Partnership Tax Practitioner Guides
IRC 707 governs three categories of partner-partnership transactions: direct dealings in a non-partner capacity under 707(a), transactions disguised as contributions and distributions but economically equivalent to taxable sales under 707(a)(2)(B), related-party loss disallowance and gain recharacterization under 707(b), and guaranteed payments for services or capital use under 707(c). Each category carries distinct tax consequences for both the partner and the partnership.
Last reviewed: July 2026
IRC 707 addresses situations where treating a partner's dealings with the partnership purely under subchapter K's flow-through framework would produce results inconsistent with economic substance. The statute creates four distinct sets of rules to capture those situations:
Understanding which provision applies -- and recognizing when more than one provision might apply simultaneously -- is the threshold analytical step in any partner-partnership transaction review.
IRC 707(a) applies when a partner engages in a transaction with the partnership in a capacity other than as a partner. The clearest examples are a partner lending money to the partnership at market interest rates, a partner selling unrelated property to the partnership, or a partner providing services to the partnership under a separately negotiated contract. In each case, the transaction is treated as if it occurred between the partnership and a stranger.
The line between a 707(a) transaction and a distributive share depends on the substance of the arrangement. A fixed payment for services rendered to the partnership -- regardless of whether the partnership has income -- is more naturally characterized as either a 707(a) payment (if it reflects an arm's-length, non-partner arrangement) or a guaranteed payment under 707(c) (if the relationship is still that of a partner providing services to the partnership). A payment structured as a percentage of partnership revenues, however, is more likely a distributive share. The partnership agreement's language is relevant but not conclusive; economic substance governs.
The disguised sale rules were enacted in 1984 to address a widely used tax shelter structure: a partner would purport to "contribute" appreciated property to a partnership and then receive a "distribution" of cash or other property, claiming that neither event was taxable. IRC 707(a)(2)(B) recharacterizes such transactions as taxable sales when the economic substance is that of a sale. Treasury issued comprehensive regulations (Treas. Reg. 1.707-3 through 1.707-9) that became effective for transactions on or after April 25, 1991.
A disguised sale occurs when, based on all facts and circumstances, (1) the partner transfers property to the partnership and (2) there is a related direct or indirect transfer of money or other consideration from the partnership to the partner. The regulations identify the following factors as tending to indicate that a disguised sale has occurred:
The 2-year presumption is a REBUTTABLE presumption that is difficult to rebut in practice. Any distribution of cash or property to a contributing partner within 2 years of a property contribution is presumed to be a disguised sale under Treas. Reg. 1.707-3(c). The partnership bears the burden of rebuttal. Failure to identify and characterize the disguised sale results in the contributing partner recognizing gain on the "contribution" date, not the date of the distribution, often in a closed tax year. Accuracy-related penalties apply.
When distributions and contributions occur more than 2 years apart, there is a presumption that the transactions are not a sale -- but the IRS retains the right to challenge the transaction under a facts-and-circumstances analysis if the evidence indicates a pre-arranged plan.
Treas. Reg. 1.707-3 governs the more common scenario: a partner contributes property and subsequently receives a distribution (the partnership distributes cash or property to the partner). Treas. Reg. 1.707-4 addresses the reverse: the partnership distributes cash or property to a partner who subsequently contributes property (the partnership "purchases" property that the partner later "contributes"). Both regulations apply the same two-factor framework and the 2-year presumption.
When a disguised sale is determined to have occurred:
When a partner contributes property to a partnership and the partnership later reimburses the partner for capital expenditures incurred within 2 years before the contribution date, the reimbursement is NOT treated as part of a disguised sale to the extent it does not exceed the lesser of (1) 20% of the fair market value of the contributed property at the time of contribution, or (2) the capital expenditures actually incurred. Properly structured preformation expenditure reimbursements allow partners to recover their out-of-pocket costs without triggering disguised sale treatment.
The preformation expenditure safe harbor is intended to allow partners who have invested capital in developing or improving property before forming a partnership to recover those costs from the partnership without the reimbursement being treated as disguised sale proceeds. The underlying rationale is that recovering actual costs already embedded in the property is distinguishable from extracting the property's value through a back-door sale.
