*Associate Director, Tax Program, and Senior Lecturer, Northwestern

University School of Law.

**Professor of Law and Director, Tax Program, Northwestern University

School of Law. The authors would like to thank Allison Christians, Charlotte Crane,

Andrea Monroe, and Adam Rosenzweig for reviewing earlier drafts of this article.

339

FLORIDA TAX REVIEW
VOLUME 7 2006 NUMBER 6

THE LAZARUS EFFECT:  A COMMENTARY ON IN-KIND 

GUARANTEED PAYMENTS

by

David L. Cameron*

Philip F. Postlewaite**

When he had said this, he cried with a loud voice, “Lazarus,

come out!” The dead man came out, his hands and feet

bound with strips of cloth, and his face wrapped in a cloth.

Jesus said to them, “Unbind him, and let him go.” 

– John 11:43-44 

I.     INTRODUCTION . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 340

II.    SECTION  707(C) – TWISTING SLOWLY IN THE WIND . . . . . . . . . . . . .  345

III.  NON-LIQUIDATING GUARANTEED  PAYMENTS MADE IN-KIND . . . . .  351

A. Central Thesis of Kahn and Cuenin’s Article . . . . . . . . . . . . . . 351

B. The Non-Partnership Setting .. . . . . . . . . . . . . . . . . . . . . . . . . . . 356

C. Non-Recognition of Gain or Loss by the Partnership . . . . . . . . 359

D. Basis of Property Received as a Guaranteed Payment . . . . . . . 373

E. Effect on Outside Basis of Guaranteed Payments . . . . . . . . . . . 380

F. Kahn and Cuenin’s Erroneous Application of the 

     Modified Aggregate Approach . . . . . . . . . . . . . . . . . . . . . . . . . . 381

G. The Application of Section 707(a)(2) .. . . . . . . . . . . . . . . . . . . . 393

IV.  LIQUIDATING DISTRIBUTIONS .. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 395

A. Application of Section 736 to Liquidating Distributions . . . . . 397

B. In-Kind Guaranteed Payments under Section 736(a) . . . . . . . . 399

V.    CONCLUSION .. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 407



340 Florida Tax Review [V0l.7:6

1. IRC § 707. All references herein are to the Internal Revenue Code of 1986,

as amended.

2. Philip F. Postlewaite & David L. Cameron, “Twisting Slowly in the Wind:

Guaranteed Payments After the Tax Reform Act of 1984,” 40 Tax Law. 649 (1987).

I. INTRODUCTION 

Section 707 of the Internal Revenue Code contains a number of

provisions that control the tax implications of transactions involving a

partnership and its partners.  In particular, section 707(a) provides that a1

transaction between a partnership and a partner, in which the partner is not

acting in his capacity as a partner, is to be treated as a transaction with a third

party. Alternatively, section 707(c) provides that a transaction between a

partnership and a partner, in which the partner is acting in his capacity as a

partner, is also to be treated as a transaction with a third party but only for

certain limited purposes and only if the payment to the partner is not

determined with regard to the income of the partnership. Payments satisfying

the requirements of section 707(c) are referred to as guaranteed payments. 

Almost 20 years ago, in response to various congressional

enactments and amendments, we authored a eulogy proposing the repeal of

section 707(c).  Although we may have been somewhat premature in laying2

to rest the concept of guaranteed payments as no longer possessing purpose

or use in Subchapter K, at a minimum we viewed section 707(c) as “twisting

slowly in the wind.” 

Like many tax academics who offer their modest contributions to

society at large and hope that somewhere in the tax-making machinery their

constructive suggestions will be seized upon to effectuate meaningful

change, we hoped that our proposed repeal of section 707(c) would actually

find its way into the tax law. Regularly, albeit privately, we lamented the

continuation of section 707(c), wondering why our call for its repeal had not

been fully embraced by those charged with the effectuation of meaningful

tax policy. We were particularly hopeful and watchful for such a change

when many in both the academic and political communities were actively



2006] The Lazarus Effect 341

3. See, e.g., Staff of the Joint Comm. on Tax’n, “Study of the Overall State of

the Federal Tax System and Recommendations for Simplification, Pursuant to

§ 8022(3)(B) of the Internal Revenue Code of 1986” (JCS-3-01, Apr. 2001); Samuel A.

Donaldson, “The Easy Case Against Tax Simplification,” 22 Va. Tax Rev. 645 (2003);

Samuel Diamon, “Simplification of the Internal Revenue Code,” 95 Tax Notes 575

(2002); Pamela Olson, “Thoughts on the Impact of Tax Complexity on Small

Businesses,” 88 Tax Notes 1531 (2000); Joseph A. Snoe, “Tax Simplification and

Fairness: Four Proposals for Fundamental Tax Reform,” 60 Albany L. Rev. 61 (1996);

Pamela J. Pecarich & Siobhan C. Rausch, “Tax Simplification Versus the Legislative

Process,” 133 Trusts & Estates 24 (Mar. 1994); Michael A. Andrews, “Tax

Simplification,” 47 SMU L. Rev. 37 (1993); Edward J. McCaffery, “The Holy Grail of

Tax Simplification,” 1990 Wisc. L. Rev. 1267; Charles E. McLure Jr., “The Budget

Process and Tax Simplification/Complication,” 45 Tax L. Rev. 25 (1989). 

4. Staff of the Joint Comm. on Tax’n, “Options to Improve Tax Compliance

and Reform Tax Expenditures” 170-73 (JCS-02-05, Jan. 27, 2005). The text of the

Report was in excess of 400 pages and offered over 65 proposals through which to

improve the tax law. See also Staff of the Joint Comm. on Tax’n, “Review of Selected

Entity Classification and Partnership Tax Issues,” 45-47 (JCS-6-97, Apr. 8, 1997)

(proposing to modify the treatment of guaranteed payments and noting prior

recommendations, including ours, for the repeal of § 707(c)).

5. “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 non-partner capacity.” Staff of the Joint Comm. on Tax’n, “Options to

Improve Tax Compliance and Reform Tax Expenditures,” supra note 4, at 172, n.401

(citing, inter alia, P. Postlewaite and D. Cameron, “Twisting Slowly in the Wind:

Guaranteed Payments After the Tax Reform Act of 1984,” 40 Tax Law. 649 (1986)).

Later, the Report stated: Several commentators have advocated an approach like that of

the proposal, stating that the ‘better approach would be to eliminate ' 707(c) totally and

provide that any payment to a partner, not determined with regard to partnership

income, constitutes a § 707(a) payment.’” Id. (citing P. Postlewaite & J. Pennell, “JCT’s

Partnership Tax Proposals – ‘Houston, We Have a Problem’,” 76 Tax Notes 527

(1997)).

calling for simplification of the Code.  The repeal of a Code provision is, by3

definition, the ultimate act of simplification. 

Against this backdrop of anticipation, one can easily imagine our

excitement when, in January of 2005, the Joint Committee on Taxation

proposed the repeal of section 707(c) in response to a Congressional request

for a periodic report from the Committee recommending improvements to

the tax law.  Not only might the reform we advocated 20 years earlier finally4

see the light of day, but the narrative accompanying the proposal and

explaining the reasons for the repeal of section 707(c) discussed and cited

with approval our earlier article.5

We quickly characterized ourselves as visionaries, men ahead of

their time, who fortunately had lived sufficiently long to see the fruits of

their labor actively embraced by the tax-making machinery. However, while

celebrating this public (foot)note of recognition, we uncovered a recently



342 Florida Tax Review [V0l.7:6

6. Douglas A. Kahn & Faith Cuenin, “Guaranteed Payments Made In Kind by

a Partnership,” 6 Fla. Tax Rev. 405 (2004).

7. John 11:1-44 (New Revised Standard). It has become quite fashionable in

the tax academy to invoke biblical references in scholarly articles. See, e.g., Martin J.

McMahon, Jr., “The Matthew Effect and Federal Taxation,” XLV B.C. L. Rev. 993

(2004) (referring to the “Matthew Effect” as based on the verse from Matthew 25:29

(“For to all those who have, more will be given, and they will have an abundance; but

from those who have nothing, even what they have will be taken away.” (New Revised

Standard)), which is synonymous with the colloquialism “the rich get richer and the

poor get poorer,” and decrying the failure of the federal tax system to address the

Matthew Effect); Deborah H. Schenk, “The Luke Effect and Federal Taxation: A

Commentary on McMahon’s The Matthew Effect and Federal Taxation,” XLV B.C. L.

Rev. 1129 (2004) (referring to the “Luke Effect” as based on the verses from Luke

18:22-25 (“How hard it is for those who have wealth to enter the kingdom of God!

Indeed, it is easier for a camel to go through the eye of a needle than for someone who

is rich to enter the kingdom of God.” (New Revised Standard)), which may be

paraphrased as “the rich love their money and will not give it up easily,” and concluding

that significantly greater progressivity of tax rates will not effectively reduce the

Matthew Effect). Any trend in the use of Biblical references in the tax literature may

reflect the influence of Professor Susan Pace Hamill, whose work directly relies upon

the Biblical text of both the New and Old Testaments in assessing the appropriateness

of certain tax policies. See Susan Pace Hamill, “An Evaluation of Federal Tax Policy

Based on Judeo-Christian Ethics,” 25 Va. Tax Rev. 671-764 (2006); Susan Pace Hamill,

“An Argument for Tax Reform Based on Judeo-Christian Ethics,” 54 Ala. L. Rev. 1

(2002). See also Adam Chodorow, “Tax Reform: What Would God Do?,” 108 Tax

Notes 1167 (2005) (noting that an income tax may be more consistent with Biblical text

than a consumption tax).

8. The character of Lazarus referred to herein is not to be confused with the

Lazarus appearing in the story of a rich man and a beggar named Lazarus, in which the

rich man finds himself cast into hell following his death while Lazarus is carried by

angels to be with Abraham. Luke 16:19-31 (New Revised Standard). Seeing Lazarus on

the other side of the chasm, the rich man asks Abraham to “have mercy on me, and send

Lazarus to dip the tip of his finger in water and cool my tongue; for I am in agony in

these flames.” Abraham reminds the rich man that because he received good things

during his lifetime while Lazarus received only evil things, Lazarus is comforted after

death. The rich man then asks that Lazarus be sent to warn his five brothers so that they

will not suffer like him after death. Abraham responds that, if the brothers have not

published article in this journal by Douglas Kahn and Faith Cuenin regarding

the treatment of in-kind guaranteed payments.  Because of the article’s6

provocative and thorough analysis, we feared that Kahn and Cuenin’s efforts

might be viewed as breathing new life into section 707(c), not dissimilar

from the return of Lazarus from the dead. 

Lazarus was a Biblical figure appearing in the Gospel of John,

which, like the Gospels of Matthew, Mark, and Luke, can be found in the

New Testament.  Lazarus, who was brought back from the dead by Christ,7

presages the most important event of the New Testament, the resurrection of

Christ following his crucifixion.  Thus, the character of Lazarus now serves8



2006] The Lazarus Effect 343

heeded the warnings of Moses and the prophets, they would not repent even if warned

by someone who is raised from the dead, alluding to Christ and his resurrection.

Although the Biblical tale of the rich man and Lazarus is obviously ripe for application

to the tax law, we leave any direct analogies to a future commentator.

9. See, e.g., Davis Bunn, The Lazarus Trap (2005); Rashid Darden, Lazarus

(2005); Joanna Brooks, America Lazarus: Religion and the Rise of African-American

and Native American Literatures (2003); David Sherman & Dan Cragg, Lazarus Rising

(2003); Carl Marcum, Cue Lazarus (2001); John Bayer, The Lazarus Project (1999);

Robert Mawson, The Lazarus Child (1998); Jo Bannister, The Lazarus Hotel (1997);

The Lazarus Man (directed by Johnny E. Jensen, 1996); Robert Pensak, Raising Lazarus

(1994); The X-Files: Lazarus (directed by David Nutter, 1994); Samuel Brassfield, The

Lazarus Generation: How to Raise the Spiritually Dead (1993); Robert Richardson, The

Lazarus Tree (1992); Morris West, Lazarus (1990); Franklin W. Dixon, The Lazarus

Plot (1987); Sting, “The Lazarus Heart,” in Nothing Like the Sun (1987); Frank Herbert

& Bill Ransom, The Lazarus Effect (1983); John Lutz, Lazarus Man (1979); Andre

Malraux, Lazarus (1977); Sylvia Plath, “Lady Lazarus,” in The Collected Poems (1962);

and Leonid Andreyev, Lazarus (1918).

10. Regretfully, our position on this issue places us in the role of the chief

priests who, following Lazarus’ return from the dead, planned the death not only of

Jesus but of Lazarus as well, “since it was on account of him that many of the Jews were

deserting and were believing in Jesus.” John 12:10-11 (New Revised Standard).

11.  Arthur B. Willis, John S. Pennell, & Philip F. Postlewaite, Partnership

Taxation (6th ed. 2002).

12. See Kahn & Cuenin, supra note 6, at 407.

in both high and popular culture as the emblem for any person or idea that

once dead, or thought dead, is miraculously returned to life.9

The fact that our recommendation concerning the repeal of section

707(c) has belatedly received the support it deserves by definition ensures

that we will oppose any interpretation of section 707(c) that may delay its

interment. An acceptance of Kahn and Cuenin’s thesis concerning section

707(c) would also undercut our previously articulated position that no

meaningful distinction exists between the operation of sections 707(a) and

707(c). Over and above the potential damage to our crusade for the repeal of

section 707(c) that may result if Kahn and Cuenin’s thesis is left

unchallenged, we believe that their conclusions regarding the application of

section 707(c) are, by themselves, incompatible with sound tax policy.10

However, this commentary is compelled by more than our goal of

ensuring that section 707(c) and the concept of guaranteed payments soon

become a distant and fading recollection of the tax bar. It is also driven by

the confusion caused by the discussion, or the limitations of the discussion,

of guaranteed payments in our treatise on partnership taxation.  Kahn and11

Cuenin detected both a lack of clarity and, at times, a lack of coverage on

this topic, an observation that has been most instructive.  Consequently, we12



344 Florida Tax Review [V0l.7:6

13. Authors of treatises regularly fear the discovery of inaccurate or incomplete

coverage of the topics they address. As one of us is about to begin a rolling revision of

the Sixth Edition of Partnership Taxation, Kahn and Cuenin’s provocative article has

alerted him to a need to clarify his views on the tax treatment of in-kind guaranteed

payments. Thus, the thoughts herein will soon find their way into the Seventh Edition

of Partnership Taxation to be completed in 2009.

14. See infra text accompanying notes 21-40.

will utilize this commentary as an initial forum in which to eliminate this

defect.13

In their article, Kahn and Cuenin conclude that the transfer of

property by a partnership to a partner as a guaranteed payment does not

result in gain or loss recognition by the partnership. This surprising result

conflicts with the generally held interpretation of section 707(c) as adopting

the entity theory of partnerships with respect to guaranteed payments.

Although their conclusion in this regard is consistent with the aggregate

theory of partnerships, they also conclude that the recipient partner takes a

fair market value basis in the transferred property rather than a carryover

basis from the partnership. Curiously, this conclusion is consistent with the

entity theory of partnerships rather than the aggregate theory of partnerships.

Finally, they conclude that the recipient partner’s basis in his partnership

interest is reduced by the partner’s share of the deduction generated by the

guaranteed payment but is not otherwise affected by the transfer of the

property. This conclusion is also consistent with the entity theory of

partnerships rather than the aggregate theory of partnerships. Thus, their

analysis results in an odd combination of both the aggregate and entity

theories of partnerships in connection with the tax treatment of a single

transaction, in this case a transaction involving an in-kind guaranteed

payment. 

Our analysis will demonstrate that a consistent application of the

entity theory of partnerships best implements the policy objectives of

Subchapter K with respect to the treatment of in-kind guaranteed payments.

As a result, our ultimate conclusions differ from Kahn and Cuenin’s only

with respect to the question of gain or loss recognition by the transferring

partnership. However, in reaching this conclusion, we undertake a more

searching analysis of the statutory language, legislative history, and judicial

interpretation of section 707 as well as a more careful application of the

governing law to a number of hypothetical situations that Kahn and Cuenin

posed in their article. 

This commentary proceeds as follows. Part II provides a summary of

the history and evolution of section 707 that we detailed in our previous

article.  In particular, we reiterate the fact that the enactment of section14

707(a)(2) in 1984 fundamentally changed the interpretation of section 707

and effectively repealed section 707(c). Part III then considers the question

of in-kind guaranteed payments, focusing first on Kahn and Cuenin’s central



2006] The Lazarus Effect 345

15. See infra text accompanying notes 41-68.

16. See infra text accompanying notes 69-110.

17. See infra text accompanying notes 111-31.

18. See infra text accompanying notes 132-37. This portion of the article is

followed by a detailed examination of Kahn and Cuenin’s incomplete analysis that

resulted in their questionable conclusion that a partnership should not recognize gain or

loss on the transfer of an in-kind guaranteed payment.  See infra text accompanying

notes 138-55.

19. See infra text accompanying notes 156-62.

20. See infra text accompanying notes 163-91.

21. IRC § 707(a).

thesis  and then considering the three questions that in-kind guaranteed15

payments explicitly raise: (1) the recognition of gain or loss by the

transferring partnership,  (2) the basis of the transferred property in the16

hands of the recipient partner,  and (3) the effect of the transfer on the17

recipient partner’s basis in his partnership interest.  Although we18

acknowledge that, in the absence of section 707(a)(2), our conclusions are

not entirely free from doubt, we believe that the better interpretation of

section 707(c) requires that a partnership recognize gain or loss on the

transfer of property in satisfaction of a guaranteed payment. After bringing

the changes wrought by section 707(a)(2) into the analysis, any lingering

doubt in this regard vanishes.  Finally, we consider the treatment of in-kind19

transfers in the liquidation setting that are referred to as guaranteed payments

under section 736 and again conclude that the proper interpretation of

Subchapter K requires that the partnership recognize gain or loss in

connection with any such transfers.20

II. SECTION 707(C) – TWISTING SLOWLY IN THE WIND

In 1954, Congress enacted sections 707(a) and 707(c). While both

provisions ensured third-party treatment for payments between a partnership

and its partners, Congress intended that some differences, as reflected in the

statutory language, would exist between the tax treatment of transfers under

the two subsections. As originally enacted, section 707(a) provided as

follows: 

If a partner engages in a transaction with a partnership other

than in his capacity as a member of such partnership, the

transaction shall, except as otherwise provided in this

section, be considered as occurring between the partnership

and one who is not a partner.21



346 Florida Tax Review [V0l.7:6

22. IRC ' 707(c). As discussed below, for clarity purposes, Congress

subsequently added a requirement to ensure that payments under § 707(c) were subject

to the capitalization rules of § 263 as well.

23. Although § 707(c) makes no explicit reference to the capacity in which the

partner is acting, the legislative history and the Regulations indicate that § 707(a) is the

controlling provision for transactions in which the partner is acting in the capacity of a

non-partner, leaving § 707(c) to govern transactions in which the partner is acting in the

capacity of a partner and the payments are determined without regard to the income of

the partnership. Postlewaite & Cameron, supra note 2, at 676-77.

24. For a more expansive discussion of this issue, see Postlewaite & Cameron,

supra note 2, at 665-66.

Notwithstanding a similar focus, section 707(c) was somewhat more narrow

in its statutory command as its breadth was circumscribed by the following

language: 

To the extent determined without regard to the income of the

partnership, payments to a partner for services or the use of

capital shall be considered as made to one who is not a

member of the partnership, but only for the purposes of

section 61(a) (relating to gross income) and for purposes of

section 162(a) (relating to trade or business expenses).  22

Based on the language of these provisions, section 707(a) governed

payments to a partner for activities not connected to those required by his

partner status, while section 707(c) controlled if the activities were connected

to his partner status.  The mutual exclusivity of the two subsections ensures23

that a payment can not simultaneously fall into both categories.

Given the differing statutory language and the explanations of each

type of payment in the legislative history, differences in the tax treatment of

payments under sections 707(a) and 707(c) initially existed. However, over

the ensuing 30 years, Congress eroded the most significant differences

between the two subsections. 

