1954 treatment of guaranteed payments as different from a distributive share of partnership income provided the relatively narrow clarification that such payments are includable in the partner's income (not treated as a return of capital). The rules for guaranteed payments provide that a partner receiving a guaranteed payment is treated as a third party (rather than as a partner), but only for purposes of income inclusion by the partner (sec. 61) and deduction of the payment by the partnership (sec. 162(a), subject to capitalization requirements of section 263).397 The partnership deducts guaranteed payments in determining partnership income. Present law provides a specific rule that matches the timing of inclusion of guaranteed payments and the deduction of such payments by the partnership. The timing rule is that guaranteed payments are included in gross income in the taxable year of the partner that ends within, or ends at the same time as, the taxable year of the partnership in which the partnership deducts the A partner who engages in a transaction with a partnership, other than in its capacity as a partner, is treated as if it was not a member of the partnership with respect to the transaction. This rule applies both to performance of services for a partnership by a partner, and transfers (including indirect transfers) of property between the partnership and the partner. Thus, the partnership and the partner are treated in the same manner as if the transaction were between the partnership and a third party. 399 The partnership is allowed a deduction with respect to a nonpartner payment in accordance with its method of accounting (provided capitalization rules do not apply); the partnership may deduct such a payment to a cash-basis partner no earlier than the day that the amount is includible in the partner's income.400 The partner includes the payment in income in accordance with its own method of accounting (provided exclusion rules do not apply). For example, a cash method partner generally includes the payment upon receipt; an accrual method partner generally includes the amount when the right to the payment accrues. These timing rules differ from the timing rule for inclusion and deduction of guaranteed payments. accomplish this narrow purpose, as redefined by the Senate, and was expanded to include payments for the use of capital." McKee, Nelson & Whitmire, Federal Taxation of Partnerships and Partners, 13-40, 3d ed. 2004. Reasons for Change The statutory distinction between guaranteed payments and nonpartner payments may have little continuing purpose. Eliminating the distinction between the two sets of rules would conform the income and deduction timing rules applicable to all payments to partners that are not based on partnership net income to the more generally applicable timing rules applicable to other taxpayers, and would eliminate opportunities for manipulation of the tax rules and provide simplification benefits. Description of Proposal Under the proposal, all compensation for services or use of capital that is not based on the net income (or an item of net income) of the partnership is treated as arising from a transaction between a partnership and a nonpartner. Under the proposal, the income and deduction timing rule for guaranteed payments is repealed and such payments are subject to the income and deduction timing rules for nonpartner payments. In determining whether an amount is a nonpartner payment, the proposal applies a standard of whether the amount is determined by reference to net income (or an item of net income) of the partnership, in lieu of the present-law standard of whether the partner is acting in its capacity as a partner. Thus, the proposal clarifies the treatment of all payments made to a partner that are not determined by reference to the net income of the partnership. Effective Date The proposal applies to taxable years beginning after the date of enactment. Discussion The present-law rules relating to guaranteed payments and nonpartner payments give rise to confusion, uncertainty and needless complexity in several respects. The treatment of guaranteed payments as nonpartner payments only for income inclusion and deduction purposes, but not for other tax purposes, has given rise to conflicting regulatory and judicial interpretations. The difference in the timing rules for deduction and income inclusion with respect to the two types of payments is confusing and may create opportunities for manipulation of the tax law. Further, there is uncertainty as to the scope of the application of the nonpartner payment rules of section 707(a) because it may be unclear whether a partner is acting in its capacity as a partner. Both guaranteed payments for capital, and guaranteed payments for services, have counterparts in the section 707(a) rules for nonpartner payments. Several commentators have questioned the continued viability of a concept of guaranteed payments separate from the concept of payments treated as made to a partner in a nonpartner capacity. 401 401 See, e.g., L. Steinberg, "Fun and Games with Guaranteed Payments," 57 Tax Lawyer 533 (Winter 2004); S. Banoff, "Guaranteed Payments for the Use of Capital: Schizophrenia in Subchapter K," 70 Taxes 820 (1992); P. Postlewaite and D. Cameron, "Twisting Slowly in the Wind: Guaranteed Payments After the Tax Reform Act of 1984," 40 Tax Lawyer 649 (1986). Several commentators have advocated an approach like that of the proposal, stating that the "better approach would be to eliminate section 707(c) totally and provide that any payment to a Eliminating the guaranteed payment rules would eliminate the confusion resulting from third-party status for some purposes and distributive share status for other purposes, as well as the confusion arising from the application of two sets of income and deduction timing rules to payments to partners. Choosing the more generally applicable timing rules applicable to nonpartner payments, rather than the partnership-specific rule for guaranteed payments that is provided under present law, promotes neutrality in the tax