Partners intending to rely on the preformation expenditure safe harbor should document the capital expenditures at the time they are incurred, obtain an independent appraisal of the contributed property's fair market value as of the contribution date, and confirm that the reimbursement amount does not exceed the applicable cap before the distribution is made. Contemporaneous documentation significantly reduces audit risk.
IRC 707(b)(1) losses are PERMANENTLY disallowed -- not deferred. When a more-than-50% partner sells property to the partnership at a loss, that loss is gone. Unlike the IRC 267 related-party loss rule (where the deferred loss can be recaptured by the transferee), the IRC 707(b)(1) disallowance is permanent with respect to the selling partner. The only potential benefit is that the purchasing partnership may apply the disallowed loss to reduce gain recognized when it resells the property -- but only to the extent of gain, and only by the partnership itself (not by the selling partner's distributive share). Identify all more-than-50% ownership relationships before any sale between a partner and the partnership.
No loss is recognized on a sale or exchange of property, directly or indirectly, between a partnership and a partner who owns, directly or indirectly, more than 50% of the capital interest or profits interest in the partnership. The rule applies symmetrically: it covers sales from partner to partnership and from partnership to partner. The disallowance is at the seller level. The loss is permanent with respect to the selling partner.
The purchasing entity (the partnership, if the seller is the partner) may use the amount of the disallowed loss to offset gain recognized on a subsequent resale of the property to a third party -- but only to the extent of actual gain, and only at the partnership level. This partial offset does not restore the loss to the selling partner.
IRC 707(b)(2) recharacterizes gain on a sale or exchange of property between a partner and the partnership as ordinary income if the property is not a capital asset in the hands of the transferee. The rule prevents a taxpayer from converting ordinary income property (inventory, receivables, depreciable property subject to recapture) into capital gain by selling it through a related partnership. Key examples include:
For purposes of the more-than-50% ownership test in IRC 707(b), constructive ownership attribution applies under rules similar to IRC 267(c). A partner is treated as owning interests actually or constructively owned by:
Interests attributed to a partner from one source are then re-attributed outward under certain chain-attribution rules. The constructive ownership analysis must be completed before assuming the 707(b) rules do not apply to a given transaction.
IRC 707(b) overlaps in part with IRC 267 (related-party loss deferral and gain recharacterization for individuals and corporations) and IRC 1239 (ordinary income treatment for depreciable property sold between related persons). Where both IRC 707(b) and IRC 267 could apply, IRC 707(b) governs for partner-partnership transactions. IRC 1239 may independently require ordinary income treatment for gain on sales of depreciable property in certain related-party contexts, even if IRC 707(b)(2) does not apply.
The distinction between a guaranteed payment under IRC 707(c) and a distributive share is determined by whether the payment is "determined without regard to the income of the partnership." A payment that is fixed in amount (for example, $50,000 per year) is a guaranteed payment. A payment that is a percentage of partnership income is a distributive share. Mischaracterization is an audit trigger: guaranteed payments are ordinary income to the recipient in the partnership's tax year in which they are deducted (or, if the payment is not deductible, in the partnership's year in which it is paid or accrued). Distributive shares follow different timing rules.
IRC 707(c) provides that a payment to a partner for services or for the use of capital, made without regard to the income of the partnership, is treated as a payment to a person who is not a member of the partnership. The critical element is the "without regard to income" requirement. A payment is a guaranteed payment only if it is fixed in advance or otherwise computable without reference to partnership income.
Guaranteed payments are always ordinary income to the recipient, regardless of the character of the income at the partnership level. Even if the partnership's income consists entirely of long-term capital gains, a guaranteed payment retains its ordinary income character. This rule is fundamentally different from a distributive share, where the character of the income passes through from the partnership to the partner.
The timing of a partner's income inclusion for a guaranteed payment follows a specific rule: the partner includes the guaranteed payment in gross income for the partner's taxable year within which the partnership's taxable year ends in which the partnership is required to take the guaranteed payment into account. For accrual-basis partnerships, this is generally the year the payment accrues; for cash-basis partnerships, it is the year paid. This timing rule -- rather than the date of actual receipt by the partner -- controls.
Guaranteed payments reduce the partnership's ordinary income (or increase its loss) available for allocation among partners as distributive shares. The payment is typically treated as an expense of the partnership -- deductible under IRC 162 for services, or as a cost of capital. Guaranteed payments for capital are not deductible if the capital is invested in a non-income-producing asset; capitalization rules under IRC 263 may apply.