The first such change occurred with respect to the capitalization

requirements applicable to payments under sections 707(a) and 707(c).24

Following the enactment of section 707, it was generally accepted that

section 707(a) payments were subject to the capitalization rules of section

263. However, the limited reference in section 707(c) to sections 61(a) and

162(a) emboldened some practitioners to suggest that guaranteed payments

were not subject to the capitalization requirements of the Code. Once this

issue was identified, the Service and the courts did not hesitate to expand the

number of sections beyond those to which guaranteed payments are



2006] The Lazarus Effect 347

25. Cagle v. Comm’r, 63 T.C. 86 (1974), aff’d, 539 F.2d 409 (5th Cir. 1976);

Rev. Rul. 75-214, 1975-1 C.B. 185.

The courts also confronted the question of whether the reference to § 61(a) in

§ 707(c) incorporated other provisions of the Code pertaining to exclusions from gross

income as well. In Carey v. United States, 427 F.2d 763 (Ct. Cl. 1970), the court

concluded that guaranteed payments in the form of salary received by a partner for

services performed abroad were excludable from the partner’s gross income under

§ 911. The court reasoned that § 707(c)’s reference to § 61(a) included the phrase

“[e]xcept as otherwise provided in this subtitle.” The court rejected the argument that

the guaranteed payments represented a portion of the partner’s distributive share of

partnership income for purposes of § 911. See Miller v. Comm’r, 52 T.C. 752 (1969),

acq. (interpreting § 707(c) in the same manner as as the court in Carey). Similarly, in

Armstrong v. Phinney, 394 F.2d 661 (5th Cir. 1968), the court stated that, if the benefits

involved in that case were found to be guaranteed payments, they would be excludable

from the gross income of the recipient partner under § 119 as a result of § 707(c)’s

reference to § 61(a). But see Rev. Rul. 91-26, 1991-1 C.B. 184 (accident and health

insurance premiums paid by a partnership on behalf of its partners are includable in the

partners’ gross incomes because the premiums are treated as a distributive share of

partnership income under § 707(c)); G.C.M. 34173 (arguing that a partner cannot be

treated as an employee of the partnership even if the partner is treated as “one who is

not a partner” under § 707(a) or “one who is not a member of the partnership” under

§ 707(c)). Accord Rev. Rul. 69-184, 1969-1 C.B. 256 (bona fide members of a

partnership are not employees of the partnership for purposes of FICA, FUTA, and

income tax withholding).

26. Tax Reform Act of 1976, Pub. L. No. 94-455, § 213(b)(3), 90 Stat. 1520,

1547 (1976). Following this amendment, § 707(c) read as follows: 

To the extent determined without regard to the income of the

partnership, payments to a partner for services or the use of capital

shall be considered as made to one who is not a member of the

partnership, but only for the purposes of section 61(a) (relating to

gross income) and, subject to section 263, for purposes of section

162(a) (relating to trade or business expenses).

 

Interestingly, the original House bill regarding this amendment made it applicable to all

taxable years to which the 1954 Code applied on the rationale that the provision merely

declared and clarified existing law. H.R. 10612, 94th Cong.  § 210(e) (1975); H.R. Rep.

No. 94-658, at 122 (1975), reprinted in 1976 U.S.C.C.A.N. 2897, 3017.

27. IRC § 706(a); Regs. § 1.707-1(c). For a more expansive discussion of this

issue, see Postlewaite & Cameron, supra note 2, at 668-73.

explicitly subject under the language of section 707(c).  Congress25

subsequently put the capitalization question to rest with an amendment

specifically subjecting guaranteed payments to the rules of section 263.26

Regarding timing issues, section 706(a) and the Regulations for

guaranteed payments mandated a matching of income inclusion by the

recipient of the guaranteed payment with the deductibility of the payment to

the partnership.  If the partnership were on a different accounting method27



348 Florida Tax Review [V0l.7:6

28. IRC §§ 267(a)(2) and 267(e). Section 267(e) specifically excludes

guaranteed payments from the requirements of § 267(a)(2). IRC § 267(e)(4). Section

267(e) was enacted as part of the Tax Reform Act of 1984, Pub. L. No. 98-369,

§ 174(a)(2), 98 Stat. 494, 705-06 (1984).

29. Matching in the timing of the income inclusion by the partner and the

expense deduction by the partnership is not required under § 267(a)(2) in connection

with a transaction under § 707(a) if the partnership is on the cash method and the payee

is on the accrual method, the services are rendered in Year 1, and the payment is not

made until Year 2. Such a situation is not considered abusive because the income, and

not the deduction, is accelerated as a result of the accounting methods of the parties

involved.

30. In 2001, the Joint Committee on Taxation recommended conformity of the

timing rules applicable to guaranteed payments and to transactions between a

partnership and a partner not acting in the capacity of a partner. 2 Joint Comm. on

Tax’n, “Study of the Overall State of the Federal Tax System and Recommendations for

Simplification, Pursuant to § 8022(3)(B) of the Internal Revenue Code of 1986,” 291-94

(JCS-3-01, Apr. 2001). The Joint Committee recommended that the timing of the

income inclusion by the partner be based on the partnership’s time of deduction. The

Joint Committee also considered the repeal of § 707(c) but refused to recommend such

a proposal on the grounds that it would create complexity by eliminating the existing

certainty surrounding the treatment of guaranteed payments and because such a proposal

was unnecessarily broad in curing the inconsistent timing rules applicable to payments

under §§ 707(a) and 707(c). 

than the partner (accrual versus cash or vice versa), the accounting method of

the partnership controlled the year of the income inclusion to the partner.

Thus, a cash method partner could experience an acceleration of income

without receipt of payment if the partnership were an accrual method

partnership and the partner was on the cash method of accounting.

However, section 707(a) payments were not subject to such

matching. A partnership on the accrual method of accounting could deduct

the payment before its payment and inclusion by a service-performing,

cash-method partner. Again such differences and their exploitation

precipitated a Congressional response which subjected most section 707(a)

payments to the matching requirements of section 267, which further

minimized the distinctions between sections 707(a) and 707(c).   Although28

the timing of payments under section 707(a) was controlled by the

accounting method of the recipient partner while the timing of payments

under section 707(c) was controlled by the accounting method of the

partnership, a matching of income inclusion by the partner and expense

deduction by the partnership generally resulted.  Thus, much of the29

difference in the tax treatment between the two types of payments was

rapidly eroding.30

In 1984, Congress dealt the final blow to what little remained of the

vitality and independence of section 707(c) through its enactment of section



2006] The Lazarus Effect 349

31. Tax Reform Act of 1984, Pub. L. No. 98-369, § 73(a), 98 Stat. 494, 591

(1984).

32. For a more expansive discussion of this issue, see Postlewaite & Cameron,

supra note 2, at 676-94.

33. See, e.g., Pratt v. Comm’r, 64 T.C. 203 (1975), aff’d in part and rev’d in

part, 550 F.2d 1023 (5th Cir. 1977); Rev. Rul. 81-300, 1981-2 C.B. 143; Rev. Rul.

81-301, 1981-2 C.B. 144.

34. 1981-2 C.B. 143.

35. In this regard, Revenue Ruling 81-300 rejected the position of the Tax

Court in Pratt v. Comm’r, 64 T.C. 203 (1975), aff’d in part and rev’d in part, 550 F.2d

1023 (5th Cir. 1977), concluding that payments determined with respect to gross rentals

of the partnership were determined with regard to the income of the partnership and,

thus, excluded from treatment under § 707(c).

36. S. Rep. No. 98-169, at 227 (1984). See also Staff of the Joint Comm. on

Tax’n, General Explanation of H.R. 4170, 227-28 (1984). In issuing Regulations under

§ 707(a)(2) following its enactment in 1984, the Service did not address the treatment

of services but reserved Regulation § 1.707-2 for future coverage of the issue.

707(a)(2).  The legislative history behind the enactment suggested that the31

capacity distinction between sections 707(a) and 707(c) warranted a new

focus on entrepreneurial risk, as to both fact and amount of payment, from

the perspective of the recipient partner.32

Historically, capacity was determined by focusing on the nature of

the services rendered by the partner in relation to the activities of the

partnership.  For example, in Revenue Ruling 81-300,  the general partners33 34

of a limited partnership contributed time and effort through the rendition of

managerial activities on behalf of the partnership in return for a fee equal to

5% of the gross rentals of the partnership. The Service reasoned that, because

the partners rendered the managerial activities in their capacity as partners,

section 707(a) was inapplicable to the transaction. In addition, the Service

concluded that a fee dependent on the gross rentals of the partnership was

“determined without regard to the income of the partnership.”  Thus, the35

Service treated the fee as a guaranteed payment under section 707(c).

As part of the Tax Reform Act of 1984, Congress enacted section

707(a)(2) which requires third-party treatment for any partner who renders

services or transfers property to a partnership and who thereafter receives a

related direct or indirect allocation of partnership income and a distribution

of partnership property if such transfers are “properly characterized as a

transaction occurring between the partnership and a partner acting other than

in his capacity as a member of the partnership.” In making this

determination, the legislative history focused on the entrepreneurial risk to

which the partner is exposed with respect to the amount of any related

distribution and whether the distribution will, in fact, be made.36

As part of its discussion of section 707(a)(2)(A) in the legislative

history, Congress referenced Revenue Ruling 81-300 and stated that the

transaction described therein should be governed by section 707(a), rather



350 Florida Tax Review [V0l.7:6

37. S. Rep. No. 98-169, at 230 (1984). See also Staff of the Joint Comm. on

Tax’n, General Explanation of H.R. 4170, 230-31 (1984). 

38. Most casebook authors and other academic commentators have not rushed

to acknowledge that the enactment of § 707(a)(2) dramatically affected the capacity

analysis applicable to guaranteed payments. Instead, they largely limit any discussion

of § 707(a)(2) to the issue of distinguishing payments under § 707(a)(1) from a partner’s

distributive share of partnership income and a distribution of partnership property and

continue to cite the law as it existed prior to 1984, including the Pratt decision, when

considering the capacity question in the context of guaranteed payments. See, e.g.,

Stephen A. Lind, Stephen Schwartz, Daniel J. Lathrope & Joshua D. Rosenberg,

Fundamentals of Partnership Taxation: Cases and Materials 222-42 (7th ed., 2005);

Glenn C. Coven, Robert J. Peroni & Richard C. Pugh, Taxation of Business Enterprises:

Cases and Materials 973-90 (2d ed., 2002); Laura E. Cunningham & Noel B.

Cunningham, The Logic of Subchapter K: A Conceptual Guide to the Taxation of

Partnerships 120-21 (2d ed., 2000); Jerold A. Friedland, Understanding Partnership and

LLC Taxation § 7.02 (2000). But see Alan Gunn & James R. Repetti, Partnership

Income Taxation 124-25 (4th ed., 2005) (acknowledging the difficulty of applying the

capacity analysis under § 707(a)(2) to the problem of distinguishing a guaranteed

payment from a § 707(a) payment); Karen C. Burke, Federal Income Taxation of

Partners and Partnerships 234-35 and 243 (3d ed., 2005) (acknowledging the capacity

analysis introduced by § 707(a)(2) and noting that “[s]ince § 707(c) payments are by

definition fixed, all such payments might plausibly be treated as § 707(a) payments”).

See also 4 Boris I. Bittker & Lawrence Lokken, Federal Taxation of Income, Estates &

Gifts ¶ 89.1.3 (3d ed., 2003) (noting that the distinction drawn in the Pratt decision

between activities within and without the scope of the partnership to resolve the

capacity question was effectively eliminated by the enactment of § 707(a)(2)(A)).

39. Nevertheless, the Regulations under § 707 do recognize a continuing role

for guaranteed payments following the enactment of § 707(a)(2). Thereunder, a payment

for the use of capital that is characterized by the parties as a guaranteed payment and is

reasonable (as defined therein) is presumed to be a guaranteed payment for capital and

not part of a sale of property for purposes of § 707(a)(2)(B). Regs. § 1.707-4(a)(1). The

Regulations make no mention of the revised capacity analysis introduced by § 707(a)(2)

to determine if such payments properly fall within § 707(c) as subject to the

entrepreneurial risks of the partnership and, thus, paid to the partner in his capacity as

than section 707(c).  The only apparent explanation for this statement is that37

the new concept of capacity reflected in section 707(a)(2) focusing on

economic risk should apply in the context of section 707(c) as well.  38

With this dramatic alteration in the determination of capacity, the

distinction between a section 707(a) payment and a section 707(c) payment

virtually disappeared because most transactions designed to compensate a

partner/service-provider or partner/capital-provider lack risk as to both the

fact and the amount of payment. Consequently, most, if not all, payments

previously falling under section 707(c) now fall under section 707(a). It is a

rare setting in which a payment could meet the textual requirements of

section 707(c) and yet possess entrepreneurial risk as to the fact and the

amount of payment.  As described above, this change was not all that39



2006] The Lazarus Effect 351

a partner. Nevertheless, the Regulations apply a facts and circumstances inquiry to

determine if the payment should properly be treated as part of a sale of property.

Compare Regs. § 1.707-4(a)(4), example (1) (in which a payment is treated as a

guaranteed payment for capital) and example (2) (in which the presumption that a

payment is a guaranteed payment for capital is rebutted). Although this portion of the

Regulations is seemingly inconsistent with the proper application of the capacity

analysis following the enactment of § 707(a)(2), such payments do not raise the

complications associated with in-kind guaranteed payments that are at issue herein

because they are expressly limited to transfers of money. Regs. § 1.707-4(a)(1)(ii).

Thus, their treatment under § 707(c), rather than § 707(a), is virtually meaningless. 

40. Postlewaite & Cameron, supra note 2, at 694-96.

41. Kahn & Cuenin, supra note 6, at 408-10. Kahn and Cuenin also provide the

reader with a review of the tax treatment for both the partnership and the recipient

partner of liquidating and non-liquidating distributions of partnership property. Id. at

411-14.

remarkable because the distinctions between the two subsections had been

previously eroded.

Given these developments, we, almost 20 years ago, called into

question the continuation of section 707(c).  The erosion of any distinctions40

between the subsections as a result of legislative changes by Congress

between 1954 and 1984 had effectively eliminated any differences in the tax

treatment for payments classified as payments under section 707(a) and those

classified as guaranteed payments under section 707(c). Furthermore, the

revised capacity analysis introduced through the enactment of section

707(a)(2) made section 707(c) inapplicable to the typical types of payments

that it previously covered. Section 707(c) had been effectively repealed and

all that remained was statutory surplusage prone to produce confusion and

complexity. Accordingly, we advocated that the slow death of the concept of

guaranteed payments be hastened by the outright repeal of section 707(c).

III. NON-LIQUIDATING GUARANTEED PAYMENTS MADE IN-KIND

 

A. Central Thesis of Kahn and Cuenin’s Article

Kahn and Cuenin begin their article with a brief introduction to the

purpose and operation of section 707(c) and the concept of guaranteed

payments.  Kahn and Cuenin embrace the historical emphasis, no longer41

controlling in light of the subsequent legislative enactments previously

described, on an evaluation of the capacity in which a partner is acting in

order to distinguish between payments under sections 707(a) and 707(c).

Thus, their discussion fails to incorporate the profound developments

introduced by the Tax Reform Act of 1984 that resulted from a

Congressional reinterpretation of the capacity test. As a result, they overlook

the central role played by section 707(a)(2) to the questions they consider. 



352 Florida Tax Review [V0l.7:6

42. Kahn & Cuenin, supra note 6, at 406-07. They also cite leading treatises

in the field of partnership taxation as supporting this conclusion. Id. (citing 2 Willis,

Pennell & Postlewaite, supra note 11, at ¶ 15.06 and 1 William S. McKee,William F.

Nelson & Robert L. Whitmire, Federal Taxation of Partnerships and Partners ¶ 13.03[5]

(3d ed., 1997). See also Rev. Rul. 91-26, 1991-1 C.B. 184 (treating accident and health

insurance premiums paid by a partnership on behalf of its partners as a guaranteed

payment and referring to guaranteed payments under § 707(c) as “[a]mounts paid in

cash or in-kind by a partnership”). 

Given Kahn and Cuenin’s subsequently articulated desire to implement the

statutory language of § 707(c) as closely as possible, it is curious that they do not

explore the distinct difference in the statutory language between § 707(c)’s explicit

reference to “payments” to a partner and § 707(a)’s more general reference to

“transactions” between a partner and a partnership. This difference in language, as well

as the acknowledged Congressional failure apparently to consider in-kind guaranteed

payments when enacting § 707 in 1954, may well suggest that § 707(c) was never

intended to apply to in-kind transfers of partnership property. See Armstrong v.

Phinney, 394 F.2d 661 (5th Cir. 1968) (questioning whether in-kind meals and lodging

received by a partner could constitute “payments” for purposes of § 707(c)). Thus,

through close attention to the statutory language and through the adoption of reasonable

assumptions regarding Congressional intent, the problems encountered in considering

the application of § 707(c) to in-kind transfers could easily be avoided.

43. Kahn & Cuenin, supra note 6, at 407 and 417-18.

44. Kahn & Cuenin, supra note 6, at 410 and 423-24. This latter type of

guaranteed payment is illustrated through an example contained in the Regulations.

Regs. § 1.707-1, example (2). Under this example, Partner C provides services to the

partnership and is entitled to receive 30% of partnership income, before taking into

account any guaranteed payments, but not less than $10,000. If the partnership’s income

is $60,000, C will receive a distributive share of partnership income of $18,000 and no

guaranteed payment. However, if the partnership’s income is only $20,000, C will

receive a distributive share of partnership income of only $6,000. Because C is entitled

to receive not less than $10,000, the difference, $4,000, is a guaranteed payment. 

Kahn and Cuenin’s attention to this type of guaranteed payment is curious for

three reasons. First, it is not clear how frequently payments are structured in this

manner. Thus, their importance in determining the proper interpretation of § 707(c) may

be overstated. Second, the Regulations apparently fail to follow the legislative history

While acknowledging that guaranteed payments are traditionally

made in cash, Kahn and Cuenin conclude, given the absence of a statutory or

regulatory prohibition, that such payments can be made in-kind as well.42

Kahn and Cuenin briefly acknowledge the infrequency with which such

payments are made, a recognition which by itself might dictate an

interpretation of the statutory and regulatory framework in such a way as to

minimize aberrational results.  They then move their focus from the typical43

type of guaranteed payment (a payment fixed in amount) to address an

infrequent, atypical type of guaranteed payment (a payment structured as a

percentage of partnership income with a minimum dollar amount) and the tax

issues which present themselves in such a case.44



2006] The Lazarus Effect 353

with respect to such payments. Both the House and Senate Reports regarding § 707 state

that “[a] partner who is guaranteed a minimum annual amount for his services shall be

treated as receiving a salary in that amount.” H.R. Rep. No. 83-1337, at A227 (1954),

reprinted in 1954 U.S.C.C.A.N. 4017, 4367; S. Rep. No. 83-1622, at 387 (1954),

reprinted in 1954 U.S.C.C.A.N. 4621, 5029. We raised this issue in our earlier article

and proposed that the entire minimum amount be considered as a payment to a third

party regardless of the partner’s share of partnership income. See Postlewaite &

Cameron, supra note 2, at 700-02. But see Rev. Rul. 66-95, 1966-1 C.B. 169

(prohibiting a partnership from treating the entire minimum amount of a guaranteed

payment structured as a percentage of partnership income, but not less than a specified

dollar amount, as deductible under § 707(c)). Third, a payment in this form is not

“determined without regard to the income of the partnership” as required by the explicit

language of § 707(c). See Martin B. Cowan, “Compensating the General Partner: The

Pratt Case,” 56 Taxes 10 (1978). As described above, the amount of the guaranteed

payment depends entirely on the income of the partnership. Some of the potential

problems regarding guaranteed payments structured in this manner were noted

immediately following the enactment of § 707(c). See J. Paul Jackson, Mark H.

Johnson, Stanley S. Surrey, Carolyn K. Tenen & William C. Warren, “The Internal

Revenue Code of 1954: Partnerships,” 54 Colum. L. Rev. 1183, 1203 (1954). See also

Rev. Rul. 69-180, 1969-1 C.B. 183 (detailing the treatment of this type of guaranteed

payment when the partnership has both ordinary income and capital gain).