law as between comparably situated taxpayers. The proposal would apply to all payments made to a partner that are not determined by reference to the net income of the partnership, rather than requiring a factual inquiry as to whether a partner is acting in its capacity as a partner with respect to the payment. A net income test would in many circumstances require a simpler factual determination than would the present-law test relating to the partner's capacity as a partner. partner, not determined with regard to partnership income, constitutes a section 707(a) payment.” VI. INTERNATIONAL PROVISIONS A. Amend the Employer-Provided Housing Exclusion and Impose a Stacking Rule with Respect to Non-Excludable Income (sec. 911) Present Law In general U.S. citizens generally are subject to U.S. income tax on all their income, whether derived in the United States or elsewhere. A U.S. citizen who earns income in a foreign country also may be taxed on such income by that foreign country. The United States generally cedes the primary right to tax income derived by a U.S. citizen from sources outside the United States to the foreign country where such income is derived. Accordingly, a credit against the U.S. income tax imposed on foreign source income is generally available for foreign taxes paid on that income, to the extent of the U.S. tax otherwise owed on such income. If the foreign income tax rate is lower than the U.S. income tax rate, then the United States generally provides a credit up to the amount of the foreign tax and imposes a residual tax to the extent of the difference. U.S. citizens living abroad may be eligible to exclude from their income for U.S. tax purposes certain foreign earned income and foreign housing costs, in which case no residual U.S. tax is imposed to the extent of such exclusion, regardless of the foreign tax paid on such income (if any). In order to qualify for these exclusions, an individual must be either: (1) a U.S. citizen who is a bona fide resident of a foreign country for an uninterrupted period that includes an entire taxable year;" or (2) a U.S. citizen or resident present overseas for 330 days out of any 12-consecutive-month period. In addition, the individual must have his or her tax home in a foreign country. 402 Exclusion for compensation The foreign earned income exclusion generally applies to income earned from sources outside the United States as compensation for personal services rendered by the taxpayer. The maximum exclusion amount for foreign earned income is $80,000 per taxable year for 2005 and thereafter. For taxable years beginning after 2007, the maximum exclusion amount is indexed for inflation. Exclusion for housing costs The amount of the employer-provided housing exclusion is equal to the excess of the taxpayer's "housing expenses" over a base housing amount. The term "housing expenses" means the reasonable expenses paid or incurred during the taxable year with respect to the 402 Only U.S. citizens may qualify under the bona fide residence test. However, resident aliens of the United States who are citizens of foreign countries that have a treaty with the United States may qualify for section 911 exclusions under the bona fide residence test by application of a nondiscrimination provision. taxpayer's housing in the foreign country. The term includes expenses attributable to housing, such as utilities and insurance, but does not include interest and taxes, which are separately deductible. If the taxpayer maintains a second household outside the United States for a spouse or dependents who do not reside with the taxpayer because of adverse living conditions, then the housing expenses of the second household are also eligible for exclusion. Under present law, the base housing amount is 16 percent of the annual salary earned by a GS-14, Step 1, U.S. government employee. For 2005, this salary is $76,193 and thus the current base housing amount is $12,190. In the case of housing costs that are not paid or reimbursed by the taxpayer's employer, the amount that would be excludible is treated instead as a deduction. Exclusion limitation amounts The combined foreign earned income exclusion and housing cost exclusion may not exceed the taxpayer's total foreign earned income for the taxable year. The taxpayer's foreign tax credit is reduced by the amount of such credit that is attributable to excluded income. Reasons for Change Under present law, an individual working abroad has the potential to exclude significant amounts of housing benefits. The employer-provided housing exclusion is equal to the excess of an individual's housing expenses over a base amount, but substantial amounts above the base may be excluded from income because the exclusion is limited to "reasonable housing expenses," which allows for generous interpretation by the taxpayer. The proposal would establish an objective cap to determine "reasonable housing expenses." The proposal would also tie the employer-provided housing exclusion to the foreign earned income cap to bring the two exclusions into conformity. Under present law, individuals working abroad can also benefit from being subject to low income tax rates on their non-excludible income. The taxable income of section 911 beneficiaries is subject to rates that ordinarily are applicable to taxpayers with substantially less economic income. The proposal would impose a stacking rule that requires individuals with section 911 benefits to stack their taxable income after their section 911 exclusion amounts, thereby subjecting such individuals to the same rates applicable to individuals living and working in the United States who have the same amount of economic income. Description of Proposal Exclusion for compensation The foreign earned income exclusion remains capped at $80,000 per annum, but is indexed for inflation every year instead of only taxable years after 2007. Exclusion for housing costs The employer-provided housing exclusion is modified by tying it to the foreign earned income cap and applying an objective standard to the term "reasonable housing expenses." |