Guaranteed payments reduce the paying partner's capital account (treated as an economic expense of the partnership chargeable against the partners' accounts based on the partnership agreement). The recipient partner's outside basis increases by the amount of the guaranteed payment included in income under IRC 705(a)(1), in the same manner as any other item of income recognized by the partner from the partnership.
A guaranteed payment for the use of capital is a payment that compensates a partner for the use of capital the partner has invested in the partnership, analogous to interest on a loan. Unlike a true loan from a partner to the partnership (which would generate interest income under IRC 707(a)), a guaranteed payment for capital arises within the partnership relationship and is governed by IRC 707(c). The distinction matters: a guaranteed payment for capital does not affect the partnership's obligation under its debt instruments and does not affect the liability-sharing rules under IRC 752.
The self-employment tax treatment of guaranteed payments from a limited partnership interest is unsettled. Renkemeyer v. Commissioner, 136 T.C. 137 (2011), held that GPs received by an LLP partner who provided material services are subject to SE tax. The IRS proposed regulations under IRC 1402(a)(13) that would define when limited partners are subject to SE tax on GPs, but those proposed regulations have not been finalized as of July 2026. Consult current IRS guidance at IRS.gov before advising clients on SE tax exposure for GPs from limited partnership interests.
Guaranteed payments for services rendered by a general partner in the ordinary course of the partnership's trade or business are treated as net earnings from self-employment under IRC 1402(a). General partners include guaranteed payments from services in their self-employment income base, and the payments are subject to FICA-equivalent taxes (15.3% on earnings up to the Social Security wage base, 2.9% Medicare tax above that threshold, plus the additional 0.9% Medicare surtax where applicable). Guaranteed payments for the use of capital are generally not subject to self-employment tax because they are analogous to investment returns rather than service compensation.
IRC 1402(a)(13) provides that a limited partner's distributive share of partnership income or loss is excluded from self-employment income. Congress's intent was to exclude passive investment returns from the SE tax base. However, IRC 1402(a)(13) expressly states that guaranteed payments for services are NOT excluded -- they remain subject to SE tax even for limited partners.
In Renkemeyer v. Commissioner, 136 T.C. 137 (2011), the Tax Court held that attorneys who were limited liability partners (LLP partners) in a law firm and who personally provided legal services could not exclude their guaranteed payments from self-employment income under the IRC 1402(a)(13) limited partner exception. The court reasoned that the purpose of the exclusion was to shelter passive investment returns, not labor income. Partners who materially participate in providing services cannot claim the exclusion with respect to service-based guaranteed payments.
The IRS issued proposed regulations under IRC 1402(a)(13) that would define the circumstances under which limited partners (and members of LLCs taxed as partnerships) are subject to self-employment tax on their distributive shares and guaranteed payments. Those proposed regulations have not been finalized as of July 2026. Until final regulations are issued, practitioners must navigate this area using statutory text, the Renkemeyer holding, and any subsequent IRS guidance. Consult IRS.gov for the current regulatory status before advising clients.
Practitioners advising clients on guaranteed payment structures -- particularly for LLPs, LLCs taxed as partnerships, and entities with limited partners who provide services -- should evaluate SE tax exposure as a primary consideration. The risk of SE tax characterization may affect the choice between a guaranteed payment structure, a distributive share allocation, and a direct employment arrangement with the partnership under IRC 707(a).
The mixing bowl rules under IRC 704(c)(1)(B) and IRC 737 create gain recognition events when a partnership distributes contributed property to a non-contributing partner within 7 years of contribution (IRC 704(c)(1)(B)) or when a contributing partner receives a distribution of property other than the contributed property within 7 years of the contribution (IRC 737). These rules are designed to prevent partners from using the partnership as a conduit to shift built-in gain.
The interaction with the disguised sale rules under IRC 707(a)(2)(B) is significant: if a contribution-and-distribution sequence is recharacterized as a disguised sale under IRC 707(a)(2)(B), the property is treated as having been sold to the partnership -- not contributed. Because there is no contribution for purposes of subchapter K, the mixing bowl rules do not apply to the recharacterized transaction. The 7-year clock under IRC 704(c)(1)(B) and IRC 737 does not start running on property that was transferred to the partnership in a disguised sale, because that property was purchased, not contributed.