45. Kahn & Cuenin, supra note 6, at 406.

46. Kahn & Cuenin, supra note 6, at 422-27.

47. Kahn & Cuenin, supra note 6, at 407.

48. Kahn & Cuenin, supra note 6, at 428-36.

49. Kahn & Cuenin, supra note 6, at 419-22.

Kahn and Cuenin assert that the “unresolved question” is whether

in-kind guaranteed payments made by the partnership “will cause the

partnership that made the payment to recognize gain or loss if the property is

appreciated or depreciated.”  With respect to this question, they conclude45

that the partnership should recognize neither gain nor loss on the transfer of

an in-kind guaranteed payment, treating such a payment instead as a

distribution of partnership property.  46

Thereafter, Kahn and Cuenin focus on two related but “unresolved

questions . . . (1) how is a partner’s basis in property that was received as a

guaranteed payment to be determined, and (2) . . . what effect does the

payment have on the partner’s outside basis in his partnership interest.”47

Referencing the lack of coverage and clarity in the treatment of the issue in

the leading works on partnership taxation, Kahn and Cuenin conclude, in the

first of their deviations from the statutory language of Subchapter K, that the

service provider/partner receives a fair market value basis in the transferred

property.  Furthermore, and in another deviation from the statutory language48

of Subchapter K, they conclude that a partner’s basis in his partnership

interest is not directly affected by the payment.  They do note that an49

indirect impact on the recipient’s partnership interest occurs because the



354 Florida Tax Review [V0l.7:6

50. IRC § 707(c) (emphasis added). Kahn & Cuenin, supra note 6, at 409-10

and 415-19.

51. Kahn & Cuenin, supra note 6, at 415 (stating that “[t]he ‘but only for the

purposes of’ language of the statute strongly suggests that for all other purposes the

payment is treated as a distribution to a partner”).

52. Kahn & Cuenin, supra note 6, at 418.

53. 52 T.C. 752 (1969).

payment is deductible to the partnership and the partner’s share of the

deduction filters its way through to the partner in the determination of his

distributive share of partnership income. 

To reach their conclusions regarding the tax implications of in-kind

guaranteed payments, Kahn and Cuenin rely heavily on the precise language

of section 707(c), which requires that guaranteed payments be treated as

made to a third party “but only for the purposes of section 61 . . . and, subject

to section 263, for purposes of section 162(a) . . . .”  For any purpose other50

than those specified in the statute, Kahn and Cuenin assert that the payment

is to be treated as a distribution by the partnership subject to the controlling

provisions of Subchapter K.  However, on a number of subsequent51

occasions, Kahn and Cuenin recognize a policy need to deviate from the

confines of the statutory language. As a result, they do not advocate a literal

application of the language of section 707(c) but suggest that it creates a

“presumption” that a payment will be treated as a partnership distribution

other than for the purposes of sections 61(a), 162(a), and 263.  Thus, “there52

is a burden on those who would seek to expand the entity treatment to

demonstrate that there is a compelling reason to do so.” They claim to have

satisfied this burden when they deviate from the strictures of the legislative

language, as for example, when they conclude that the recipient partner takes

a fair market value basis in the property received. Nevertheless, they

implicitly fail to satisfy this burden when they conclude that a partnership

recognizes neither gain nor loss on the transfer of an in-kind guaranteed

payment despite the unusual tax treatment when property is transferred in

return for the rendition of services. This willingness to selectively apply the

statutory language of section 707(c) for different aspects of the same

transaction calls into question the persuasiveness of their advocacy. 

Their analysis also appears to be in conflict with the Tax Court’s

approach to the statutory language of section 707(c). In Miller v. Comm’r,53

the court concluded that guaranteed payments in the form of salary received

by a partner for services performed abroad were excludable from the

partner’s gross income under section 911. The court reasoned that section

707(c)’s reference to section 61(a) included the phrase “[e]xcept as otherwise

provided in this subtitle” and that section 911 provided otherwise. The court

also reasoned that the legislative history to section 707 indicated that “the

general approach of the section is to apply the entity theory to the dealings



2006] The Lazarus Effect 355

54. Id. at 761.

55. Id. (quoting H.R. Rep. No. 83-2543, at 59 (1954) (Conf. Rep.), reprinted

in 1954 U.S.C.C.A.N 5280, 5319-20.

56. Id. at 762.

between partners and the partnership,”  relying on the following statement54

from the legislative history: 

No inference is intended, however, that a partnership is to be

considered as a separate entity for the purpose of applying

other provisions of the internal revenue laws if the concept

of the partnership as a collection of individuals is more

appropriate for such provisions.55

The court found no reason why, for purposes of section 911, the entity theory

should not be applied as consistent with the policy goals of both sections

707(c) and 911. Thus, the court appeared to create a presumption that the

entity, not the aggregate, theory should prevail under section 707(c) unless

the aggregate theory was more appropriate in a particular context. 

The Tax Court also addressed the implications of the “but only for

the purposes of” language under setion 707(c) and concluded that it was

intended to achieve only a very narrow purpose regarding the timing of

guaranteed payments. 

This conclusion does not ignore the effect of the “but only”

words. These words were added to section 707(c) by the

Senate which at the same time also amended section 706 to

provide that guaranteed payments received by a partner are

to be included in his income for his taxable year in which the

partnership’s taxable year ends. In connection with section

707(c), the Senate committee report indicates that the reason

for the change was to provide that guaranteed payments are

to be included in income at the same time as a partner’s

distributive share – not at the time when compensation

would ordinarily be included in income. This is the only

example in the legislative history of the need for the “but

only” words.  56

Thus, the Tax Court did not view the “but only for the purposes of” language

as creating any presumption regarding the interpretation of section 707(c). 

In summary, Kahn and Cuenin conclude that an in-kind guaranteed

payment results in ordinary income for the recipient partner equal to the fair

market value of the property received, a basis for the property in the hands of

the recipient partner equal to the property’s fair market value, and no direct



356 Florida Tax Review [V0l.7:6

57. Kahn & Cuenin, supra note 6, at 414-15. Interestingly, Kahn and Cuenin

suggest that a sole proprietor recognizes gain or loss because “the employer is satisfying

a debt with appreciated or depreciated property, and so there is an exchange of the

property for the debt.” Id. at 414. Subsequently, they claim that the issue for

determination is whether an in-kind guaranteed payment should “be treated as if it were

made by an employer (a separate entity) to an employee.” Id. at 415. By moving the

issue to whether an employer-employee relationship exists, they ignore the more

important component of their formulation – whether there was an exchange of property

for debt.

basis adjustment to the recipient partner’s partnership interest. While the

partnership receives a deduction on the transfer, they assert that it is immune

from gain or loss recognition. According to Kahn and Cuenin, these results

are dictated by a combination of the statutory language of section 707(c), the

provisions of Subchapter K applicable to partnership distributions, and

general tax policy principles. 

B. The Non-Partnership Setting 

Interestingly, the conclusions reached by Kahn and Cuenin conflict

with the results derived in an identical transaction in the context of an

individual/sole proprietorship. Although considered by Kahn and Cuenin

only in passing,  the sole proprietorship paradigm involving an employer57

satisfying an obligation for services rendered by his employee through the

transfer of property rather than cash not only is instructive regarding the

proper tax treatment of guaranteed payments, but also serves as a baseline

against which any conclusions regarding the tax treatment of guaranteed

payments can be compared. Significantly, the identical questions are

confronted – income issues to the employee, including the amount of income

and its character, the basis of any property received by the employee, the

recognition of income or loss by the employer through the transfer of

property to satisfy an obligation for services rendered, and the deduction by

the employer for the expenditure incurred. 

In the sole proprietor paradigm, encountered in the first four weeks

of virtually every basic tax course, the tax landscape is fairly well defined

with regard to the tax issues confronted by both the employer and the

employee. The typical hypothetical involves the following: Assume that a

full-time employee, E, has rendered services during the past month in return

for his employer’s promise to pay him $10,000 per month. At the end of the

month, E’s employer, R, offers to pay him in-kind through the transfer of

property previously purchased for $8,000. E and R agree that the value of the

property is $10,000, and E is willing to accept the property in satisfaction of

his claim for payment for the services rendered. What are the tax

consequences to the parties? 



2006] The Lazarus Effect 357

58. IRC § 61(a)(1); Regs. § 1.61-2(d).

59. IRC § 1012; Regs. §§ 1.61-2(d)(2) and 1.1012-1(a).

60. IRC §§ 162(a)(1) and 212; Regs. §§ 1.162-1(a), 1.162-7, and 1.212-1.

61. IRC §§ 61(a)(3) (referring to gains from dealings in property), 1001(a)

(specifying the determination of gain realized), and 1001(c) (requiring the recognition

of realized gain unless a non-recognition provision is applicable). See also Regs.

§§ 1.61-6, 1.1001-1(a), and 1.1002-1.

62. Kahn & Cuenin, supra note 6, at 414-15.

63. IRC §§ 1221 and 1231.

Notwithstanding the usual confusion that ensues in the classroom,

ultimately the professor leads the class to see, understand, and conclude that

E has ordinary income in the amount of $10,000 from compensation for

services rendered under section 61 of the Code.  Since his receipt was in-58

kind, rather than in cash, the tax law accords him a basis in the property in

order that, upon a future sale, a proper determination of gain or loss can be

made.  The tax law quite properly and logically accords E a basis equal to59

the amount of income reported on the transfer. Thus, E receives the property

with a basis equal to its fair market value of $10,000.

After addressing the tax consequences to E, the class turns its

attention to the other side of the transaction. Most students instantly advocate

a deduction for R, assuming of course that the activity in which E rendered

his services is one that is either a trade or business or an activity for the

production of income, in the amount of $10,000.  (It is usually left to the60

professor to caution that, before finalizing such a conclusion, a determination

needs to be made as to whether such a payment, in cash or in-kind, requires

capitalization under section 263.) The final component in addressing the

totality of the tax issues presented, often left to the professor to forcefully

advocate, is the determination of whether gain or loss results from R’s

satisfaction of an obligation by transferring property with a fair market value

that differs from R’s basis in that property.  Students soon realize that R61

should be treated as if he transferred cash to E in the amount of the

obligation and subsequently transferred the property to E in return for the

cash deemed paid.  Thus, in this example, R takes a $10,000 current62

deduction, combined with the realization and recognition of $2,000 of gain,

the character of which will depend on the type of property transferred in the

hands of R.  63

Most would neither question nor object to the conclusions reached in

this example involving a sole proprietor. Nevertheless, Kahn and Cuenin

advance the bold proposition that the movement of a virtually identical

transaction into the poorly understood and frequently complex world of

partnership taxation can upset our understanding of these fundamental tax

principles. While acknowledging that the tax treatment involving an in-kind

guaranteed payment generally follows the sole proprietor paradigm, Kahn

and Cuenin conclude that for purposes of gain or loss recognition by the



358 Florida Tax Review [V0l.7:6

64. See Kahn & Cuenin, supra note 6, at 417.

65. Kahn & Cuenin, supra note 6, at 417. Kahn and Cuenin cite § 751 as

another example of a section of Subchapter K that applies both the entity and aggregate

approach.

66. Kahn & Cuenin, supra note 6, at 417. Kahn and Cuenin cite the legislative

history in support of their assertion that Congress intended to adopt this flexible

approach to transactions between a partnership and its partners. Id. at n.48 (citing H.R.

Rep. No. 83-2543, at 59 (1954) reprinted in 1954 U.S.C.C.A.N. 5280, 5319-20).

67. Kahn & Cuenin, supra note 6, at 417-18.

68. Kahn & Cuenin, supra note 6, at 418.

transferring partnership, the transfer constitutes a distribution of partnership

property otherwise subject to the property distribution scheme of Subchapter

K. Accordingly, the partnership recognizes neither gain nor loss on the

satisfaction of its obligation through the transfer of an in-kind guaranteed

payment. As a general matter, one would expect a heavy burden of proof on

those advocating any tax treatment that is so obviously contradictory with the

basic principles of taxation. 

In responding to our asserted analogy between the sole proprietor

and partnership situations, Kahn and Cuenin would likely claim that the

involvement of a partner rendering services to a partnership rather than a

third-party employee complicates any attempt to apply the sole proprietor

paradigm and raises the slippery questions of whether the partnership should

be conceptualized as an entity separate from its partners or as simply an

aggregate of its individual partners.  Indeed, Kahn and Cuenin decline to64

take sides on this question, recognizing that Congress refused to exclusively

adopt either an entity or aggregate approach to the taxation of partnerships in

enacting Subchapter K. Moreover, they assert that individual sections of

Subchapter K, including section 707(c), reflect this “dual approach.”  As65

stated in their article, “[section 707(c)] treats the partnership as an entity to

the extent that it requires the partner to recognize ordinary income and grants

the partnership a deduction; and it applies aggregate or conduit treatment to

the extent that the payment is treated as a partnership distribution.”66

Nevertheless, Kahn and Cuenin acknowledge that Congress likely

did not consider the tax consequences of in-kind guaranteed payments.  We67

agree with them that any legislative intent regarding this question “will have

to be extrapolated from the meager history that is available and from the

assumption that Congress would wish the statute to be construed in a manner

that arrived at results that conform to the broad policies that underlie

Subchapter K.”  However, we believe that the proper interpretation of68

section 707(c) is derived from a comprehensive understanding of the history

of section 707(c) and an appreciation of the fact that Subchapter K’s non-

recognition provisions are an exception from baseline principles, illustrated

in the sole proprietor paradigm, requiring the recognition of realized gain or

loss resulting from any and all property transactions. 



2006] The Lazarus Effect 359

69. Kahn and Cuenin suggest that the statutory reference to § 61 contained in

§ 707(c) was only to ensure ordinary income treatment by the recipient partner. Kahn

& Cuenin, supra note 6, at 422. They do note, however, that an argument could be made

that the reference to § 61(a) incorporates § 61(a)(3) applicable to “gains derived from

dealings in property” which could require gain recognition by the partnership in

connection with an in-kind guaranteed payment. Id. (citing 1 McKee, Nelson &

Whitmire, supra note 42, at ¶ 13.03[5], n.174). They reject this argument because

§ 61(a) does not refer to losses, and, under such an argument, a partnership making an

in-kind guaranteed payment would not be allowed to realize a loss if property with a

basis greater than its fair market value were transferred as a guaranteed payment. 

The argument that § 707(c)’s reference to § 61(a) incorporates § 61(a)(3) is

probably erroneous because it is inconsistent with the statutory evolution of § 707(c) in

any event. As originally passed by the House, § 707(c) applied only to partnership

payments for the rendition of services by a partner, and the language referred

specifically to § 61(a)(1)’s inclusion of compensation for services in gross income. H.R.

8300, 83d Cong.  § 707(c) (1954). The more general reference to § 61(a) was made by

the Senate, presumably when it expanded § 707(c) to apply to payments for the use of

capital. S. Rep. No. 83-1622, at 387 (1954), reprinted in 1954 U.S.C.C.A.N. 4621, 5029.

The reference to § 61(a)(1) in the original bill strongly suggests that the reference to

§ 61(a) was intended to apply only to the treatment of a guaranteed payment by the

recipient partner and not to the transferring partnership. An appreciation of the statutory

evolution of § 707(c) and its intended reference to § 61(a)(1) and, presumably,

§ 61(a)(4) with respect to payments for the use of capital also avoids any possible

confusion that the intended reference is to § 61(a)(13) – a partner’s distributive share of

partnership gross income – and any possible implications that such a reference might

generate. See G.C.M. 34173. Nevertheless, the courts have not adopted such a limited

C. Non-Recognition of Gain or Loss by the Partnership

As previously described, Kahn and Cuenin part company with the

sole proprietor paradigm with respect to the partnership’s recognition of gain

or loss on the transfer of an in-kind guaranteed payment. As a result, the

resolution of this question is central to their analysis. The mere comparison

of the partnership setting with the sole proprietor paradigm without more

would seemingly mandate an affirmative response to the question. Nothing

from the standpoint of general tax policy principles appears to distinguish the

two situations and, thus, from a policy perspective, there would appear to be

no compelling rationale for treating the virtually identical situations

differently. 

Nevertheless, Kahn and Cuenin resolve this question in the negative,

based on two related rationales – the statutory language of section 707(c) and

the policies underlying Subchapter K. According to Kahn and Cuenin, the

statutory language of section 707(c) imposing third-party treatment in

connection with guaranteed payments is applicable “only for the purposes of

sections 61(a) . . . 263 . . . [and] 162(a).”  As a result, Kahn and Cuenin69



360 Florida Tax Review [V0l.7:6

view of the statutory language of § 707(c) and have interpreted it as incorporating all

of § 61(a). See supra note 25.

Kahn and Cuenin are probably incorrect that the reference to § 61(a) was only

to ensure ordinary income treatment by the recipient partner. The problem that existed

prior to the enactment of § 707(c) was that a salary payment to a partner in excess of the

partnership’s income was treated as derived from the partners’ capital. Thus, a portion

of such a payment was a return of capital for the recipient partner, which was excluded

from gross income. See Lloyd v. Comm’r, 15 B.T.A. 82 (1929); Estate of Tilton, 8

B.T.A. 914 (1927); G.C.M. 6582, VIII-2 C.B. 200 (1929). The reference to § 61(a) was

probably intended to ensure that the entire payment was included in the recipient

partner’s gross income and was not intended to characterize for tax purposes the nature

of the income received. See infra note 149.

70. While Kahn and Cuenin do not explicitly explore this aspect of the history

of § 707(c) as part of their interpretative methodology, it is noteworthy that earlier

“strict constructionists” concluded that the limiting language of § 707(c), as originally

enacted, precluded the application of the capitalization rules. See supra text

accompanying notes 24-26. Nevertheless, the courts held to the contrary, and Congress

subsequently amended § 707(c) to resolve any lingering uncertainty. Although the

frequency of transactions involving guaranteed payments that should be capitalized

probably exceeds that of transactions involving in-kind guaranteed payments, the

judicial approach in addressing the capitalization issue suggests that the resolution of

the question of in-kind guaranteed payments in a manner consistent with third-party

treatment should not easily be dismissed.

71. Kahn & Cuenin, supra note 6, at 415 (emphasis added.)

72. IRC § 706(a); Regs. §§ 1.706-1(a) and 1.707-1(c). Kahn & Cuenin, supra

note 6, at 415, n.42. Kahn & Cuenin also note that the timing rules applicable to related

persons in certain circumstances under § 267(a)(2) do not apply to guaranteed payments

under § 267(e)(4). Id.

acknowledge that third party treatment is mandated with respect to the

compensatory aspects of the transaction, i.e., income inclusion on the part of

the recipient partner under section 61(a) and the availability of the

corresponding deduction on the part of the transferring partnership under

sections 162 and 263.70

Kahn and Cuenin then assert that the “language of the statute

strongly suggests that for all other purposes the payment is treated as a

distribution to a partner.”  Thus, they maintain that the default treatment of a71

guaranteed payment is that of a distribution of partnership property. To

support this assertion, they point to the Code and Regulations which use the

partnership’s accounting method for determining the timing of the recipient

partner’s income inclusion of the guaranteed payment.  They observe that72

the rule applicable to the timing of the recipient partner’s inclusion of a

guaranteed payment is the same as the rule applicable to a partner’s

distributive share of partnership income. For Kahn and Cuenin, this

similarity of treatment between the timing rules governing guaranteed

payments and those governing a partner’s distributive share of partnership



2006] The Lazarus Effect 361

73. IRC § 706(a); Regs. §§ 1.706-1(a) and 1.707-1(c). Regulation § 1.707-1(c)

specifically states that “a partner must include such payments as ordinary income for his

taxable year within or with which ends the partnership taxable year in which the

partnership deducted such payments as paid or accrued under its method of accounting.”

See Gaines v. Comm’r, T.C. Memo. 1982-731, 45 T.C.M. (CCH) 363 (noting the

equivalent treatment of the partner’s distributive share of partnership income and stating

that “any unfairness in taxing a partner on guaranteed payments that he neither receives

nor benefits from results from the conduit theory of partnerships, and is a consequence

of the taxpayer’s choice to do business in the partnership form”). Although § 707(c)

refers to a “payment,” the timing of a guaranteed payment by an accrual-method

partnership to a cash-method partner is unrelated to the time of actual payment. The

potential inconsistency between the use of the word “payment” in § 707(c) and the

timing rule under § 706(a) was noted immediately following the enactment of

Subchapter K. See J. Paul Jackson,et al., supra note 44, at 1203.

74. Such a view would be consistent with the conceptualization of guaranteed

payments prior to the 1954 enactment of Subchapter K. See Kahn & Cuenin, supra note

6, at 409. For a more extensive discussion of the treatment of guaranteed payments prior

to the enactment of Subchapter K, see Postlewaite & Cameron, supra note 2, at 651-53.

