Section 707 of the Internal Revenue Code sets the rules for transactions between a partner and their partnership when the partner is not simply sharing in profits. It has four working parts: 707(a) treats a partner dealing with the partnership in a non-member capacity as an outsider; 707(a)(2) lets the IRS recharacterize disguised service payments and disguised sales; 707(b) disallows losses and converts capital gains to ordinary income on transactions with controlling partners; and 707(c) governs guaranteed payments made without regard to partnership income. Each subsection addresses a different way the line between “partner” and “third party” can blur, and each carries distinct tax consequences.
When a Partner Acts Outside the Partnership Role
Section 707(a)(1) treats a partner who deals with the partnership in a capacity other than as a member as if the transaction happened between the partnership and a stranger.1Office of the Law Revision Counsel. 26 USC 707 – Transactions Between Partner and Partnership A partner might lease office space to the partnership, sell it inventory, or bill it for legal or accounting work. If a partner rents a building to the partnership for $5,000 a month, the partnership books rent expense and the partner reports rental income. The payment is owed whether or not the partnership makes money that year, which is what separates it from a distributive share.
Documentation carries the outcome. Written agreements, invoices, and terms that match what an unrelated vendor would receive help establish arm’s-length dealing. Without that record, the IRS can reclassify the payment as a disguised distribution or a guaranteed payment on the theory that the partner was really acting as a member.
Disguised Payments for Services
Section 707(a)(2)(A) targets a subtler arrangement: the partnership allocates income to a partner and distributes cash in a linked pattern that, viewed together, looks like a service fee rather than profit-sharing. When that is the better description, the IRS can recharacterize the entire arrangement as a 707(a)(1) transaction between the partnership and a non-partner.1Office of the Law Revision Counsel. 26 USC 707 – Transactions Between Partner and Partnership
The stakes come from character. A distributive share carries whatever character the partnership’s income has, potentially including capital gains, while a recharacterized service payment is ordinary income and often deductible by the partnership. The two questions that matter: would the allocation have been made regardless of the services, and did the partner bear meaningful entrepreneurial risk tied to partnership profits? If both answers are no, expect reclassification.
Disguised Sales of Property
Section 707(a)(2)(B) addresses the situation where a partner contributes property to the partnership and, around the same time, receives a cash distribution. A property contribution is normally tax-free under Section 721. But if the contribution and cash payment are economically linked, the IRS can treat the sequence as a taxable sale.2Internal Revenue Service. Removal of Temporary Regulations on a Partner’s Share of a Partnership Liability for Disguised Sale Purposes
The Two-Year Presumption
Treasury Regulation 1.707-3 turns on timing. Property in and cash out within a two-year window are presumed to be a sale unless the facts clearly say otherwise. Transfers more than two years apart are presumed not to be a sale, and the IRS carries the burden.3eCFR. 26 CFR 1.707-3 – Disguised Sales of Property to Partnership; General Rules
It is a presumption, not a safe harbor. Partners who treat a two-year-window transaction as something other than a sale must disclose the transfers to the IRS, and transfers outside the window can still be recharacterized if the facts point that way.
Factors That Signal a Sale
When the presumption does not settle the question, the regulations list factors the IRS weighs. Among the most important:
- Certainty of payment. If the timing and amount of the distribution were determinable with reasonable certainty when the property was transferred, that looks like a sale price.
- Legally enforceable right. A partner with a contractual right to the payment regardless of partnership performance is functionally a seller.
- Secured payments. Rights secured by partnership assets or third-party guarantees resemble a sale rather than an entrepreneurial stake.
- Disproportionate distributions. Cash that is large relative to the partner’s ongoing profit share suggests purchase consideration.
- No repayment obligation. If there is no duty to return the money, or repayment is deferred so far out that its present value is trivial, the economics look like a completed sale.3eCFR. 26 CFR 1.707-3 – Disguised Sales of Property to Partnership; General Rules
The Qualified Liability Exception
When a partnership assumes debt tied to contributed property, the assumption normally counts as consideration flowing back to the partner, which can trigger the disguised sale rules. Treasury Regulation 1.707-5 carves out “qualified liabilities,” whose assumption generally is not treated as sale proceeds.4eCFR. 26 CFR 1.707-5 – Disguised Sales of Property to Partnership; Special Rules Relating to Liabilities
A liability qualifies under one of several tests. The most common: it was incurred more than two years before the transfer and encumbered the property throughout that period; it arose in the ordinary course of the trade or business connected to the transferred property, with substantially all related business assets also transferred; or it is traceable to capital expenditures on the property. The exception is central in real estate partnerships, where contributed property almost always carries mortgage debt.