This interaction creates a planning inflection point: a taxpayer might prefer disguised sale treatment (and its resulting cost basis in the partnership) over contribution treatment (with carryover basis and mixing bowl risk) if the property has embedded gain and the mixing bowl exposure is material. Conversely, a taxpayer with a low-basis, low-appreciation property might prefer contribution treatment to avoid the immediate gain recognition that comes with disguised sale characterization. The choice is not entirely elective -- the facts must support the characterization -- but structuring transactions with the mixing bowl interaction in mind is a legitimate planning objective.
The One Big Beautiful Budget Act (Pub. L. 119-21, 2025) ("OBBBA") does not amend IRC 707 directly. The disguised sale rules, the guaranteed payment regime, and the related-party loss and gain provisions remain unchanged by OBBBA. However, practitioners should be aware that OBBBA includes changes to related provisions that may affect the economics and tax analysis of transactions otherwise subject to IRC 707:
Because OBBBA is recent legislation and IRS guidance continues to be developed, practitioners should check IRS.gov and Treasury's website for the latest regulatory and administrative guidance on the interaction of OBBBA provisions with partnership tax rules before advising clients on transactions involving IRC 707.
IRC 707 issues arise across the full lifecycle of a partnership -- at formation, during operations, and upon restructuring. The following strategic considerations apply to most partnership engagements:
When a partner contributes property and the partnership intends to make a distribution to that partner, deferring the distribution beyond 2 years from the contribution date eliminates the Treas. Reg. 1.707-3(c) presumption. If deferral is not practical, the partnership should document the independent business purpose for the distribution and confirm that it does not meet the factors listed in Treas. Reg. 1.707-3(b)(2) as indicative of a sale. Obtain a contemporaneous appraisal of the contributed property.
When a distribution within the 2-year window is economically necessary -- for example, to fund the contributing partner's tax liability arising from the contribution -- the partnership should prepare a memorandum documenting the independent business rationale. Evidence that the distribution was funded from operating cash flows (not the proceeds of the contributed property), that the amount was not determined at the time of contribution, and that the distribution was subject to the entrepreneurial risks of the partnership can support rebuttal of the presumption.
Partners who have incurred capital expenditures on property within 2 years before contribution to a partnership should quantify those expenditures, obtain a current appraisal of the property's fair market value, and calculate the maximum reimbursement available under the Treas. Reg. 1.707-4(a) safe harbor (the lesser of 20% of FMV or actual expenditures). Structure the reimbursement to stay within that cap. Document all expenditures with invoices, contracts, and capitalization records.
Before any sale or exchange between a partner and the partnership, conduct a full constructive ownership analysis applying the IRC 267(c) attribution rules as incorporated by IRC 707(b). A transaction that appears on its face to be between unrelated parties may trigger 707(b) loss disallowance or gain recharacterization once family attribution and entity attribution are applied. Map all ownership interests -- direct, constructive, and attributed -- before the transaction closes.
Partnership agreements should clearly specify whether a payment to a partner is a guaranteed payment (fixed amount, not dependent on income) or a distributive share (computed as a percentage of income or loss). Ambiguous provisions create audit risk and timing mismatches. If the intent is a guaranteed payment, the agreement should state that it is "determined without regard to the income of the partnership" and specify the fixed amount or formula. If the intent is a distributive share, do not include language that could be read as fixing the amount independent of income.
For entities with partners providing material services -- law firms, accounting firms, investment management partnerships, medical practices -- the SE tax treatment of guaranteed payments should be modeled at the outset of the entity design. The Renkemeyer holding makes it difficult to structure service income as a non-SE-taxable guaranteed payment from a limited partner interest when the partner is actively providing services. Consider whether an employment arrangement under IRC 707(a) (with W-2 wages and FICA withholding at ordinary rates) might be more transparent and audit-resistant than a guaranteed payment structure. Confirm the regulatory status of proposed regs under IRC 1402(a)(13) before filing.