Kahn and Cuenin acknowledge that Congress viewed the pre-1954 treatment of such

payments as “unrealistic and unnecessarily complicated.” Kahn & Cuenin, supra note

6, at 409 (citing H.R. Rep. No. 83-1337, at 68 (1954), reprinted in 1954 U.S.C.C.A.N.

4017, 4094). Nevertheless, they insist Congress intended to retain this earlier

conceptualization rather than treat guaranteed payments as payments to a third party for

all purposes. Although they may be correct with regard to Congress’s original intent

(see infra note 149), the courts have not interpreted § 707(c) in this manner.

income is interpreted as evidence of Congressional intent to treat a

guaranteed payment as a distribution of partnership property.

However, the similarity of rules regarding the timing of income

resulting from guaranteed payments and distributive shares of partnership

income are largely irrelevant to any connection between guaranteed

payments and distributions of partnership property. A partner includes his

distributive share of partnership income in gross income whether or not he

receives a distribution of partnership property from the partnership during

the year. Similarly, a cash-method partner includes a guaranteed payment in

gross income whether or not he receives property, either in cash or in-kind,

from an accrual-method partnership during the year in satisfaction of that

guaranteed payment.  Nevertheless, this observation implies little, if73

anything, about the treatment of a guaranteed payment as a distribution of

partnership property. 

The similarity of guaranteed payments and distributive shares of

partnership income becomes relevant to a conclusion that guaranteed

payments should be treated in a manner similar to distributions of partnership

property only if a guaranteed payment is conceptualized as a special

allocation of partnership income and a simultaneous (or subsequent

distribution) of partnership property.  Kahn and Cuenin are supported in this74



362 Florida Tax Review [V0l.7:6

75. Regs. § 1.707-1(c). Interestingly, the statement in the Regulations that

“guaranteed payments are regarded as a partner’s distributive share of ordinary income”

is seemingly inconsistent with statements included in the legislative history. Both the

House and Senate Reports regarding § 707 state that “[t]he amount of such payment

shall be included in the partner’s gross income, and shall not be considered a distributive

share of partnership income.” H.R. Rep. No. 83-1337, at A227 (1954), reprinted in 1954

U.S.C.C.A.N. 4017, 4367; S. Rep. No. 83-1622, at 387 (1954), reprinted in 1954

U.S.C.C.A.N. 4621, 5029.

76. Regs. § 1.707-1(c). Kahn & Cuenin, supra note 6, at 415. In addition, the

Regulations dictate that a guaranteed payment cannot qualify for the sick pay exclusion

under prior law at § 105(d) and that a partner who receives a guaranteed payment is not

regarded as an employee for purposes of employee withholding and deferred

compensation.

77. Kahn and Cuenin note that no similar limitations exist under § 707(a),

thereby suggesting that the limiting language of § 707(c) was intended to have some

significance. However, the question is not whether a difference exists between §§ 707(a)

and 707(c), but whether the statutory and non-statutory exclusions can be reconciled

with the treatment of guaranteed payments as distributions of partnership property.

78. Regs. § 1.704-1(b)(2)(iv)(o). Kahn & Cuenin, supra note 6, at 418. While

the Regulations under § 704 dictate the treatment of guaranteed payments for capital

account purposes, their guidance is meager at best. Regulation § 1.704-1(b)(2)(iv)(o),

which addresses guaranteed payments, provides nothing more than an instruction

consistent with a conceptualization of guaranteed payments as transfers in cash. Under

this Regulation, the recipient partner’s capital account is adjusted only by his share of

the partnership’s “deduction, loss, or other downward capital account adjustment

endeavor by the regulatory statement that, with certain exceptions,

“guaranteed payments are regarded as a partner’s distributive share of

ordinary income.”75

However, Kahn and Cuenin must confront the fact that the explicit

statutory limitations contained in the language of section 707(c) are not

exclusive. For example, the Regulations provide that guaranteed payments

do not constitute an interest in partnership profits for purposes of sections

706(b)(3), 707(b), and 708(b).  These provisions are each concerned with76

determining the extent of a partner’s interest in a partnership and exclude

guaranteed payments from that determination. However, if guaranteed

payments are properly viewed as a special allocation of partnership income

and a subsequent distribution of partnership property, the opposite

conclusion would appear to ensue. Because guaranteed payments are

typically structured as predictable distributions of fixed amounts, it is

surprising they are excluded from the determination of a partner’s interest in

a partnership.77

Significantly, Kahn and Cuenin also cite the fact that guaranteed

payments are not treated as allocations of partnership income and

distributions of partnership property for purposes of maintaining the

partners’ capital accounts under the Regulations to section 704.  Under these78



2006] The Lazarus Effect 363

resulting from such payment.” The focus of the language on a “deduction, loss, or other

downward adjustment” most likely reflects the drafters desire for thoroughness and to

ensure a proper adjustment should the payment constitute a capital expenditure. The

reference to “loss” is puzzling, although possibly explained in an overall loss, rather

than net income, situation for the partnership. Significantly, the Regulation does not

reference the term “gain.” Thus, it seems logical to conclude that the Regulations gave

no consideration to in-kind guaranteed payments.

79. Regs. § 1.704-1(b)(2)(iv)(b).

80. Kahn & Cuenin, supra note 6, at 417.

81. Kahn & Cuenin, supra note 6, at 418.

82. Kahn & Cuenin, supra note 6, at 418.

Regulations, a partner’s capital account is only adjusted by the partner’s

distributive share of any deduction resulting from a guaranteed payment.

This provision, at a minimum, suggests that a guaranteed payment is

conceptualized for purposes of maintaining capital accounts as a payment to

a third party. If, as Kahn and Cuenin propose, a guaranteed payment should

be treated as an allocation of partnership income and a distribution of

partnership property, additional adjustments would be required.  Thus, the79

exceptions to the regulatory statement that “guaranteed  payments are

regarded as a partner’s distributive share of ordinary income” appear to

effectively swallow the general rule. 

As a result of these non-statutory exceptions to the treatment of

guaranteed payments as distributions of partnership property, Kahn and

Cuenin are forced to shift the focus of their analysis from the statutory

language of section 707(c) to a policy-based approach in order to suggest

that the classic aggregate/entity dichotomy supports the treatment of a

guaranteed payment as a distribution of partnership property.  Kahn and80

Cuenin’s earlier reliance on the statutory language of section 707(c) is

transformed into a pragmatic approach in which Congress in enacting

Subchapter K refused to “slavishly adhere to consistency” in choosing

between an entity or aggregate approach. Thus, the literal text is no longer

controlling. Instead, Kahn and Cuenin acknowledge that the principles of

sound tax policy should control the question presented. Presumably, a

symmetry between sole proprietorships and partnerships should become

compelling under such an analysis. 

However, as part of their pragmatic approach to resolving the section

707(c) problem, Kahn and Cuenin contend that “the statutory limitation

creates a presumption that, for purposes other than those three Code sections,

the payment will be treated as a partnership distribution . . . .”  This81

presumption imposes “a burden on those who would seek to expand the

entity treatment to demonstrate that there is a compelling reason to do so.”82

For Kahn and Cuenin, a compelling reason is apparently a conflict with

either the policies of Subchapter K or the avoidance of any potential tax



364 Florida Tax Review [V0l.7:6

83. Kahn & Cuenin, supra note 6, at 418. Curiously, Kahn and Cuenin make

no effort to determine the compelling reason that the Regulations depart from the

statutory language for purposes of §§ 704(b), 706(b)(3), 707(b), and 708(b). See supra

text accompanying notes 76-77. Such an inquiry might shed some light on the

government’s view of any such compelling reason standard.

84. IRC § 731(b). Kahn & Cuenin, supra note 6, at 418-19 and 427.

85. Kahn & Cuenin, supra note 6, at 422.

86. Kahn & Cuenin, supra note 6, at 422.

87. See infra text accompanying notes 138-55.

88. Kahn & Cuenin, supra note 6, at 423.

89. The type of guaranteed payment at issue is one in which the partner

receives a percentage of partnership income, but not less than a specified dollar amount.

For example, assume that Partner C provides services to the partnership and is entitled

to receive 30% of partnership income, before taking into account any guaranteed

payments, but not less than $10,000. Regs. § 1.707-1(c), example (2). If the

partnership’s income is $60,000, C will receive a distributive share of partnership

income of $18,000 and no guaranteed payment. However, if the partnership’s income

is only $20,000, C will receive a distributive share of partnership income of only 

liability.  Because they fail to find any such compelling reason, they83

conclude that the statutory limitations of section 707(c) control. As a result, a

guaranteed payment should be treated in the same manner as a distribution of

partnership property in which the partnership recognizes neither gain nor loss

on an in-kind transfer.84

Not only do Kahn and Cuenin not find a compelling reason to treat

guaranteed payments as payments to a third party, they suggest that the

treatment of guaranteed payments as distributions of partnership property

better effectuates the policy objectives of Subchapter K.  This conclusion is85

based on the policy of Subchapter K to defer the recognition of gain or loss

in connection with property transfers between partners and partnerships “to

the extent that deferral is feasible and [any transfer] does not create an

opportunity for significant tax evasion.”  Kahn and Cuenin clearly86

demonstrate that deferral of gain or loss by the partnership is feasible, but, as

described below,  they fail to adequately consider the opportunities for tax87

evasion that their proposal entails.

Additionally, Kahn and Cuenin assert that recognition of gain or loss

on the transfer of an asset in satisfaction of its obligation to a service

provider “would cause a greater amount of complexity than that which

Congress sought to remove by adopting the guaranteed payment

provision.”  To document the potential complexity resulting from a88

requirement that the partnership recognize gain or loss, they resort to an

atypical type of payment, one in which the payment is, in part, a guaranteed

payment and, in part, a distribution of partnership property, thereby requiring

an apportionment of the inside basis of the transferred property between the

guaranteed payment portion of the transfer and the distribution portion.89



2006] The Lazarus Effect 365

$6,000. Because C is entitled to receive not less than $10,000, the difference, $4,000,

is a guaranteed payment. 

Kahn and Cuenin protest that, if gain or loss had to be recognized by the

partnership with respect to an in-kind guaranteed payment, the transfer of property in

satisfaction of the guaranteed payment in such a situation would require that the inside

basis of the transferred property be apportioned between the part of the transaction

treated as a partnership distribution and the part of the transaction treated as a

guaranteed payment. Kahn & Cuenin, supra note 6, at 423. But this assumes that the

partnership transfers property worth $10,000 to the partner, equal to both the partner’s

distributive share of partnership income and the partner’s guaranteed payment. If

property worth only $4,000, the amount of the guaranteed payment, is distributed, no

such apportionment would be necessary.

90. See, e.g., IRC § 1011(b) (requiring the allocation of basis in a part sale/part

gift to a charitable organization in order to determine the amount of gain from the sale

portion of the transfer); IRC § 1060 (requiring the allocation of basis among the assets

of a going business when acquired for a lump sum); Regs. § 1.61-6(a) (requiring the

equitable apportionment of basis among the several parts of a larger parcel of property

when one or more of those parts are sold); Regs. § 1.167(a)-5 (requiring the allocation

of basis between depreciable and non-depreciable property acquired for a lump sum “as

for example, buildings and land”); Rev. Rul. 53-286, 1953-2 C.B. 20 (requiring the

allocation of basis between the personal and business use of property in determining

gain or loss on sale); Sharp v. United States, 199 F. Supp. 743 (D. Del. 1961), aff’d, 303

F.2d 783 (3d Cir. 1962) (same).

91. Kahn and Cuenin go on to complain that further complication ensues in

such a situation because the amount of the guaranteed payment depends on the dollar

amount of the partner’s distributive share of partnership profits. Kahn & Cuenin, supra

note 6, at 423-24. They apparently believe that the gain or loss resulting from the

distribution of partnership property in satisfaction of the guaranteed payment will

require the recomputation of the amount of the guaranteed payment. Even if correct,

their concern in this regard is overstated. More importantly, any such complications are

easily avoided. 

Their concern that any gain or loss resulting from the distribution of

partnership property in satisfaction of the guaranteed payment will require the

recomputation of the amount of the guaranteed payment is overstated because in many,

if not most, instances the partnership will not distribute property in satisfaction of a

guaranteed payment until the taxable year following that in which the services are

actually rendered. This is because the partnership’s income, and thus the amount of the

guaranteed payment, cannot be determined until after the end of the taxable year. For

a cash-method partnership, the transfer of the property in the following taxable year

means that both the deduction of the guaranteed payment and the recognition of any

gain or loss resulting from the transfer would be deferred to that year. Although an

accrual-method partnership would be allowed a deduction for the guaranteed payment

However, any necessary allocation of basis to ensure proper results would

hardly be unique to section 707(c). It is present elsewhere in the Code and, in

itself, has not been found debilitating to the administration of the tax law.90

One should not be surprised that an added layer of difficulty is encountered

in such an atypical setting.91



366 Florida Tax Review [V0l.7:6

in the taxable year in which the services are actually rendered, the recognition of any

gain or loss resulting from the transfer would be deferred to the following taxable year

when the transfer is made. Thus, in both cases, any gain or loss resulting from the

transfer is not relevant to the determination of the amount of the guaranteed payment in

the taxable year in which the services are rendered.

Nevertheless, Kahn and Cuenin’s concern could arise for either an

accrual-method partnership or a cash-method partnership that transfers property in

satisfaction of the guaranteed payment in the year the services are actually rendered

despite the fact that the amount of the guaranteed payment is unknown at the time of the

transfer. In such a situation, the amount of the gain or loss resulting from the transfer

could be relevant to the determination of the amount of the guaranteed payment itself.

However, the complexities encountered in this situation are easily avoided.

The basic equation to determine the amount of a guaranteed payment when

structured as a percentage of partnership income subject to a minimum amount is:

GP = MA - (PI * DS)     Equation 1

where PI > 0 and MA > PI * DS

and GP  = guaranteed payment; 

MA = the guaranteed minimum dollar amount; 

PI     = partnership income before taking into account any guaranteed

           payment; and 

DS  = the partner’s distributive share of partnership income. 

Using the facts of the regulatory example described in note 89, supra, in which the

partner is entitled to a distributive share of partnership income of 30% but not less than

$10,000 and the partnership has income of only $20,000, the partner would receive a

distributive share of partnership income of $6,000 and a guaranteed payment of $4,000.

Regs. § 1.707-1, example (2). 

Admittedly, the determination of the amount of the guaranteed payment is

made significantly more complicated through the inclusion of any gain or loss

recognized by the partnership as a result of the transfer of partnership property in

satisfaction of the guaranteed payment. Kahn and Cuenin are correct that the inclusion

of this recognized gain or loss will affect the amount of the partnership’s income which

will affect the amount of the guaranteed payment which will, in turn, affect the amount

of the recognized gain or loss which will affect the amount of the partnership’s income,

and so on in a pyramiding fashion. They recognize that this problem “can  be solved

through the use of an algebraic formula” but caution that concerns regarding the

administrability of the tax laws favor the avoidance of such a formula. Kahn & Cuenin,

supra note 6, at 424. See Old Colony Trust Co. v. Comm’r, 279 U.S. 716 (1929)

(recognizing that an algebraic formula could be used to determine the appropriate

amount of tax when an employer pays the income taxes of an employee which generates

additional income to the employee, which, in turn, results in additional income taxes to

be paid by the employer, thereby generating additional income to the employee, and so

on). 



2006] The Lazarus Effect 367

Assuming that the fair market value of the property to be transferred is equal

to the amount of the guaranteed payment, the algebraic formula necessary to determine

the amount of the guaranteed payment in such a situation is: 

GP = [MA - (PI * DS)] / [1 + (1 - X) * DS]     Equation 2

where PI > 0 and MA > PI * DS

and GP  = guaranteed payment; 

MA = the guaranteed minimum dollar amount; 

PI    = partnership income before taking into account any guaranteed

          payment;

DS  = the partner’s distributive share of partnership income; and

X    = is the ratio of the basis of the property to be transferred to its

          fair market value.

Using the facts of the example previously described and assuming that the partnership

wishes to satisfy the guaranteed payment through the transfer of an interest in property

with a fair market value of $25,000 and a basis of $15,000 (in which case X would equal

0.6 ($15,000 divided by $25,000)), the guaranteed payment would be only $3,571 rather

than $4,000, partnership income would be $21,429, and the partner’s distributive share

of partnership income would be $6,429. In this case, the partnership would transfer to

the recipient partner a 14.28% interest in the property with a value of $3,571 and a basis

of $2,143. 

Fortunately, all of the computational complications previously described can

be easily avoided in the same manner that they are avoided in connection with the

deduction of guaranteed payments in the determination of partnership income. In the

example from the Regulations, the facts provide that partnership income is determined

‘before taking into account any guaranteed payments.’ Regs. § 1.707-1, example (2).

Thus, the deduction generated by the guaranteed payment is not considered for purposes

of determining the amount of partnership income. In the absence of such a provision,

the guaranteed payment would be deductible by the partnership in the determination of

partnership income which would affect the amount of the guaranteed payment which

would, in turn, affect the amount of the partnership’s income, and so on. The algebraic

formula that would have to be applied to properly account for the deduction of any

guaranteed payment in this situation is: 

 GP = [MA - (PI * DS)] / (1 - DS)     Equation 3

where PI > 0 and MA > PI * DS 

and GP  = guaranteed payment; 

MA = the guaranteed minimum dollar amount; 

PI     = partnership income before taking into account any guaranteed

           payment; and 

DS  = the partner’s distributive share of partnership income. 



368 Florida Tax Review [V0l.7:6

Using the facts of the regulatory example described in note 89, supra, and assuming that

partnership income is determined only after taking into account any guaranteed

payment, the guaranteed payment would be $5,714, partnership income would be

$14,286, and the partner’s distributive share of partnership income would be $4,486. 

If the complications that the deduction of any guaranteed payment would create

can be avoided simply by providing that partnership income for purposes of calculating

any guaranteed payment is determined “before taking into account any guaranteed

payments,” such words could also easily be interpreted to avoid the complications of a

requirement that the determination of any guaranteed payment take into account any

gain or loss recognized on the transfer of partnership property in satisfaction of the

guaranteed payment. In a footnote, Kahn and Cuenin acknowledge that “[t]he gain or

loss from making the guaranteed payment would be excludable, for example, if the

partnership provision that the partner is to receive a percentage of partnership income

‘computed before taking into guaranteed payments into account’ is construed to exclude

a gain or loss recognized on the constructive sale of the distributed property as well as

the deduction allowed for making that payment.” Id. at n.61. Significantly, however,

they fail to suggest any reason why such a similar interpretation would somehow be

improper. Furthermore, if the words “before taking into account any guaranteed

payments” apply to avoid the complications resulting from the deduction of a

guaranteed payment, they should apply to any gain or loss on the transfer of property

in satisfaction of a guaranteed payment when, unlike the deduction generated by a

guaranteed payment for an accrual-method partnership, the transfer might not even

occur in the partnership’s current taxable year. Thus, no need to recompute the

partnership’s income would actually arise.

92. Kahn & Cuenin, supra note 6, at 424-25.

93. Kahn & Cuenin, supra note 6, at 425. Kahn and Cuenin recognize that a

similar burden arises under § 751, which requires gain or loss recognition in connection

with certain distributions of partnership property. They conclude, however, that

Congress viewed this added administrative burden as justified in order to prevent the

Kahn and Cuenin suggest that the complexity incurred by requiring

the partnership to recognize gain or loss on the transfer of partnership

property in satisfaction of a guaranteed payment is exacerbated if the

partnership has an election in effect under section 754.  After providing an92

example of the basis adjustments under section 743(b) resulting from an

election under section 754, they assert that the administrative burden of

complying with such a requirement could become significant. 

[I]f the partnership must recognize gain or loss on the

guaranteed payment portion of the distributed property, not

only will the inside basis of each asset that was distributed

have to be apportioned between the guaranteed payment

portion and the partnership distribution portion, but there

would have to be a separate calculation and apportionment

made for every partner’s share. Especially when there are a

sizeable number of partners, all of whom have special shares

of inside basis, that could become burdensome.93



2006] The Lazarus Effect 369

potential shifting of characterization of income among partners. Properly framed, the

question then becomes whether the absence of a requirement for gain or loss recognition

by the partnership presents a similar opportunity for abuse. See infra text accompanying

notes 127-31.