Guaranteed Payments Under 707(c)
Section 707(c) defines guaranteed payments as amounts paid to a partner for services or the use of capital that are determined without regard to partnership income.1Office of the Law Revision Counsel. 26 USC 707 – Transactions Between Partner and Partnership A managing partner who takes $120,000 a year to run the business, profitable year or not, is getting a guaranteed payment.
The recipient includes the payment in gross income under Section 61(a). The partnership deducts it as a business expense under Section 162(a) when it is for routine services. If the payment relates to a long-term asset such as constructing a building, the cost is capitalized under Section 263 and added to the asset’s tax basis rather than deducted immediately.5Internal Revenue Service. 26 CFR 1.707-1 – Partner Not Acting in Capacity as Partner
Self-Employment Tax
Nothing is withheld from a guaranteed payment. The partner owes self-employment tax covering Social Security and Medicare. The combined rate is 15.3% on earnings up to the Social Security wage base, which is $184,500 for 2026.6Social Security Administration. Contribution and Benefit Base That breaks down to 12.4% for Social Security and 2.9% for Medicare.7Internal Revenue Service. Self-Employment Tax (Social Security and Medicare Taxes) Earnings above the wage base still carry the 2.9% Medicare portion, and an additional 0.9% Medicare surtax applies once self-employment income exceeds $200,000 for single filers or $250,000 for joint filers.8Internal Revenue Service. Questions and Answers for the Additional Medicare Tax
Because nothing is withheld, quarterly estimated payments are usually required. Falling behind triggers a failure-to-pay penalty of 0.5% of the unpaid tax for each month or partial month the balance stays open, up to 25%.9Internal Revenue Service. Failure to Pay Penalty
K-1 Reporting
Guaranteed payments appear on Schedule K-1 (Form 1065) in boxes 4a (services), 4b (capital), and 4c (total).10Internal Revenue Service. 2025 Schedule K-1 (Form 1065) The partner reports the amount as ordinary income for the taxable year in which the partnership’s tax year ends, not necessarily when the cash arrives.
Sales and Losses With a Controlling Partner
Section 707(b) imposes two restrictions on transactions between a partnership and someone who owns more than 50% of the capital or profits interest. The same rules apply between two partnerships controlled by the same persons.
Under 707(b)(1), a loss from a sale or exchange between a controlling partner and the partnership is completely disallowed. The partner cannot deduct it.11Office of the Law Revision Counsel. 26 U.S. Code 707 – Transactions Between Partner and Partnership The rule stops a majority owner from selling a depreciated asset to the partnership, claiming the loss, and continuing to benefit from the same asset through the partnership interest.
Under 707(b)(2), when a controlling partner sells property to the partnership or vice versa and the property is not a capital asset in the buyer’s hands, any gain is ordinary income rather than capital gain.11Office of the Law Revision Counsel. 26 U.S. Code 707 – Transactions Between Partner and Partnership This shows up with inventory and depreciable business equipment. Without the rule, a partner could sell appreciated property to their own partnership and pay capital gains rates on what is effectively business income.
Constructive Ownership Sweeps in Family
The more-than-50% test is not limited to direct holdings. Section 707(b)(3) borrows the constructive ownership rules of Section 267(c), which attribute ownership among family members and related entities. A partner holding 30% personally whose spouse holds 25% is treated as owning 55%. Brothers, sisters, spouses, ancestors, and lineal descendants can each trigger attribution. Family-run partnerships need to run every intercompany sale through combined family ownership, not just the individual partner’s stake.
Section 707 Payments and the QBI Deduction
The Section 199A deduction allows eligible taxpayers to deduct up to 20% of qualified business income from a pass-through entity. Section 707 payments are carved out. Both guaranteed payments under 707(c) and payments to a partner acting outside their capacity as a member under 707(a) are excluded from the definition of qualified business income.12Internal Revenue Service. Qualified Business Income Deduction
That creates a real planning tension. A distributive share of ordinary partnership income can qualify for the 20% deduction, subject to income limits and other rules, while guaranteed payments for the same work do not. Two partners doing identical work can face very different effective rates depending on how their compensation is structured. For a partner in the 37% bracket, the 20% deduction on a distributive share can be worth tens of thousands of dollars a year compared with the same amount taken as a guaranteed payment. Fixed compensation buys certainty; it also costs the deduction.