The statements below summarize key technical positions addressed in this guide. Each claim is supported by the referenced authority but may be affected by subsequent legislation, regulatory changes, court decisions, or IRS guidance. Practitioners must verify current law before relying on any position.
| # | Claim | Authority | Accuracy / Hedge |
|---|---|---|---|
| 1 | A distribution of cash or property to a contributing partner within 2 years of a property contribution is presumed to be a disguised sale; the partnership bears the burden of rebuttal. | Treas. Reg. 1.707-3(c) | Well-settled under current regulations; presumption is rebuttable but difficult to overcome in practice. |
| 2 | IRC 707(b)(1) permanently disallows the loss recognized by a more-than-50% partner on a sale of property to the partnership; the disallowance is not deferred and cannot be recaptured by the selling partner. | IRC 707(b)(1) | Well-settled statutory rule; contrast with IRC 267 deferral rule, which is distinguishable. |
| 3 | Gain recognized on a sale or exchange of property between a more-than-50% partner and the partnership is recharacterized as ordinary income if the property is not a capital asset in the hands of the transferee. | IRC 707(b)(2) | Well-settled; applies to both partner-to-partnership and partnership-to-partner transfers. |
| 4 | Guaranteed payments under IRC 707(c) are always ordinary income to the recipient, regardless of the character of partnership income. | IRC 707(c); Treas. Reg. 1.707-1(c) | Well-settled; character does not pass through from the partnership to the guaranteed payment recipient. |
| 5 | The self-employment tax treatment of guaranteed payments from a limited partnership interest is unsettled; limited partners who provide material services may be subject to SE tax under Renkemeyer. | IRC 1402(a)(13); Renkemeyer v. Commissioner, 136 T.C. 137 (2011); proposed regs (not finalized) | Contested area. Proposed regulations under IRC 1402(a)(13) remain unfinalized as of July 2026. Verify current guidance at IRS.gov before advising clients. |
| 6 | The preformation expenditure safe harbor protects reimbursements up to the lesser of 20% of the fair market value of contributed property or the actual capital expenditures incurred within 2 years before contribution. | Treas. Reg. 1.707-4(a) | Well-settled regulatory safe harbor; dual-cap calculation must be applied correctly. |
| 7 | When a partnership assumes a liability of the contributing partner in connection with a property contribution, the partner's allocable share of that liability is not treated as disguised sale consideration under the debt-financed distribution exception. | Treas. Reg. 1.707-5 | Generally settled but highly fact-specific; recourse vs. nonrecourse classification and liability allocation must be analyzed for each transaction. |
| 8 | Under Renkemeyer, LLP partners who personally provide services to the partnership cannot exclude their guaranteed payments from self-employment income on the basis that they are "limited partners" under IRC 1402(a)(13). | Renkemeyer v. Commissioner, 136 T.C. 137 (2011) | Tax Court precedent; IRS has not formally acquiesced. Consult current IRS guidance for any subsequent developments. |
| 9 | Constructive ownership attribution rules (similar to IRC 267(c)) apply in determining whether a partner owns more than 50% of capital and profits interests for purposes of IRC 707(b). | IRC 707(b)(3); attribution rules analogous to IRC 267(c) | Well-settled; family attribution and entity attribution must both be applied and may chain. |
| 10 | If a contribution-and-distribution sequence is recharacterized as a disguised sale under IRC 707(a)(2)(B), the mixing bowl rules under IRC 704(c)(1)(B) and IRC 737 do not apply to the recharacterized transaction, because there is no contribution for subchapter K purposes. | IRC 707(a)(2)(B); IRC 704(c)(1)(B); IRC 737; Treas. Reg. 1.704-4(a)(1) | Generally supported by the regulatory framework; the interaction is technically settled but must be applied carefully when both regimes could otherwise apply. |
This guide is updated periodically to reflect new legislation, regulatory guidance, and Tax Court decisions. Verify all positions against current law before relying on them in a client matter.
1. What is a disguised sale under IRC 707(a)(2)(B)?
A disguised sale under IRC 707(a)(2)(B) occurs when a partner purports to contribute property to a partnership and receives a related distribution, but the economic substance of the transaction is a taxable sale. The IRS looks at whether the two transfers -- contribution and distribution -- are mutually dependent so that neither would have been made without the other. When the disguised sale rules apply, the contributing partner is treated as selling the property to the partnership on the contribution date, recognizing gain or loss at that time, and the partnership receives a cost basis in the property rather than a carryover basis.