94. Kahn & Cuenin, supra note 6, at 425, n.63.

95. Kahn & Cuenin, supra note 6, at 426-27.

96. See supra text accompanying notes 81-84.

97. Kahn & Cuenin, supra note 6, at 426 and 430-31.

98. Kahn & Cuenin, supra note 6, at 426, 433, n.77. In addition, the timing of

any preserved gain is deferred of course, although this result occurs any time that a

transfer of property is treated as a distribution of partnership property. Id. at 433. Kahn

and Cuenin fail to appreciate that their approach gives rise to yet another form of abuse,

a partnership deduction in excess of any amounts previously included in the income of

the partners. See infra text accompanying notes 128-30. 

However, in a footnote, Kahn and Cuenin acknowledge that the

partnership will have to apportion the inside basis of the transferred assets

between the guaranteed payment and the distribution portions of the

transaction in order to determine the proper basis of the property in the hands

of the recipient partner regardless of whether the partnership is required to

recognize gain or loss.  Thus, the only additional administrative burden in94

requiring the recognition of gain or loss with respect to the property

transferred to satisfy the guaranteed payment arises in determining each

partner’s share of that gain or loss. The real question is whether this added

level of complexity is appropriately attributable to a requirement to recognize

gain or loss with respect to the in-kind guaranteed payment or simply one of

a number of additional burdens that result from a partnership’s decision to

make a section 754 election. 

Only at this point in their analysis do Kahn and Cuenin finally

address the real issue at hand: whether the treatment of a guaranteed payment

as a distribution of partnership property entails any opportunity for abuse and

whether a requirement that the partnership recognize gain or loss on the

transfer of partnership property in satisfaction of a guaranteed payment might

avoid such abuse.  In other words, this inquiry attempts to determine if a95

compelling reason exists to rebut the presumption that a guaranteed payment

will be treated as a distribution of partnership property under the statutory

language of section 707(c).  Interestingly, Kahn and Cuenin acknowledge96

that the potential for abuse exists under their proposal if the partnership

transfers appreciated property that would otherwise generate ordinary income

if sold by the partnership to the recipient partner in satisfaction of a

guaranteed payment. Because the partnership level gain in the transferred

property is preserved in the outside basis of the partners’ partnership interests

under the approach advanced by Kahn and Cuenin,  the potential exists that97

the preserved gain might be converted into capital gain on the sale of a

partner’s interest.98



370 Florida Tax Review [V0l.7:6

The treatment of an in-kind guaranteed payment as a distribution of partnership

property also raises the curious result that, under § 735, the transfer of any unrealized

receivables or inventory items as described in § 751(c) and 751(d), respectively, will

give rise to ordinary income or loss on disposition (albeit only if disposed of within five

years in the case of inventory items) by the recipient partner despite the fact that, under

Kahn and Cuenin’s approach, he receives a fair market value basis in the property. See

2 Willis, Pennell & Postlewaite, supra note 11, at ¶ 13.04. Such a result seems

inappropriate if the property is properly characterized as a capital asset in the hands of

the partner since the characterization rules of § 735 are intended to prevent the

conversion of ordinary income at the partnership level into capital gain at the partner

level, principally with respect to pre-distribution gain. In addition, § 735 again

demonstrates the extent to which Congress is willing to impose restrictions on

transactions that can result in the conversion of ordinary income into capital gain as a

result of distributions of partnership property.

99. Kahn & Cuenin, supra note 6, at 426.

100. Kahn & Cuenin, supra note 6, at 426.

101. Curiously, Kahn and Cuenin do not grapple with the question whether

§ 751 would actually apply to a transfer of property in satisfaction of a guaranteed

payment, relying solely on a Regulation suggesting that payments for services are

immune from the application of § 751. Kahn & Cuenin, supra note 6, at 411-12 (citing

Although recognizing the potential for abuse, Kahn and Cuenin state

that the possibility of such abuse “is not of sufficient significance to warrant

both abandoning the principle of non-recognition that plays such a prominent

role in Subchapter K and embracing the administrative complexity that

recognition will engender.”  In addition, they state: 99

the choice available for the construction of the currently

applicable provision is either to deny nonrecognition entirely

to guaranteed payments or to accept the potential for shifting

of characterization as a relatively minor cost of the benefit of

having nonrecognition so that ordinary transactions of this

nature are not deterred. The latter course seems far more

desirable given the strong sentiment in Subchapter K to

allow nonrecognition so as to prevent the tax law from

unnecessarily influencing legitimate business transactions.100

However, their position in this regard appears flawed for a number of reasons

as discussed below. Furthermore, they are not explicit in describing why the

policy of non-recognition under Subchapter K weighs more heavily on the

decision-making scale than the concern over the potential for tax abuse.

Their only possible response in this regard would be based on a failure to

rebut the implicit presumption that they earlier asserted exists under section

707(c). 

Kahn and Cuenin do acknowledge that Congress enacted section 751

to prevent a similar type of potential abuse.  They point out that the101



2006] The Lazarus Effect 371

Regs. § 1.751-1(b)(1)(ii)). However, if a guaranteed payment is properly conceptualized

as a distribution of partnership property, § 751 would be applicable if the transfer

resulted in a disproportionate distribution of the partners’ rights to ordinary income

assets. See 2 Willis, Pennell & Postlewaite, supra note 11, at ¶ 14.02. Alternatively, if

the transfer of property in satisfaction of a guaranteed payment results in the recognition

of gain or loss on the transfer by the partnership, § 751 is not implicated and the

complexities to which Kahn and Cuenin allude can be avoided.

102. Kahn & Cuenin, supra note 6, at 426. Kahn and Cuenin cite only the 1986

statement of one commentator before a subcommittee of the House Ways and Means

Committee as evidence of the “severe criticism” surrounding § 751. Id. at 426, n.64.

103. Kahn & Cuenin, supra note 6, at 426. They also state that a provision

requiring the recognition of gain in connection with a guaranteed payment to the extent

of any appreciation that would be taxed as ordinary income if sold could only be

adopted through legislative amendment. Id. at n.64. Although the necessity for

legislative action is probably correct if we were advocating such an approach, the

third-party treatment that we propose, requiring the recognition of gain or loss by the

transferring partnership regardless of its character, would not require legislative

amendment. Instead, it would require only the application of basic principles of the

existing tax law as reflected in the sole proprietor paradigm.

104. Kahn & Cuenin, supra note 6, at 418, 426. See also supra text

accompanying note 85.

105. Kahn & Cuenin, supra note 6, at 427.

complexity engendered by section 751 has been the subject of “severe

criticism” and that an interpretation of section 707(c) as requiring third-party

treatment would also entail an element of complexity.  As a result, they102

caution against an interpretation of section 707(c) that would introduce a

“complex and cumbersome structure that [would prove] very difficult to

administer.”103

However, the existence of section 751 cuts against their argument in

this regard since it indicates a high degree of Congressional tolerance for

complexity to combat potential abuse. Presumably, we should be more

concerned about interpreting the Code in a manner that will best effectuate

the policies of Subchapter K and basic tax principles  than in avoiding104

“severe criticism.” Given the doubts described above concerning the extent

of any significant additional complexity that a gain or loss recognition

requirement would entail, the balance may well fall in favor of preventing

the potential for tax abuse. 

Kahn and Cuenin cite as illustrative of an asserted Congressional

preference for non-realization, even at the expense of potential conversion of

ordinary income into capital gain, the basis adjustment rules under sections

108(b)(2)(E) and 1017 in connection with discharge of indebtedness income

under section 108(a)(1)(B).  They assert that these provisions create the105

possibility that a taxpayer may convert deferred discharge of indebtedness

income that would otherwise be taxable as ordinary income into capital gain



372 Florida Tax Review [V0l.7:6

106. They assert that such a result could occur because the Regulations under

§ 1017 provide ordering rules under which the basis of property that would produce

capital gain (or § 1231 gain) can be reduced to account for the discharge of indebtedness

income excluded from gross income under § 108. Regs. § 1.1017-1(a).

107. Kahn & Cuenin, supra note 6, at 427.

108. Section 1017(d) requires that any property whose basis is reduced under

§ 1017 and that is not § 1245 or § 1250 property will be treated as § 1245 property and

that a reduction under § 1017 is to be treated as a depreciation deduction. IRC

§ 1017(d)(1). With respect to § 1250 property, the determination of what would have

been the depreciation adjustments under the straight line method are made as if no basis

reduction had been made under § 1017. IRC § 1017(d)(2). “The effect of this rule is that

if the property was actually depreciated on a straight line basis, there is additional

depreciation, subject to recapture, equal to the § 1017 reduction.” Boris I. Bittker &

Lawrence Lokken, Federal Taxation of Income, Estates and Gifts ch. 51.3.2, n.19 (3d

ed., 2000). Thus, any gain attributable to a basis reduction under § 1017 will be

recaptured as ordinary income under any circumstances.

109. Several commentators have reached a similar conclusion, albeit for a

variety of reasons. McKee, Nelson & Whitmire, supra note 42, at ¶ 13.03[5]; Sheldon

I. Banoff, “Guaranteed Payments for the Use of Capital: Schizophrenia in Subchapter

K,” 70 Taxes 820, 836-37 (1992). One commentator has noted that an in-kind

guaranteed payment can be conceptualized as a cash payment in satisfaction of the

guaranteed payment followed by a sale of the transferred property in a taxable

transaction in exchange for the cash. Id. at 836, n.122. In such a situation, the

partnership would recognize gain or loss on the transfer. This is, of course, precisely the

type of transaction that Congress intended to be treated as a transaction with a third

party under § 707(a)(2)(A). See infra text accompanying notes 156-62.

to be recognized at a later date.  At a minimum, they suggest that these106

provisions “indicate that Congress is willing to allow ordinary income to be

converted into capital gain in order to implement a system of non-

recognition.”  However, Kahn and Cuenin appear to have overlooked the107

fact that section 1017(d) specifically requires that any gain resulting from a

basis reduction under sections 108 and 1017 be recaptured as ordinary

income.  Thus, sections 108 and 1017 may better serve to illustrate a108

Congressional tolerance of non-recognition only when the shifting of the

character of any gain can be avoided.

To us, it would appear easier, more logical, and “better attuned” to

Congressional concerns regarding tax policy to conclude that under section

707(c) the transfer of partnership property in satisfaction of a guaranteed

payment requires gain or loss recognition by the partnership rather than

treatment as a distribution of partnership property.  Although there may be109

some additional administrative complexity as a result, this approach equates

guaranteed payments with payments to a third party, payments with which

most taxpayers are intimately familiar. Even Kahn and Cuenin acknowledge

that, under section 707(c), the references to sections 61(a), 162(a), and 263

are not exclusive: “Entity treatment is applied in a few other circumstances,



2006] The Lazarus Effect 373

110. Kahn & Cuenin, supra note 6, at 427.

111. Kahn & Cuenin, supra note 6, at 428-36.

112. See supra text accompanying notes 47-48.

113. Curiously, Kahn and Cuenin begin this section of their article with the

observation that “the basis of the property received is important not only for its own

sake, but also because that determination could influence the decision whether the

partnership should recognize gain.” Kahn & Cuenin, supra note 6, at 428. Unfortunately,

their failure to revisit the implications of this observation means that they do not fully

explore the opportunities for tax avoidance that their proposal entails. See infra text

accompanying notes 129-30.

114. IRC § 732(a)(1). The basis of the property received in a distribution by

the partnership is limited to the partner’s basis in his partnership interest. IRC

§ 732(a)(2).

but only where it was needed to prevent results that would contravene basic

tax principles.”  As illustrated by the paradigm of the sole proprietor,110

compensatory in-kind transfers of property result in income to the recipient

and (typically) a deductible expense to the payor, as well as the recognition

of gain or loss by the payor with respect to the property transferred. Clearly,

the tax results in the sole proprietor paradigm are illustrative of “basic tax

principles” under the Code. The proposed non-recognition of gain or loss on

the transfer of partnership property in satisfaction of a guaranteed payment,

as advocated by Kahn and Cuenin, conflicts with these basic principles. 

D. Basis of Property Received as a Guaranteed Payment 

Having concluded that there is no gain or loss recognition to the

partnership on the transfer of partnership property in satisfaction of a

guaranteed payment, Kahn and Cuenin address the determination of the basis

of the property received in the hands of the recipient partner.  As previously111

described, they conclude that the recipient partner takes a fair market value

basis in the property received.  Because the result of their approach is112

consistent with that under the sole proprietor paradigm, we can find no fault

with their conclusion. Their analysis, however, is another matter.113

Because section 707(c) makes no reference to specific provisions of

the Code that would require third-party treatment in connection with the

basis issue, the presumption employed by Kahn and Cuenin requires that the

transferred property be treated as a distribution of partnership property

generally resulting in a carryover basis for the property in the partner’s

hands.  To avoid this result and provide the property with a fair market114

value basis, Kahn and Cuenin attempt to identify a compelling reason for

such a conclusion in order to rebut this presumption. They claim to have

accomplished this objective through a capital account analysis demonstrating

that a carryover basis for the transferred property would improperly account



374 Florida Tax Review [V0l.7:6

115. Kahn & Cuenin, supra note 6, at 428-32. As described below, this analysis

appears flawed. See infra text accompanying notes 138-49.

116. Kahn & Cuenin, supra note 6, at 432.

117. Kahn & Cuenin, supra note 6, at 433.

118. Kahn & Cuenin, supra note 6, at 433.

119. Kahn & Cuenin, supra note 6, at 433. See supra text accompanying notes

95-108.

120. Kahn & Cuenin, supra note 6, at 428-29.

for the amount of income that the recipient partner would ultimately

recognize on the subsequent disposition of his partnership interest.115

Kahn and Cuenin acknowledge that their approach, which does not

require the recognition of gain or loss by the partnership and allows the

recipient partner to receive a fair market value basis in the transferred

property, preserves the appropriate amount of gain or loss as does a

third-party approach in which gain or loss is recognized by the partnership

and the transferred property takes a fair market value basis in the hands of

the recipient partner.  They claim the only difference between their116

proposal and the sole proprietor paradigm is the timing of the recognition of

this gain or loss and the potential character of the gain or loss. Under their

proposal, the gain or loss attributable to the transferred property will not be

recognized when the transfer is made but only at some later time when the

partners dispose of their partnership interests.  In addition, and as117

previously described, gain that would otherwise be taxable as ordinary

income can be converted into capital gain if the property transferred would

have generated ordinary income if sold by the partnership.118

Despite these differences, Kahn and Cuenin revert to their previous

discussion that promoting the policy goal of Subchapter K to allow for the

non-recognition of gain or loss on distributions of partnership property is

more important than the “minor cost” associated with the conversion of

ordinary income into capital gain.  However, in dismissing this type of119

potential for abuse, they overlook another significant problem that their

proposal entails. Unlike typical distributions of partnership property, in

which the unrecognized gain or loss is preserved in the property itself, the

unrecognized gain or loss in the transferred property under their proposal is

transferred to the partners’ partnership interests. In addition, because the

transferred property receives a fair market value basis in the hands of the

recipient partner, that partner can subsequently deal with the property free of

any tax implications. These two facts, by themselves, create opportunities for

abuse. 

This problem can be illustrated through the examples developed by

Kahn and Cuenin. They describe a situation in which P, a general

partnership, has three equal partners, A, B, and C.  In Year 1, P has neither120



2006] The Lazarus Effect 375

121. In their description of the facts of the example, Kahn and Cuenin state that

the book value of each asset equals its fair market value. In addition, they focus on the

partners’ capital accounts and assert that, because the book value of each asset equals

its fair market value, the appreciation of each asset has already been included in the

partners’ capital accounts. Kahn and Cuenin may have made the assumption that the

book value of each asset equals its fair market value to simplify the explication of their

analysis. In reality, this would be a most unusual situation because capital accounts are

not adjusted except as authorized under the § 704 Regulations. Kahn and Cuenin state

only that “[u]nder certain specified circumstances, the book value of the partnership’s

assets and the partners’ capital accounts can be written up or down to reflect a

revaluation of the partnership’s assets.” Kahn & Cuenin, supra note 6, at 428, n.68

(citing Regs. § 1.704-1(b)(2)(iv)(f)). While this general statement is correct, the

difficulty is that a revaluation of all assets is not permitted under the circumstances that

they are addressing, a distribution of partnership property. In such a situation, only the

book value of the distributed asset would be written up or down to its current value.

Regs. § 1.704-1(b)(2)(iv)(f)(5)(ii). A further difficulty arises because of their unique

interpretation that the transfer of the asset is not a distribution for purposes of

determining the property’s basis. Thus, it is far from clear that any book up would be

available for any asset under their interpretation. Confusingly, later in the article, they

apply their analytical framework to a situation in which the book and fair market values

of the distributed property differ and demonstrate that their approach is unaffected.

Kahn & Cuenin, supra note 6, at 433-35. Because the use of the partners’ capital

accounts is unnecessary to the actual analysis, we have modified Kahn and Cuenin’s

examples and refer only to the bases and fair market values of the partners’ partnership

interests instead of referring to their capital accounts.

net income nor net loss. In addition, the partnership has no liabilities.  The121

bases and fair market values of the partnership’s assets and the partners’

partnership interests are as provided in Figure 1. Each partner has $10,000 of

gain inherent in his partnership interest ($30,000 fair market value minus

each partner’s $20,000 outside basis).

Figure 1

Partnership’s Assets and Partners’ Partnership Interests

Prior to the Guaranteed Payment

Assets    Partnership Interests 

      AB               FMV          AB     FMV   

Cash   $35,000         $35,000      A     $20,000         $30,000 

Land 1   $10,000         $25,000      B     $20,000 $30,000 

Land 2   $15,000         $30,000      C     $20,000 $30,000 

Total   $60,000         $90,000      Total    $60,000 $90,000 

On December 31, Year 1, P transfers Land 2 to A as a guaranteed

payment. Under Kahn and Cuenin’s proposal, A has ordinary income of

$30,000 and takes a basis in Land 2 equal to its fair market value, $30,000.



376 Florida Tax Review [V0l.7:6

122. See IRC § 705(a)(2); Regs. § 1.705-1(a)(3).

123. Although each partner continues to have $10,000 of gain inherent in his

partnership interest, the distribution of partnership property that would have resulted in

ordinary income to the partnership if sold will result in the conversion of what would

have been ordinary income into capital gain on the sale of the partnership interest. See

supra text accompanying notes 95-108.

124. See Kahn & Cuenin, supra note 6, at 432.

125. See IRC § 705(a); Regs. § 1.705-1(a).

126. The character of this gain would be based on the type of property

transferred to A in satisfaction of the guaranteed payment. Thus, this approach would

not result in a potential shift of the character of gain realized by the partners on the

disposition of their partnership interests as compared with the approach proposed by

Kahn and Cuenin. See supra note 123.

In addition, P is allowed a deduction of $30,000. The deduction reduces each

partner’s outside basis by $10,000.  As a result, the bases and fair market122

values of the partnership’s assets and the partners’ partnership interests are as

provided in Figure 2. As can be seen, each partner continues to have $10,000

of gain inherent in his partnership interest ($20,000 fair market value minus

$10,000 outside basis).123

Figure 2

Partnership’s Assets and Partners’ Partnership Interests

Under Kahn and Cuenin’s Approach

Assets    Partnership Interests 

      AB               FMV          AB     FMV   

Cash   $35,000         $35,000      A     $10,000 $20,000 

Land 1   $10,000         $25,000      B     $10,000 $20,000 

Total   $45,000         $60,000      C     $10,000 $20,000 

    Total     $30,000 $60,000 

If the guaranteed payment is treated as a payment to a third party, the

results are different.  As under the Kahn and Cuenin proposal, A has124

ordinary income of $30,000 and takes a basis in Land 2 equal to its fair

market value, $30,000. However, P recognizes $15,000 of gain on the

transfer and is allowed a deduction of $30,000. Each partner is allocated a

net deduction of $5,000 because the recognized gain increases each partner’s

outside basis by $5,000 while the deduction reduces each partner’s outside

basis by $10,000.  As a result, the bases and fair market values of the125

partnership’s assets and the partners’ partnership interests are as provided in

Figure 3. As can be seen, each partner has only $5,000 of gain inherent in his

partnership interest ($20,000 fair market value minus $15,000 outside basis).

