same reason.

For IRC § 707(b), check the percentage first — more than 50 percent, not at least 50 — then ask whether the question is about a loss (disallowed, with IRC § 267(d) relief for the transferee) or a gain (ordinary if the property is not a capital asset to the transferee).

Check yourself

1. A partnership pays guaranteed payments of $7,000 to partner A and $5,000 to partner B, and none to partner C. Profit shares are 40, 40 and 20 percent. Ordinary partnership income for the year, after the guaranteed payments, is $100,000. What does C include?

Answer: $20,000. C receives no guaranteed payment, so C’s inclusion is the 20 percent distributive share of the $100,000 of residual ordinary income. The guaranteed payments have already been deducted in arriving at that figure, so subtracting them again would double-count.

2. A partnership agreement entitles a partner to $50,000 a year for services. The partnership has an ordinary loss of $200,000 for the year before that payment. Is the payment still made and deducted?

Answer: yes. A guaranteed payment is one determined without regard to the income of the partnership (IRC § 707(c)), so profitability is irrelevant to whether it is made or deducted. The partner reports $50,000 of ordinary income, and the loss allocated among the partners is $250,000 rather than $200,000.

3. A cash-basis partner receives a guaranteed payment in March 2027 that an accrual-basis calendar-year partnership accrued and deducted for its year ended 31 December 2026. In which year does the partner include it?

Answer: 2026. Under Reg. § 1.707-1(c) the partner includes the payment for the taxable year within or with which ends the partnership taxable year in which the partnership deducted it. The partner’s own method of accounting and the date of receipt do not control.

4. A partner owning 55 percent of a partnership’s capital sells it land at a $90,000 loss. The partnership later sells the land to an unrelated buyer at a $60,000 gain. What are the consequences?

Answer: the partner’s $90,000 loss is disallowed under IRC § 707(b)(1). On the partnership’s later sale, IRC § 267(d) applies as if the loss had been disallowed under IRC § 267(a)(1), so the $60,000 of gain is not recognised, being less than the previously disallowed loss. The remaining $30,000 of disallowed loss gives no deduction to anyone.

5. A partner receives a guaranteed payment of $120,000. Should the partnership issue a Form W-2 and withhold?

Answer: no. IRC § 707(c) treats the payment as made to a non-partner only for IRC §§ 61(a) and 162(a); for every other purpose Reg. § 1.707-1(c) regards it as a distributive share of ordinary income, and expressly says the recipient is not an employee for withholding purposes. It is reported on the Schedule K-1 and is self-employment income to the partner.

Change log

2026-08-21Initial draft. Sets out the IRC § 707(a)(1) rule for a partner transacting other than as a partner and the § 707(a)(2) disguised sale and disguised payment rules, the § 707(c) definition of a guaranteed payment and its limitation to IRC §§ 61(a) and 162(a), the Reg. § 1.707-1(c) timing rule tying the partner's inclusion to the partnership year of deduction and the rule that a guaranteed payment is a distributive share of ordinary income for every other purpose, and the § 707(b)(1) disallowance of losses and § 707(b)(2) ordinary income treatment of gains in more-than-50-percent controlled partnership transactions.