2. How does the 2-year presumption work in disguised sale analysis?
Under Treas. Reg. 1.707-3(c), if a partner contributes property to a partnership and the partnership transfers money or other consideration to that partner within 2 years of the contribution, the transfers are presumed to constitute a sale of the property by the partner to the partnership. This presumption is rebuttable, but the partnership bears the burden of proof and rebuttal is difficult in practice. Transfers occurring more than 2 years apart are presumed not to be a sale, though the IRS may still challenge them under a facts-and-circumstances analysis.
3. What is a guaranteed payment under IRC 707(c)?
A guaranteed payment under IRC 707(c) is a payment made by a partnership to a partner for services rendered or for the use of capital, where the payment amount is determined without regard to the income of the partnership. Guaranteed payments are treated as ordinary income to the recipient and are generally deductible by the partnership (subject to capitalization rules and other limitations). The recipient includes the guaranteed payment in income for the partner's tax year within which the partnership's tax year ends in which the payment is required to be taken into account.
4. How does IRC 707(b)(1) differ from the IRC 267 related-party loss rule?
IRC 707(b)(1) permanently disallows the loss sustained by a more-than-50% partner on a sale or exchange of property with the partnership. The loss is gone for the selling partner -- it cannot be recaptured or deferred. Under IRC 267, by contrast, a loss between related parties is deferred (not permanently disallowed), and the transferee can use the deferred loss to offset gain when the property is later sold to an unrelated party. Under IRC 707(b)(1), the purchasing partnership may apply the disallowed amount to reduce gain when it later resells the property, but the benefit runs to the partnership, not to the selling partner.
5. When does a distribution within 2 years of a contribution escape disguised sale treatment?
Several exceptions can prevent disguised sale treatment even when a distribution occurs within 2 years of a contribution. These include: (1) the preformation expenditure safe harbor under Treas. Reg. 1.707-4(a), which protects reimbursements of capital expenditures incurred before the contribution up to the lesser of 20% of the contributed property's fair market value or the actual expenditures; (2) debt-financed distributions under Treas. Reg. 1.707-5, where the distribution reflects the partner's share of partnership liabilities assumed in connection with the contributed property; (3) distributions that qualify as preferred returns under the safe harbor of Treas. Reg. 1.707-4(a)(2); and (4) operating cash flow distributions meeting certain requirements. Facts-and-circumstances documentation is critical for any of these exceptions.
6. Are guaranteed payments subject to self-employment tax?
Guaranteed payments for services rendered by general partners are generally subject to self-employment (SE) tax. The treatment of guaranteed payments from limited partnership interests is less settled. IRC 1402(a)(13) provides a limited partner exclusion from SE tax for distributive shares, but the IRS and Tax Court have held that the exclusion does not necessarily extend to guaranteed payments where the partner is actively providing services. The Tax Court in Renkemeyer v. Commissioner, 136 T.C. 137 (2011), held that managing LLP partners providing services could not exclude their guaranteed payments from SE tax. Proposed regulations under IRC 1402(a)(13) have not been finalized as of July 2026. Practitioners should consult current IRS guidance before advising clients.
7. What is the preformation expenditure safe harbor under Treas. Reg. 1.707-4(a)?
The preformation expenditure safe harbor under Treas. Reg. 1.707-4(a) provides that when a partner contributes property to a partnership and the partnership reimburses the partner for certain capital expenditures incurred within 2 years before the contribution, the reimbursement is not treated as part of a disguised sale. The reimbursement escapes disguised sale treatment to the extent it does not exceed the lesser of (1) 20% of the fair market value of the contributed property at the time of contribution, or (2) the capital expenditures actually incurred. Expenditures incurred more than 2 years before the contribution date are not eligible for this safe harbor.
8. How does a disguised sale affect the partnership's basis in the contributed property?
When a transaction is treated as a disguised sale under IRC 707(a)(2)(B), the partnership is considered to have purchased the property from the contributing partner at the time of the contribution. As a result, the partnership takes a cost basis in the property equal to the amount realized by the partner (i.e., the deemed sale price), rather than a carryover basis under IRC 723. This cost basis result is a key distinction from a true contribution. If the partnership later makes an IRC 754 election, an IRC 743(b) adjustment may be available when the contributing partner's interest is subsequently transferred, but the basis in the property itself starts at cost from the disguised sale.