This reflects the fact that each partner has already accounted for $5,000 of

gain attributable to the property transferred to partner A.  As compared to126



2006] The Lazarus Effect 377

127. Kahn and Cuenin acknowledge the fact that “[i]deally, a partner’s share

of the net unrealized appreciation of properties held by the partnership should be the

same as the appreciation of the partner’s interest in the partnership . . . .” but note that

this situation will not always exist as a result of §§ 734(a) and 743(a). Kahn & Cuenin,

supra note 6, at 430. Unfortunately, the adoption of Kahn and Cuenin’s approach will

create yet another situation in which the tax results will diverge from the ideal. 

Kahn and Cuenin will have difficulty in claiming that the imbalance between

the partners’ aggregate outside bases and the aggregate inside bases of the partnership’s

assets could be cured through an adjustment to the bases of the partnership’s assets

under § 734 if the partnership files a timely election under § 754. This is because an

adjustment under § 734 is available only if the distributee partner recognizes gain or loss

under § 731(a)(1) or § 731(a)(2) as a result of the distribution or the basis of the

distributed property in the hands of the recipient partner differs from that of the property

in the hands of the partnership as a result of the application of the basis limitations under

§ 732(a)(2) or § 732(b). IRC § 734(b). Because the recipient partner does not recognize

gain or loss on the distribution of an in-kind guaranteed payment under § 731(a)(1) or

§ 731(a)(2) and takes a fair market value basis in the transferred property unaffected by

the basis limitations of § 732(a)(2) or § 732(b), a basis adjustment under § 734(b) is

unavailable under Kahn and Cuenin’s approach.

the results under Kahn and Cuenin’s proposal, the third-party approach

prevents both the deferral of income and the potential shift in the character of

the gain from ordinary income to capital gain if the property transferred is a

non-capital asset.

Figure 3

Partnership’s Assets and Partners’ Partnership Interests

Under an Entity Approach

Assets    Partnership Interests 

      AB               FMV          AB     FMV   

Cash   $35,000         $35,000      A     $15,000 $20,000 

Land 1   $10,000         $25,000      B     $15,000 $20,000 

Total   $45,000         $60,000      C     $15,000 $20,000 

    Total     $45,000 $60,000 

In addition, and as shown in Figure 2, Kahn and Cuenin’s approach

leads to a discrepancy between the partners’ aggregate outside bases

($30,000) and the aggregate inside bases of P’s assets ($45,000).  In their127

article, they acknowledge this fact but ignore its true significance.

 

Prior to the making of the guaranteed payment, there was

$30,000 appreciation in both P’s inside assets and in the

partners’ partnership interests. The appreciation in the

partners’ partnership interests was unchanged by the

payment, but $15,000 of P’s inside appreciation in Land 2



378 Florida Tax Review [V0l.7:6

128. Kahn & Cuenin, supra note 6, at 432. No similar discrepancy results under

the third-party approach because the partners’ aggregate outside bases ($45,000) is

equal to the aggregate inside bases of P’s assets ($45,000). Thus, the gain inherent in

the partners’ partnership interests is fully reflected in the partnership’s assets.

Transactions involving these assets will cause the partners to recognize neither excess

or inadequate gain or loss.

129. See  McKee, Nelson & Whitmire, supra note 42, at ¶ 13.03[5] (noting that

“[i]nherent in the allowance of a market value deduction is the realization of gain or loss

by the transferor of the property”). See also Martin J. McMahon, Jr., “Recognition of

Gain By a Partnership Issuing an Equity Interest for Services,” 109 Tax Notes 1161

(2005) (describing the opportunity for tax arbitrage when a partnership is permitted a

deduction equal to the value of any appreciated property transferred in return for the

rendition of services without the concomitant recognition of gain).

We recognize that the Service has recently issued a Proposed Regulation

providing that no gain or loss is recognized by a partnership on the transfer or

substantial vesting of a compensatory partnership interest despite the fact that the

transfer is treated as a guaranteed payment and the partnership is entitled to a deduction

in connection therewith. Prop. Regs. § 1.721-1(b)(2). Nevertheless, the proper treatment

of compensatory partnership interests (assuming that no gain or loss recognition by the

was removed from P and exists only as it continues to be

reflected in the partners’ appreciation in their partnership

interests. The total potential amount of gain to be recognized

was not changed. There was $30,000 of potential gain before

the payment was made, and the same amount afterwards.128

As a result, transactions involving the partnership’s assets will not fully

account for the gain inherent in the partners’ partnership interests. For

example, the partnership could sell Land 1, resulting in P’s recognition of

$15,000 of gain and causing each of the partners to report a distributive share

of partnership income of $5,000. Despite having liquidated the partnership’s

assets, each of the partners will still have $5,000 of gain inherent in their

partnership interests. The partners will only recognize this gain if the

partnership is itself liquidated or the partners sell their partnership interests. 

Although Kahn and Cuenin’s approach preserves the proper amount

of gain in the partners’ partnership interests, this discrepancy creates the

opportunity for abuse through the manipulation of basis. For example, under

their proposal, A, B, and C have each obtained a $10,000 deduction, $5,000

of which is attributable to appreciation in value that, although preserved in

the partners’ partnership interests, will not be subject to tax until the

disposition of those interests. In effect, the partnership can use appreciated

property to create deductions equal to the value of the transferred appreciated

property without the partners suffering the burden of the corresponding gain

recognition until some indefinite time in the future. Deductions are typically

not allowed on the transfer of appreciated property unless the taxpayer has

previously taken the value supporting the deduction into income.  Thus,129



2006] The Lazarus Effect 379

partnership on the transfer of such an interest is the proper treatment) may be

distinguishable from the proper treatment of the more typical situation involving

guaranteed payments paid in return for the rendition of services since no actual transfer

of partnership property occurs in the context of compensatory partnership interests.

130. Kahn and Cuenin end this portion of their article with an example in

which the outside basis of the partner receiving the guaranteed payment is not equal to

the partner’s share of the partnership’s aggregate inside bases of the partnership’s assets

because the partner acquired the interest through either purchase or inheritance. Kahn

& Cuenin, supra note 6, at 435-36. They proceed to demonstrate how, under their

proposal, the transfer of appreciated partnership property to the partner in satisfaction

of a guaranteed payment will allow the partner to avoid gain recognition on any

subsequent sale of the property as well as any subsequent sale of his partnership interest.

In the absence of a § 754 election, the partner would have been required to recognize

his share of partnership gain had the property been sold by the partnership to a

third-party. Of course, the partner could have avoided any such gain if a § 754 election

had been in effect. At the same time, the proper amount of gain for the remaining

partners is unaffected. 

Kahn and Cuenin appear to be making the argument that their proposal has the

benefit of avoiding gain recognition for such a partner when the partnership has not

made a § 754 election and that third-party treatment of a guaranteed payment would not

provide such a benefit. Kahn & Cuenin, supra note 6, at 439 (stating that “the deferral

system that applies to the guaranteed payment is one that would actually cure a glitch

in Subchapter K in some circumstances, and so can be said to further tax policy rather

than to hinder it” (footnote omitted)). However, their proposal has no effect in

connection with any other assets held by the partnership so that, unless the partnership

expects to transfer all of its property to the partner in satisfaction of a guaranteed

payment obligation, the problems faced by the partner in the absence of a § 754 election

cannot be avoided. Instead of viewing this as a benefit of their proposal, it simply

illustrates why a § 754 election is often of value to a partner acquiring a partnership

interest by purchase or inheritance. It would seem to be of only minor significance that

a particular approach to a question of statutory interpretation should be preferred to

another approach when, under certain circumstances, the first approach alleviates in part

Kahn and Cuenin’s proposal creates unacceptable tax shelter opportunities.

In addition, A now has an asset, Land 2, that can be disposed of without

recognition of gain. 

Kahn and Cuenin may maintain, as they do with the potential abuse

resulting from the conversion of ordinary income into capital gain, that this

concern is simply a “minor cost” that must be tolerated to effectuate the

policy of non-recognition on distributions of partnership property under

Subchapter K that they otherwise find compelling. However, a typical

distribution of partnership property does not entail the creation of deductions

that can be used to shelter other income nor does it result in a fair market

value basis in the distributed property that allows the recipient partner to

dispose of the property without tax implications. These distinctions seem, to

us, to be sufficiently compelling to require third-party treatment in

connection with all aspects of a guaranteed payment.130



380 Florida Tax Review [V0l.7:6

a problem that the second approach does not when an election, freely available to all

taxpayers regardless of which approach is adopted, may be made to fully resolve the

precise problem at hand.

131. Kahn & Cuenin, supra note 6, at 428.

132. Kahn & Cuenin, supra note 6, at 419-22. Actually, Kahn and Cuenin

address this question before addressing the questions of the recognition of gain or loss

by the partnership and the basis of the transferred property in the hands of the recipient

partner. Unlike the answers to the latter two questions, the answer to the question of the

effect of an in-kind guaranteed payment on the recipient partner’s basis in his

partnership interest appears not to raise issues that might have caused Kahn and Cuenin

to reassess their conclusions regarding gain or loss by the partnership and the basis of

the transferred property. See supra text accompanying notes 69-131.

133. IRC § 733; Regs. § 1.731-1.

134. See IRC § 705(a)(2); Regs. § 1.705-1(a)(3). Kahn and Cuenin note that

the effect on the partner’s outside basis would be identical to the effect of the

distribution on the partner’s capital account. Kahn & Cuenin, supra note 6, at 419 (citing

Regs. § 1.704-1(b)(2)(iv)(o)).

At the beginning of the section addressing the basis determination

for the property received in the hands of the recipient partner, Kahn and

Cuenin observed that “the basis of the property received is important not

only for its own sake, but also because that determination could influence the

decision whether the partnership should recognize gain.”  For the reasons131

articulated in this section of our article, as well as those in the previous

section, we believe that gain or loss recognition by the partnership is a

necessary consequence of in-kind guaranteed payments. 

E. Effect on Outside Basis of Guaranteed Payments

Finally, Kahn and Cuenin address the effect of an in-kind guaranteed

payment on the recipient partner’s basis in his partnership interest.132

Because section 707(c) makes no reference to specific provisions of the Code

that would require third-party treatment in connection with this basis issue,

the presumption employed by Kahn and Cuenin would require that the

transferred property be treated as a distribution of partnership property

generally, thus resulting in a reduction of the partner’s partnership interest in

an amount equal to the basis of the transferred property.  To avoid this133

result and conclude that no basis reduction results from the guaranteed

payment (other than the partner’s share of the deduction associated with the

guaranteed payment as provided under the Regulations to section 705),134

Kahn and Cuenin attempt to identify a compelling reason for such a

conclusion to rebut this presumption. As with the question involving the

basis of the transferred property in the hands of the recipient partner, they

claim to have accomplished this objective through a capital account analysis

in which treating the transfer as a distribution of partnership property with a

reduction in the basis of the recipient partner’s partnership interest equal to



2006] The Lazarus Effect 381

135. Kahn & Cuenin, supra note 6, at 419-22. But see infra text accompanying

notes 138-55.

136. Kahn & Cuenin, supra note 6, at 421-22.

137. See supra text accompanying notes 67-68.

the basis of the property in the hands of the partnership improperly accounts

for the amount of income that the recipient partner should appropriately

recognize.135

Kahn and Cuenin begin their analysis by examining a guaranteed

payment paid in cash to reach their conclusion that no direct basis reduction

is appropriate. They then extend the same treatment to in-kind payments

without any further discussion.  The important aspect of this analysis is that136

the same result is far more directly achieved through the application of the

basic tax principles reflected in the sole proprietor paradigm. The question

then becomes whether Congress would have endorsed this more complicated

analysis if, as Kahn and Cuenin acknowledge, it had paid any attention to

in-kind guaranteed payments when drafting Subchapter K.  The complexity137

of the analysis (as well as the potential for abuse as described in the previous

sections of this article) leaves us with significant doubts that it would. 

F. Kahn and Cuenin’s Erroneous Application of the Modified Aggregate

Approach 

Before considering the implications of the enactment of section

707(a)(2) to the treatment of guaranteed payments under section 707(c),

Kahn and Cuenin’s overall analysis must be revisited. As described above,

they claim that (1) the partnership recognizes neither gain nor loss on the

transfer of an in-kind guaranteed payment, (2) the basis of the transferred

partnership property in the hands of the recipient partner is equal to its fair

market value, and (3) the only adjustment in the recipient partner’s basis in

his partnership interest resulting from a guaranteed payment is the partner’s

share of the deduction generated by the guaranteed payment. To reach their

first conclusion, they treat a guaranteed payment as a distribution of

partnership property based on the limitations contained in the language of

section 707(c). They depart from the language of section 707(c) to reach

their second and third conclusions and claim to have compelling reasons to

do so, largely because they assert that the appropriate results are otherwise

impossible to achieve. However, consistent treatment of a guaranteed

payment as both an allocation of partnership income and a distribution of

partnership property will produce the appropriate results, albeit results

different from those obtained by Kahn and Cuenin, who fail to follow

through with their analysis based on the statutory language of section 707(c).

If a guaranteed payment is treated as an allocation of partnership

income followed by a distribution of partnership property, Kahn and



382 Florida Tax Review [V0l.7:6

138. See supra text accompanying notes 120-23.

Cuenin’s first conclusion that the partnership realizes neither gain nor loss on

the transfer of an in-kind guaranteed payment is correct. However, their

second and third conclusions do not follow from the first. Instead, the basis

of the transferred partnership property in the hands of the recipient partner

should be a carryover basis from the partnership, consistent with the general

rule applicable to distributions of partnership property, and the adjustments

to the recipient partner’s outside basis similarly should follow the rules

applicable to all allocations of partnership income and distributions of

partnership property. 

Kahn and Cuenin’s analysis with respect to their second and third

conclusions is based on a consideration of the economics of the transaction.

To demonstrate the proper application of Kahn and Cuenin’s preferred

interpretation of section 707(c), let us return to the example contained in

their article and described above.  P, a general partnership, has three equal138

partners, A, B, and C. In Year 1, P has neither a net income nor a net loss. In

addition, the partnership has no liabilities. The bases and fair market values

of the partnership’s assets and the partners’ partnership interests are as

provided in Figure 1. (For convenience, Figures 1 and 2 are reproduced

below.) 

Figure 1

Partnership’s Assets and Partners’ Partnership Interests

Prior to the Guaranteed Payment

Assets    Partnership Interests 

      AB               FMV          AB     FMV   

Cash   $35,000         $35,000      A     $20,000 $30,000 

Land 1   $10,000         $25,000      B     $20,000 $30,000 

Land 2   $15,000         $30,000      C     $20,000 $30,000

Total   $60,000         $90,000      Total     $60,000 $90,000 

On December 31, Year 1, P transfers Land 2 to A as a guaranteed

payment. Under Kahn and Cuenin’s proposal, A has ordinary income of

$30,000 and takes a basis in Land 2 equal to its fair market value, $30,000.

In addition, P is allowed a deduction of $30,000. The deduction reduces each

partner’s outside basis by $10,000. As a result, the bases and fair market

values of the partnership’s assets and the partners’ partnership interests are as

provided in Figure 2.



2006] The Lazarus Effect 383

139. Kahn & Cuenin, supra note 6, at 432.

140. The modified aggregate approach described herein is intended to describe

the treatment of a guaranteed payment under § 707(c) as originally enacted. It is an

alternative to the pure aggregate approach that the courts generally applied in

determining the tax treatment of partner salaries prior to the enactment of § 707(c). For

further discussion of the pure aggregate approach and the modified aggregate approach,

see infra note 149. Kahn and Cuenin’s approach is not reflective of either the pure

aggregate approach or the modified aggregate approach. As described previously, Kahn

and Cuenin’s approach is a strange hybrid, combining aspects of the modified aggregate

approach and the entity approach.

Figure 2

Partnership’s Assets and Partners’ Partnership Interests

Under Kahn and Cuenin’s Approach

Assets    Partnership Interests 

      AB               FMV          AB     FMV   

Cash   $35,000         $35,000      A     $10,000 $20,000 

Land 1   $10,000         $25,000      B     $10,000 $20,000 

Total   $45,000         $60,000      C     $10,000 $20,000 

    Total     $30,000 $60,000 

According to their analysis, the amount of appreciation in each

partner’s partnership interest, $10,000, is the same before the transfer

($30,000 fair market value minus $20,000 outside basis) as after the transfer

($20,000 fair market value minus $10,000 outside basis). If the basis of the

transferred property in the hands of the recipient partner, A, is equal to its

fair market value, A’s potential gain on the sale of both Land 2 ($0) and his

partnership interest ($10,000) will be the appropriate amount, $10,000.

Alternatively, if the basis of Land 2 is $15,000, its basis in the hands of the

partnership, they claim that A’s potential gain on the sale of both Land 2

($15,000) and his partnership interest ($10,000) will be $25,000. “Clearly, a

gain of $25,000 would be excessive.”139

But had Kahn and Cuenin adjusted the recipient partner’s basis in his

partnership interest by treating the guaranteed payment as a distributive share

of partnership income followed by a distribution of partnership property as

they claim the explicit language of section 707(c) requires, a gain of $25,000

would not have arisen. We will refer to the treatment of a guaranteed

payment in this manner as the “modified aggregate approach.”  To140

appreciate all of the adjustments that must be made, the bases of the partners’

partnership interests must be considered at two points in time: (1)

immediately following the determination of the guaranteed payment but prior

to its payment and (2) immediately following the transfer of partnership



384 Florida Tax Review [V0l.7:6

141. Such an approach is consistent with the Regulations under § 707(c) which

recognize that an accrual-method partnership can make a guaranteed payment without

making an actual transfer of money or property. Regs. § 1.707-1(c) (second sentence).

See Gaines v. Comm’r, T.C.Memo. 1982-731, 45 T.C.M. (CCH) 363 (noting that the

absence of any actual payment does not affect the status of a transaction as a guaranteed

payment under § 707(c)); Pratt v. Comm’r, 64 T.C. 203 (1975), aff’d in part, rev’d in

part, 550 F.2d 1023 (5th Cir. 1977). As a result, a guaranteed payment can be bifurcated

into the two steps referred to in the text although the statutory language speaks only in

terms of a single payment.

142. See IRC § 705(a)(2); Regs. § 1.705-1(a)(3).

143. See IRC § 705(a)(1); Regs.§§ 1.705-1(a)(2). See Gaines v. Comm’r, T.C.

Memo. 1982-731, 45 T.C.M. (CCH) 363, n.17 (“As part of a partner’s distributive share

of profit and loss, the guaranteed payments included in his income increase the partner’s

basis in his partnership interest. Sec. 705(a)(1) and (2).”). Cf. Rev. Rul. 9126, 1991-1

C.B. 184 (accident and health insurance premiums paid by a partnership on behalf of

its partners are includable in the partners’ gross incomes because the premiums are

treated as a distributive share of partnership income under § 707(c)). 

144.  The existence of an unpaid guaranteed payment could be conceptualized

in two ways. Under the first approach (adopted in the text), the unpaid guaranteed

payment could be reflected in the capital account of the service partner as simply a

special allocation of partnership income. The partner’s capital account would be

increased by the amount of the guaranteed payment/special allocation and then reduced

by the fair market value of the partnership property distributed in satisfaction of the

guaranteed payment. Regs. §§ 1.704-1(b)(2)(iv)(b) and 1.704-1(b)(2)(iv)(e)(1). Of

course, the partner’s capital account would also be reduced by the partner’s share of the

property in satisfaction of the guaranteed payment.  This two-step analysis141

is appropriate regardless of the method of accounting adopted by the

partnership. However, its application is more clearly illustrated by

considering an in-kind guaranteed payment in the context of an

accrual-method partnership and a cash-method partner in which the transfer

of property in satisfaction of the guaranteed payment does not occur until the

year following that in which the services giving rise to the guaranteed

payment are rendered. 

Assume that in Year 1, A is entitled to a guaranteed payment of

$30,000 for services rendered to an accrual-method partnership, but no

transfer of partnership property occurs until Year 2. For Year 1, A has

ordinary income of $30,000, and P is allowed a deduction of $30,000. The

deduction reduces each partner’s outside basis by $10,000.  In addition,142

treating the guaranteed payment as a distributive share of partnership income

creates a $30,000 increase in A’s outside basis.  As a result, the bases and143

fair market values of the partnership’s assets and the partners’ partnership

interests are as provided in Figure 2A. As can be seen, each partner continues

to have $10,000 of gain inherent in his partnership interest ($50,000 fair

market value minus $40,000 outside basis for A and $20,000 fair market

value minus $10,000 outside basis for B and C).144



2006] The Lazarus Effect 385

deduction attributed to the guaranteed payment. Regs. §§ 1.704-1(b)(2)(iv)(b). If the fair

market value of the property distributed in satisfaction of the guaranteed payment

exactly equals the amount of the guaranteed payment, the net effect on the partner’s

capital account is a reduction equal to the partner’s share of  the deduction attributed to

the guaranteed payment. This is exactly the result dictated by the Regulations in

connection with guaranteed payments that are presumably paid in cash. Regs. § 1.704-

1(b)(2)(iv)(o). See supra note 78. 

Under the second approach, the unpaid guaranteed payment could be viewed

as creating an obligation on the part of the partnership and a claim by the service partner

against the assets of the partnership that must be satisfied before any liquidating

distributions may be made to the partners based on the balances of their capital

accounts. The partner’s claim would thus be analogous to that of a third party in a

comparable situation. Presumably, the obligation of an accrual-method partnership

would create a liability for purposes of § 752 that would be allocable to the partners and

result in an increase in the bases of their partnership interests. Regs.

§ 1.752-1(a)(4)(i)(B). The $20,000 basis of each partner’s partnership interest (see

Figure 1) would be reduced by that partner’s share of the deduction attributable to the

guaranteed payment and increased by that partner’s share of the resulting liability. In

such a situation, the bases and fair market values of the partnership’s assets and the

partners’ partnership interests would be as provided below. If, prior to the transfer of

cash or property by the partnership in satisfaction of the guaranteed payment, one of the

partner’s sold his partnership interest, that partner would have $10,000 of gain equal to

the difference between the amount realized of $30,000 ($20,000 fair market value plus

$10,000 relief of liability) and the $20,000 basis of his partnership interest.

Partnership’s Assets/Liabilities and Partners’ Partnership Interests

Under the Modified Aggregate Approach

      Assets/Liabilities Partnership Interests

        AB              FMV         AB               FMV 

Cash     $35,000         $35,000        A    $20,000         $20,000 

Land 1     $10,000         $25,000     B    $20,000         $20,000 

Land 2     $15,000         $30,000     C    $20,000         $20,000 

Total     $60,000         $90,000     Total    $60,000         $60,000 

Liability                         ($30,000) 

    Net                           $60,000

Although an unpaid guaranteed payment is conceptualized differently under

the two approaches described above, the tax treatment of the guaranteed payment is not

affected. The Code and Regulations are ambiguous on which conceptualization is

preferred. However, to the extent that the Regulations under §§ 704 and 752 would treat

the guaranteed payment in a manner similar to a payment involving a third party, they

serve as support for our argument that entity treatment of the guaranteed payment is

more appropriate than the approach proposed by Kahn and Cuenin. 

We now turn our attention to the implications of the transfer of

partnership property in satisfaction of the guaranteed payment. To do so, we

first consider the implications of a $30,000 cash payment, rather than an



386 Florida Tax Review [V0l.7:6

145. See IRC § 733; Regs. § 1.733-1.

in-kind transfer of partnership property, in satisfaction of the guaranteed

payment. If the guaranteed payment is treated as a distribution of partnership

property, A’s outside basis will be reduced by $30,000.  As a result, the145

bases and fair market values of the partnership’s assets and the partners’

partnership interests are as provided in Figure 2B. As can be seen, each

partner continues to have $10,000 of gain inherent in his partnership interest

($20,000 fair market value minus $10,000 outside basis). Thus, the proper

amount of income has been preserved for each partner. 

Figure 2A 

Partnership’s Assets and Partners’ Partnership Interests 

Under the Modified Aggregate Approach 

Assets    Partnership Interests 

      AB               FMV          AB     FMV   

Cash   $35,000         $35,000      A     $40,000 $50,000 

Land 1   $10,000         $25,000      B     $10,000 $20,000 

Land 2   $15,000         $30,000      C     $10,000 $20,000 

Total   $60,000         $90,000      Total     $60,000 $90,000 

Figure 2B

Partnership’s Assets and Partners’ Partnership Interests

Under the Modified Aggregate Approach

(Cash Payment)

Assets    Partnership Interests 

      AB               FMV          AB     FMV   

Cash   $  5,000         $  5,000      A     $10,000 $20,000 

Land 1    $10,000         $25,000      B     $10,000 $20,000 

Land 2    $15,000         $30,000      C     $10,000 $20,000 

Total    $30,000         $60,000      Total     $30,000 $60,000 

Importantly, Figure 2B is virtually identical to Figure 2 except in

two respects. First, the types of the partnership’s assets after the transfer are

different because P distributed cash instead of Land 2 to A to satisfy the

guaranteed payment. Second, and far more significant, there is no

discrepancy between the partners’ aggregate outside bases ($30,000) and the

aggregate inside bases of P’s assets ($30,000). As a result, transactions

involving the partnership’s assets will fully account for the gain inherent in

the partners’ partnership interests. For example, if P liquidates the



2006] The Lazarus Effect 387

146. See McKee, Nelson & Whitmire, supra note 42, at ¶ 13.03[5]; Sheldon

I. Banoff, supra note 109, at 836.

147. See IRC § 733; Regs. § 1.733-1.

148. See IRC § 732(a)(1); Regs. § 1.732-1(a).

partnership’s assets and realizes $30,000 of gain, this gain will account for

all of the gain inherent in the partners’ partnership interests. 

Now consider the implications if P satisfies the guaranteed payment

by transferring Land 2, property with a fair market value of $30,000, and the

transfer is treated as a distribution of partnership property.  A’s outside146

basis will be reduced by $15,000, the basis of Land 2 in P’s hands.  In147

addition, A will take a carryover basis of $15,000 in Land 2.  As a result,148

the bases and fair market values of the partnership’s assets and the partners’

partnership interests are as provided in Figure 2C.

Figure 2C

Partnership’s Assets and Partners’ Partnership Interests

Under the Modified Aggregate Approach

(In-Kind Payment)

Assets    Partnership Interests 

      AB               FMV          AB     FMV   

Cash   $35,000         $35,000      A     $25,000 $20,000 

Land 1   $10,000         $25,000      B     $10,000 $20,000 

Total   $45,000         $60,000      C     $10,000 $20,000 

    Total     $45,000 $60,000 

Like Figure 2B, Figure 2C is virtually identical to Figure 2 except in

two respects. First, like the results shown in Figure 2B, there is no

discrepancy between the partners’ aggregate outside bases ($45,000) and the

aggregate inside bases of P’s assets ($45,000). As a result, transactions

involving the partnership’s assets will again fully account for the gain

inherent in the partners’ partnership interests. Second, A’s outside basis is

$25,000 rather than $10,000, which will result in a $5,000 loss if sold for

$20,000. This basis and the resulting loss is appropriate, however, because A

holds Land 2 with a basis of $15,000 and a fair market value of $30,000. A’s

potential gain on the sale of both Land 2 ($15,000) and his partnership

interest (a $5,000 loss) will be $10,000. B and C continue to have $10,000 of

gain inherent in their partnership interests ($20,000 fair market value minus

$10,000 outside basis). Thus, each partner’s potential gain of $10,000 before

the payment was determined remains the same following the transfer of the

partnership property in satisfaction of the guaranteed payment. 

The benefit of treating the guaranteed payment consistently as a

distributive share of partnership income and a distribution of partnership



388 Florida Tax Review [V0l.7:6

149. The modified aggregate approach is, in our view, the approach most likely

intended by Congress when it originally enacted § 707(c). Prior to the enactment of the

1954 Code, salaries paid to partners were viewed as simply a special allocation of

partnership income and a distribution of partnership property in the form of cash. This

view prevailed because, under a pure aggregate theory of partnerships, a partner was

considered as incapable of being an employee of the partnership. Pauli v. Comm’r, 11

B.T.A. 784 (1928) (concluding that an agreement between the partners to pay salaries

only served as a basis for dividing partnership profits); Estate of Tilton, 8 B.T.A. 914

(1927) (“In effect any allowances drawn by a partner from partnership assets are

payments which he makes to himself and no man can be his own employer or

employee.”). But see Wegener v. Comm’r, 119 F.2d 49 (5th Cir. 1941) (employing the

entity theory of partnerships to require that a partner rendering services to a partnership

include the full amount of compensation in income without reduction for any alleged

self-paid portion thereof); Sverdup v. Comm’r, 14 T.C. 859 (1950) (compensation for

services not considered as a distributive share of partnership income and, thus,

excludable from gross income under § 116 of the 1939 Code); Toy v. Comm’r, BTA

Memo. 1442 (1942) (concluding that a partner was taxable on commissions he paid the

partnership on acquisition of partnership property; partner’s share of commissions not

a reduction in purchase price). 

The application of the pure aggregate theory can be illustrated through the

following example. Assume that A and B are members of the AB partnership in which

A holds a 25% interest and B holds a 75% interest. In addition to a distributive share of

partnership income, A is entitled to receive a salary of $30,000 each year. If the

partnership income is $100,000 before taking into account A’s salary, A will receive a

$47,500 distributive share of partnership income, made up of a $30,000 special

allocation of partnership income equal to the specified salary plus $17,500, A’s

distributive share of the partnership income ($70,000 after taking into account the

special allocation times 25%). B will receive a $52,500 distributive share of partnership

income ($70,000 after taking into account the special allocation times 75%). A’s

distributive share of partnership income is the same as a salary of $30,000 plus A’s

distributive share of the partnership income after treating the salary as a deductible

expense. The same is true for B as well. 

Problems with the pure aggregate theory arise, however, when partnership

income is less than the salary payment in a particular year. Under Service Rulings and

judicial decisions prior to the enactment of the 1954 Code, a partner’s salary in such a

situation was considered to be comprised of the recipient partner’s distributive share of

partnership income plus a return of capital shared between the two partners. Lloyd v.

Comm’r, 15 B.T.A. 82 (1929), acq.; Estate of Tilton, 8 B.T.A. 914 (1927); Rev. Rul.

55-30, 1955-1 C.B. 430; G.C.M. 6582, VIII-2 C.B. 200 (1929); G.C.M. 2467, VIII-2

C.B. 188 (1928). See Stout v. Comm’r, 31 T.C. 1199 (1959), aff’d in part and remanded

property is that, as compared to Kahn and Cuenin’s proposal, there is no

necessity to depart from the language of section 707(c). In addition, the

treatment of the guaranteed payment follows the general rules applicable to

allocations of partnership income and distributions of partnership property.

No special rules are necessary to properly determine either the basis of the

transferred property in the hands of the recipient partner or the basis of the

recipient partner’s partnership interest.  149



2006] The Lazarus Effect 389

sub nom., Rogers v. Comm’r, 281 F.2d 233 (4th Cir. 1960) (applying pre-‘54 law). See

also Benjamin v. Hoey, 139 F.2d 945 (1944) (partner not taxable on share of

commissions paid to a partnership by the partner). The recipient partner’s share of his

own return of capital was not taxable while the portion contributed by the other partners

was treated as income to the recipient partner and a deduction for the other partners.

The complications resulting from application of the aggregate theory in such

a situation can be illustrated using the facts of the prior example. If the partnership

income was only $20,000 in a particular year, A’s salary of $30,000 was considered to

be comprised of all of the partnership income plus a return of capital shared between the

two partners. A’s distributive share of partnership income would be $20,000 (the

amount of the partnership’s income less than the salary amount). The $10,000 of salary

in excess of A’s distributive share was considered as funded in the amount of $2,500

($10,000 times 25%) from A’s contributed capital and $7,500 ($10,000 times 75%)

from B’s contributed capital. Thus, A had income of $27,500 ($20,000 distributive share

of partnership income plus $7,500 of capital from B). A’s $2,500 return of capital was

not taxable. B had a deduction of $7,500 (B’s share of capital transferred to A). Of

course, the calculations become more complicated if multiple partners receive a salary

in such a situation. See Lloyd v. Comm’r, 15 B.T.A. 82 (1929). 

The complicated calculations described in the preceding paragraph could be

vastly simplified by treating the salary as a deductible expense of the partnership. Thus,

if the partnership’s income were only $20,000 before accounting for the partner’s salary

and partner A was entitled to a salary of $30,000, the partnership could be treated as

having a loss of $10,000 ($20,000 partnership income - $30,000 partner A’s salary),

allocated $2,500 ($10,000 partnership loss times 25%) to A and $7,500 ($50,000

partnership loss times 75%) to B. Thus, A would have net income of $27,500 ($30,000

from the salary paid - $2,500 distributive share of partnership loss), and B would have

loss of $7,500 ($10,000 partnership loss times 75%), the same results produced above.

Recognizing the equivalence in result between these two methods, Congress

probably only intended that § 707(c) incorporate the less complicated approach rather

than the more complicated approach applicable under prior law. (We have referred to

the more complicated approach applicable under prior law as the “pure aggregate

approach” and to the less complicated approach as the “modified aggregate approach.”)

This interpretation would explain the “but only” language of § 707(c) under which the

entire amount of the partner’s salary is included in the partner’s gross income under

§ 61(a) (with no portion treated as a return of capital) and the partnership is allowed a

corresponding deduction under § 162 (which had not been permitted under the pure

aggregate approach). This interpretation would also explain the statements in the

legislative history to the effect that the pre-1954 treatment of transactions between

partners and partnerships was “unrealistic and unnecessarily complicated.” H.R. Rep.

No. 83-1337, at 68 (1954), reprinted in 1954 U.S.C.C.A.N. 4017, 4094. See Arthur B.

Willis, Handbook of Partnership Taxation § 11.05 (1st ed., 1957) (“The Senate

Committee on Finance suggests that one significant effect is to clarify the tax status of

the situation where the guaranteed compensation paid to a partner exceeds partnership

net income, computed before deducting compensation to the partners.” (footnote

omitted)). 

Unfortunately, the modified aggregate approach cannot be characterized as

solely a simplified version of the pure aggregate approach because it does not reach the

same results as the pure aggregate approach when the partnership has capital gain or tax



390 Florida Tax Review [V0l.7:6

exempt income rather than, or in addition to, ordinary income. Under the modified

aggregate approach, no portion of the partner’s salary is treated as capital gain or tax

exempt income although it would be under the pure aggregate approach. Commentators

at the time noted this inconsistency. Id. at § 11.05,  n.21; J. Paul Jackson, et al., supra

note 44, at 1202. Indeed, one group of commentators criticized § 707(c) as “inequitable

in that it may deprive a partner of the tax benefits of capital gains or tax exempt

interest.” Id. at 1204. In addition, the two approaches are not the same if, under the

modified aggregate approach, the partnership is required to capitalize the salary payment

as if the payment had been made to a third-party when a distribution of partnership

income under the pure aggregate approach would not be capitalized. Curiously, a desire

to keep the results under the modified aggregate approach as consistent as possible with

the results under the pure aggregate approach may explain why § 263 was not included

in § 707(c), along with §§ 61(a) and 162(a), as originally enacted. 

In suggesting that Congress originally intended to implement the modified

aggregate approach under § 707(c), we acknowledge the conflict thus created with our

argument in this commentary that the entity theory should be applied to in-kind

guaranteed payments. Although the treatment of partner salaries by both a partner and

the partnership under the modified aggregate approach is consistent with certain aspects

of the entity theory, the modified aggregate approach was not viewed as the adoption

of the entity theory but as only a restatement of the aggregate theory in simplified form.

See Willis, Handbook of Partnership Taxation, supra at § 11.05 at 131 (“When it’ s all

sifted down, the net effect of considering guaranteed compensation paid to a partner as

made to one who is not a partner is quite innocuous and marks little change from prior

law.”). See also J. Paul Jackson, Mark H. Johnson, Stanley S. Surrey & William C.

Warren, “A Proposed Revision of the Federal Income Tax Treatment of Partnerships

and Partners – American Law Institute Draft,”  9 Tax L. Rev. 109, 138-39, 177 (1954)

(advocating the adoption of the entity theory in connection with transactions between

partners and partnerships but only when the partner is not acting in his capacity as a

partner). Because § 707(c) represented a continuation of the aggregate approach, albeit

in modified form, the aggregate theory should have continued to serve as the model for

all other purposes including, presumably, in-kind guaranteed payments, at least until the

enactment of § 707(a)(2)(A) in 1984. 

Nevertheless, almost immediately following the enactment of Subchapter K,

§ 707(c) was seen as incorporating the entity theory for most, if not all, purposes. See

Cagle v. Comm’r, 63 T.C. 86 (1974) (requiring the capitalization of guaranteed

payments prior to the amendments of § 707(c) in 1976 and referring to the “employment

of the entity theory of partnerships in this facet of partnership taxation”), aff’d, 539 F.2d

409 (5th Cir. 1976); Rev. Rul. 81-300, 1981-2 C.B. 143 (“[u]nder § 707(c), the

partnership is considered an unrelated entity for purposes of §§ 61 and 162 . . .” ); J.

Paul Jackson, et al., supra note 44, at 1201-02 (“The new law applies the entity concept

not only to a partner’s transactions with his partnership when he is not acting in his

capacity as a partner, but also to guaranteed annual payments of salary and interest.”).

Our ultimate conclusion that the entity theory should be applied in connection with

in-kind guaranteed payments does not rely on this judicial and administrative “gloss,”

however, but on the legislative enactment of § 707(a)(2)(A). See infra text

accompanying notes 156-62. 



2006] The Lazarus Effect 391

150. This concern has been noted by others. 1 McKee, Nelson & Whitmire,

supra note 42, at ¶ 13.03[5].

Of course, the results under Kahn and Cuenin’s proposal, the

modified aggregate approach developed above, and the entity approach that

we advocate differ with respect to both the timing and potentially the

character of any resulting income, gain, deduction, or loss. The results are

summarized below. 

Kahn and Cuenin’s Approach 

Year 1 tax implications for A 

 $30,000 guaranteed payment – ordinary income 

($10,000)  deduction 

Future tax implications for A 

$10,000 gain inherent in partnership interest 

$ 0 no gain or loss in Land 2

Modified Aggregate Approach 

Year 1 tax implications for A 

 $30,000 guaranteed payment – ordinary income 

($10,000) deduction 

Future tax implications for A 

($ 5,000) loss inherent in partnership interest 

 $15,000 gain inherent in Land 2

Entity Approach 

Year 1 tax implications for A 

 $30,000 guaranteed payment – ordinary income 

($10,000) deduction 

 $  5,000 share of gain on transfer of Land 2 

Future tax implications for A

 $ 5,000 gain inherent in partnership interest 

The modified aggregate approach produces some potentially

troubling results. First, the recipient partner receives a carryover basis in the

transferred property despite the fact that she was taxed on the full fair market

value of the property. As a result, she would realize additional income on a

subsequent disposition of the property.  However, this objection becomes150

questionable if the partner is viewed as taxed on the full fair market value of

the services rendered and not on the full fair market value of the property

ultimately transferred. In other words, the partner (as a provider of services)

should be viewed as the recipient of cash from the partnership in return for

the services rendered, which the partner (as a partner) immediately reconveys



392 Florida Tax Review [V0l.7:6

151. We acknowledge that this response raises the difficulty of how a partner

performing such services is acting, not as a partner, but as a third-party provider of

services if § 707(c) applies only when the partner is acting in the capacity of a partner.

That difficulty, however, is a result of the legislative shift in the definition of capacity

under § 707(a)(2)(A) without a full appreciation of its implications for guaranteed

payments under § 707(c).

152. Such an interpretation is not consistent with the capacity analysis of

§ 707(a)(2)(A), however, which views the rendition of services, the allocation of

partnership income, and the distribution of partnership property in such a situation as

all parts of a related transaction to be treated as a transaction between the partnership

and a non-partner under § 707(a)(1). This inconsistency illustrates the irreconcilability

of §§ 707(a)(2)(A) and 707(c) and the reason why we called for the repeal of § 707(c)

in our earlier article. Postlewaite & Cameron, supra note 2, at 694-96.

153. See supra text accompanying notes 129-30.

154. One is reminded of Jacob Rabkin and Mark Johnson’s admonition, “[i]f

it were a matter of redrafting the partnership tax law, perhaps as good a case can be

made for one theory as the other. One of them, however, must be consistently applied.”

Jacob Rabkin & Mark H. Johnson, “The Partnership Under the Federal Tax Law,” 55

Harv. L. Rev. 909, 949 (1942), quoted in Mark P. Gergen, “The Story of Subchapter K”

in Business Tax Stories 221 (Steven A. Bank & Kirk J. Stark eds., 2005).

to the partnership as a contribution of capital.  The subsequent distribution151

of property in satisfaction of the guaranteed payment is viewed as separate

and independent of the previous rendition of services. The partner is treated

as acting as a third party with respect to the rendition of services and as a

partner with respect to the distribution of property. Such an approach is

consistent with the statutory language of section 707(c).  152

The modified aggregate approach also raises the same problem as

Kahn and Cuenin’s approach because the partnership is permitted a

deduction equal to the full fair market value of the property transferred (or

the services rendered if one prefers).  In effect, the partnership can use153

appreciated property to create deductions equal to the value of the

appreciated property involved without the partners suffering the burden of

the corresponding gain recognition until some indefinite time in the future.

Thus, the modified aggregate approach creates the same opportunities for tax

shelter abuses that are created by Kahn and Cuenin’s approach. 

Despite the potential objections to each approach, the issue now is a

choice between, not two, but three differing interpretations of section 707(c).

Which is the proper approach? We believe that Kahn and Cuenin’s proposal

is the least acceptable. It is least consistent with the statutory language and

combines both entity and aggregate concepts in a manner that creates

opportunities for abuse as previously described.  Alternatively, both the154

modified aggregate approach and the entity approach can be supported by

various aspects of the statutory language, the legislative history, and the

Regulations surrounding section 707(c), as well as statements contained in



2006] The Lazarus Effect 393

155. One commentator acknowledges that the modified aggregate approach

produces the proper amount of income over the life of the partnership for the partners

(as do the other two methods) but results in timing differences. McKee, Nelson &

Whitmire, supra note 42, at ¶ 13.03[5]. Nevertheless, they reject this approach as

inconsistent with the language of § 707(c) and open to uncertainty and complexity when

applied in conjunction with other sections of Subchapter K.

156. We apologize to the readers who have followed our discussion up to this

point but who are only interested in the final answer to the legal question regarding the

proper treatment of in-kind transfers to partners for the rendition of services, transfers

that are typically, albeit improperly, referred to as guaranteed payments (assuming that

the term “guaranteed payments” is reserved solely for payments falling within § 707(c)).

157. Postlewaite & Cameron, supra note 2.

158. See supra text accompanying notes 31-39.

judicial decisions both before and after 1954.  Fortunately, there is no155

reason to debate the question regarding the application of the modified

aggregate approach or the entity approach because Congress resolved any

controversy through the enactment of section 707(a)(2) in 1984.

G. The Application of Section 707(a)(2)156

Although we believe that the foregoing discussion more than

adequately demonstrates the superiority of treating in-kind guaranteed

payments as transfers to a third-party for all purposes, as opposed to the

approach advocated by Kahn and Cuenin that treats in-kind guaranteed

payments as a distribution of partnership property for some purposes and as a

payment to a third-party for other purposes, this debate is largely, if not

completely, academic. Congress addressed and resolved this issue through

the enactment of section 707(a)(2) as part of the Tax Reform Act of 1984. As

a result of the enactment of section 707(a)(2), Congress effectively repealed

section 707(c) and decided that the types of guaranteed payments that Kahn

and Cuenin describe in their article should be treated as payments to a third

party under section 707(a). The enactment of section 707(a)(2) was the

motivation for our earlier article.  Our conclusion that Congress effectively157

repealed section 707(c) is applicable to both cash and in-kind guaranteed

payments. 

Congress effectively repealed section 707(c) through its redefinition

of the concept of capacity under section 707(a). As previously described,158

section 707(a)(2) requires third-party treatment for any partner who renders

services or transfers property to a partnership and who thereafter receives a

related direct or indirect allocation and distribution if such transfers are

“properly characterized as a transaction occurring between the partnership

and a partner acting other than in his capacity as a member of the



394 Florida Tax Review [V0l.7:6

159. In the context of guaranteed payments, the “related allocation” for

purposes of § 707(a)(2) is the allocation of income attributable to the guaranteed

payment and the “related distribution” is the cash or property transferred by the

partnership in satisfaction of the guaranteed payment. This conceptualization of

guaranteed payments as an allocation and distribution of partnership income is

consistent with the modified aggregate approach described above.

160. S. Rep. No. 98-169, at 227 (1984); Regs. §§ 1.707-3, 1.707-4, 1.707-5,

and 1.707-6. See also Staff of the Joint Comm. on Tax’n, General Explanation of H.R.

4170, 227-28 (1984). 

161. The Congressional reversal of the conclusion in Revenue Ruling 81-300,

1981-2 C.B. 143, that fees for managerial services based on the gross rentals of the

partnership should be treated as payments under § 707(a), rather than § 707(c),

illustrates the dramatic effect of the enactment of § 707(a)(2). S. Rep. No. 98-169, at

230 (1984). See also Staff of the Joint Comm. on Tax’n, General Explanation of H.R.

4170, 230-31 (1984). 

162. See Postlewaite & Cameron, supra note 2, at 691-93. Of course, if the

transfer is expressly dependent on the income of the partnership, the transfer will not fall

within § 707(c) because it would not be “determined without regard to the income of the

partnership” and, thus, would be excluded from § 707(c). Conversely, if not dependent

on the income of the partnership, the transfer would not be subject to the entrepreneurial

risks of the partnership and, thus, would be included under § 707(a). As a consequence,

little, if anything, continues to fall within § 707(c). As we cautioned in our earlier

article, § 707(c) has been effectively repealed.

partnership.”  In making this determination, the legislative history and159

subsequent Regulations focus on the entrepreneurial risk to which the partner

is exposed in connection with the amount of any related distribution and

whether the distribution will, in fact, be made.  This new definition of160

capacity represented a dramatic shift from the earlier definition that

examined the connection between the types of services performed by the

partner and the activities in which the partnership was engaged. 

Under this revised definition of capacity, virtually all transfers from

a partnership to a partner for the rendition of services, whether in cash or

in-kind, will receive third-party treatment under section 707(a) unless the

transfer, with respect to both the fact and the amount of payment, is subject

to the entrepreneurial risk of the partnership.  As we stated in our earlier161

article, it is difficult to envision a transfer for the rendition of services by a

partner that, unless expressly dependent on the current or future income of

the partnership, could somehow be subject to the entrepreneurial risk of the

partnership.  Certainly, the types of transfers discussed by Kahn and162

Cuenin in their article would not be subject to the entrepreneurial risk of the

partnership and, thus, would be treated under section 707(a) as a payment to

a third party. Accordingly, there is no need to engage in the complicated

analysis advocated by Kahn and Cuenin. 

Because Kahn and Cuenin did not consider the dramatic change in

the concept of capacity introduced by the enactment of section 707(a)(2),



2006] The Lazarus Effect 395

163. Kahn & Cuenin, supra note 6, at 436-38.

164. Philip F. Postlewaite & Adam H. Rosenzweig, “Anachronisms in

Subchapter K of the Internal Revenue Code: Is It Time to Part with § 736?,” 100

Northwestern L. Rev. 379 (2005). See also Walter D. Schwidetzky, “Hyperlexis and the

Loophole,” 49 Okla. L. Rev. 403 (1996); John A. Lynch, Jr., “Taxation of the

Disposition of Partnership Interests: Time to Repeal IRC § 736,” 65 Neb.L. Rev. 450

(1986); Philip F. Postlewaite, Thomas E. Dutton & Kurt R. Magette, “A Critique of the

ALI’s Federal Income Tax Project – Subchapter K: Proposals on the Taxation of

Partners,” 75 Geo. L. J. 423 (1986).

165. Kahn & Cuenin, supra note 6, at 436.

they erroneously assumed that section 707(c) remains alive and well. This

was the precise concern that we addressed almost 20 years ago, and the

reason why we have expectantly waited for some official recognition that

section 707(c) represented only a trap for the unwary. 

IV. LIQUIDATING DISTRIBUTIONS 

In the concluding section of their analysis, Kahn and Cuenin

consider the implications of in-kind guaranteed payments in the context of

liquidating distributions under section 736.  Section 736 is a complicated163

and confusing aspect of Subchapter K with a questionable policy basis when

enacted in 1954 that has been significantly undermined since that time as a

result of amendments to both Subchapter K and the Code more generally.

Because of the problems inherent in section 736, one of us has called for its

repeal in a separate article.  Consequently, the difficulties that arise in164

considering the implications of in-kind guaranteed payments under section

707(c) are only compounded in the context of section 736. 

Essentially, Kahn and Cuenin incorporate their conclusions with

respect to guaranteed payments under section 707(c) into section 736 without

significant additional analysis. They simply assert that a partnership

recognizes no gain or loss on the transfer of partnership property to a partner

in liquidation of that partner’s partnership interest and that the partner takes a

fair market value basis in the property received regardless of whether the

payment falls within section 736(a) or section 736(b).  However, Kahn and165

Cuenin apparently ignore the fact that the context of transfers under section

736 is significantly different from that of section 707(c). Most importantly,

transfers under section 736 are not part of a reciprocal relationship between

the partner and the partnership involving the rendition of services or the use

of capital. This difference, by itself, influences the analysis of the proper

treatment of such transfers. Although section 736 explicitly refers to

guaranteed payments under section 707(c), this reference may not

incorporate all of the particular details of such payments as discussed above

for the purposes of liquidating distributions. 



396 Florida Tax Review [V0l.7:6

166. See also Postlewaite & Cameron, supra note 2, at 707-08 (describing how

guaranteed payments structured as a percentage of partnership income subject to a

minimum amount may not be determined in the same manner under § 736(a) as under

§ 707(c)).

167. Cagle, 63 T.C. at 95 (1974) (footnote omitted).

168. S. Rep. No. 94-938, 94, n.7 (1976), reprinted in 1976 U.S.C.C.A.N. 3439,

3530, n.7. See Regs. § 1.707-1(c) (specifically stating that the reference to § 263

contained in § 707(c) “does not affect the deductibility to the partnership of a payment

described in § 736(a)(2) to a retiring partner or to a deceased partner’s successor in

interest”).

An example of the differences that exist between the treatment of

guaranteed payments under section 707(c) and those under section 736 is the

requirement that guaranteed payments under section 707(c) are subject to the

capitalization requirements of section 263.  Prior to the amendment of166

section 707(c) in 1976 explicitly subjecting guaranteed payments to the

capitalization requirements of section 263, the Tax Court reached the same

conclusion but cautioned that its decision for purposes of section 707(c)

might not apply for purposes of section 736. 

In deciding that the section 707(c) payment herein must run

the gauntlet of section 162(a) in order to be deductible, we

expressly reserve determination of a similar question under

section 736(a)(2) and think that no inference should be

drawn from the decision in the instant case. See sec.

1.736-1(a)(4), Income Tax Regs.  167

Thus, the Tax Court recognized that the different policy justifications for

sections 707 and 736 may require different approaches to the treatment of

guaranteed payments under each section. The court’s perceptiveness in this

regard was prescient of Congressional intent when Congress amended

section 707(c) to clarify that the capitalization requirements of section 263

applied to guaranteed payments. Congress specifically directed in the

legislative history that the amendment to section 707(c) “is not intended to

adversely affect the deductibility to the partnership of a payment described in

section 736(a)(2) to a retiring partner.”  Consequently, the history of the168

relationship between sections 707 and 736 suggests that caution should be

exercised when assuming that all aspects of section 707(c) apply in the

context of section 736(a)(2) payments treated as guaranteed payments. 

We conclude that the treatment of in-kind guaranteed payments

under section 736, a provision with a narrow statutory focus and legislative

purpose, is not identical to that under section 707(c). Instead, the reference to

guaranteed payments under section 736 was intended only to resolve

questions regarding the characterization of income by the recipient partner

and the deductibility of such transfers by the partnership. Section 736 does



2006] The Lazarus Effect 397

169. IRC §§ 736(a) and 736(b)(1). See Kahn & Cuenin, supra note 6, at 437.

170. IRC § 736(b)(3). As originally enacted in 1954, § 736(b) permitted the

treatment of payments for unrealized receivables and unspecified goodwill as payments

under § 736(a) regardless of the type of partnership or partner involved. Congress

enacted the restrictions currently imposed under § 736(b)(3) in 1993. See 2 Willis,

Pennell & Postlewaite, supra note 11, at ¶¶ 15.02 and 15.03.

171. IRC § 736(b)(2).

172. IRC § 736(a).

173. IRC § 736(a)(1).

174. IRC § 736(a)(2). In our earlier article proposing the repeal of § 707(c), we

suggested that payments in excess of those in exchange for the withdrawing partner’s

interest in partnership property under § 736(b) and determined without regard to

partnership income be treated as a payment under § 707(a)(1) as made to a partner other

not address the question of whether the partnership must recognize gain or

loss on the transfer of partnership property in satisfaction of a guaranteed

payment. The answer to that question depends on an independent analysis of

the implications of guaranteed payments in the specific context of liquidating

distributions. 

A. Application of Section 736 to Liquidating Distributions 

Section 736 applies to distributions in liquidation of a partner’s

interest in a partnership. As Kahn and Cuenin explain, section 736 divides

such distributions into two categories: section 736(b) applies to distributions

in exchange for the partner’s interest in partnership property while section

736(a) applies to all other distributions.  Importantly, section 736(b) does169

not apply to unrealized receivables held by the partnership or to goodwill of

the partnership provided that (1) capital is not a material income-producing

factor for the partnership and (2) the retiring or deceased partner was a

general partner in the partnership.  In other words, distributions in170

exchange for a partner’s interest in unrealized receivables and goodwill are

not treated under section 736(b) if the distribution is in liquidation of a

general partner’s interest in a service partnership. The exclusion from section

736(b) for distributions with respect to partnership goodwill is subject to the

additional requirement that the partnership agreement must not otherwise

provide for payments with respect to goodwill.171

Distributions that are not treated as made in exchange for the

partner’s interest in partnership property are treated under section 736(a)

either as a distributive share of partnership income or as a guaranteed

payment.  Such distributions constitute a distributive share of partnership172

income if the amount of the distribution is determined with regard to

partnership income.  Alternatively, such distributions are treated as a173

guaranteed payment described in section 707(c) if the amount of the

distribution is determined without regard to partnership income.174



398 Florida Tax Review [V0l.7:6

than in his capacity as a member of the partnership. Postlewaite & Cameron, supra note

2, at 705-09. Such an approach is consistent with the revised capacity analysis

introduced by § 707(a)(2) that considers the risk as to the fact and the amount of the

payment in determining the capacity in which a partner is acting. Payments in

liquidation of a partner’s interest in a partnership that are determined without regard to

partnership income bear no risk with respect to the amount of the payment and

presumably bear risk similar to that of a payment to a third-party with respect to the fact

of payment. The need to treat liquidating payments under § 736(a)(2) as guaranteed

payments in order to specify the characterization and timing of such payments could be

easily provided by § 707(a)(1).

175. As stated in the legislative history:

The amounts paid for the capital interest of the withdrawing partner

are treated in the same manner as a distribution. The remaining

partners, of course, are allowed no deductions for such payments.

Essentially, these payments represent a purchase by the remaining

partners of the withdrawing partner’s capital interest in the

partnership.

H.R. Rep. No. 83-1337, at 72 (1954), reprinted in 1954 U.S.C.C.A.N. 4017, 40948. See

S. Rep. No. 83-1622, at 97 (1954), reprinted in 1954 U.S.C.C.A.N. 4621, 4730.

176. Part of the rationale for treating such distributions as ordinary income to

the withdrawing partner combined with a current deduction to the remaining partners

was the view that such distributions were in the nature of deferred compensation upon

the partner’s retirement for services previously rendered. The legislative history for

§ 736 specifically anticipated a retirement payout function for § 736. The legislative

history states: 

Where a retiring partner receives a lump sum or fixed payments

determined without regard to the income of the partnership, the

portion of such payments attributable to the capital interest of the

retiring partner is to be treated as the purchase of a capital interest by

the remaining partners. The balance, however, will be treated like a

salary paid by the partnership. It will constitute ordinary income to

the recipient and a deduction to the partnership. . . . 

This distinction between distributions under sections 736(a) and

736(b) means that different tax results arise depending on the category in

which the distribution falls. Distributions under section 736(b) are effectively

treated as an acquisition by the remaining partners of the withdrawing

partner’s interest in the partnership property.  To the extent that gain is175

recognized on the distribution, the withdrawing partner typically receives

capital gain treatment, and the remaining partners are not permitted a

deduction in connection with the distribution. On the other hand,

distributions under section 736(a) typically result in ordinary income to the

withdrawing partner and a reduction in the remaining partners’ share of

partnership income.  176



2006] The Lazarus Effect 399

Thus, to the extent that payments to a retiring partner or deceased

partner’s successor are not in exchange for a capital interest, they are

treated as deductions to the remaining partners and as income to the

withdrawing partner or his successor irrespective of over how long a

period they may be paid. . . . 

S. Rep. No. 83-1622, at 98 (1954), reprinted in 1954 U.S.C.C.A.N. 4621, 4731.

177. Of course, this result was even more egregious prior to the enactment of

§ 197 in 1993 when all other taxpayers were prohibited from amortizing goodwill under

§ 167. Interestingly, even if the distribution falls under § 736(b) because the goodwill

is specified in the partnership agreement, the remaining partners may be permitted to

amortize the withdrawing partner’s share of the partnership goodwill under § 197. If the

partnership makes a § 754 election and the anti-churning rules do not apply, the

remaining partners may amortize the goodwill payments over a 15-year period under

§ 197(f)(9)(E).

178. Kahn & Cuenin, supra note 6, at 436. As a result, Kahn and Cuenin note

that the issues and disputes involving in-kind guaranteed payments are most likely to

arise in the context of liquidating distributions. Id. at 37.

The most disturbing aspect of section 736 lies in the fact that service

partnerships may treat distributions in exchange for a general partner’s

interest in the goodwill of the partnership as a distribution under section

736(a) rather than section 736(b). Although such distributions will

effectively be taxed as ordinary income to the withdrawing partner, they will

give rise to an immediate deduction to the partnership. Consequently,

partners in service partnerships are effectively able to currently deduct

payments for the purchase of goodwill from a withdrawing partner while all

other taxpayers confront a unified regime under section 197 that requires the

amortization of acquired goodwill over a 15-year period.177

B. In-Kind Guaranteed Payments Under Section 736(a)

Kahn and Cuenin begin their consideration of in-kind guaranteed

payments under section 736(a) by suggesting that, although such payments

are unusual in the section 707(c) context because payments are typically

made in cash, in-kind guaranteed payments will “occur far more frequently”

in the liquidation context under section 736.  We question whether this178

assertion is accurate. 

Liquidating distributions arise in two distinct situations: the

liquidation of the partnership as a whole, in which the enterprise terminates,

and the liquidation of a single partner, in which the partnership continues its

partnership operations. When terminated, the partnership will liquidate either

by selling the assets and distributing the sales proceeds or by distributing the

assets in-kind. If the partnership liquidates by selling its assets, the issue of

in-kind payments under section 736(a) will not arise because only cash is

distributed. Alternatively, if the partnership liquidates by distributing its



400 Florida Tax Review [V0l.7:6

179. Kahn & Cuenin, supra note 6, at 438. The omnipresence of § 1245

depreciation recapture, an unrealized receivable for purposes of § 751(b), given the

availability of expensing and rapid amortization and depreciation under §§ 168, 179, and

197 suggests that Kahn and Cuenin’s assertion may be exaggerated.

180. As one of us has cautioned elsewhere, in-kind distributions under § 736

involve numerous problems that can be avoided through the use of cash distributions.

“If any generalizations can be made, it is that fewer problems exist if property (other

assets in-kind, the partnership will likely distribute the assets on a pro rata

basis to the members of the partnership in accordance with their economic

interests in the partnership. In this situation as well, the issue of in-kind

guaranteed payments will not arise because none of the partners will receive

payments, in cash or in-kind, for their interests in unrealized receivables or

partnership goodwill, which is necessary in order to implicate section 736(a).

Instead, they will simply receive their individual share of the partnership’s

assets.  Thus, no portion of the transaction would be subject to section

736(a). 

The only setting in which section 736(a) might be implicated in a

complete liquidation of a partnership would occur in a non-pro rata

distribution of the partnership’s assets. Importantly, non-pro rata

distributions of the partnership’s assets in a complete liquidation would have

to run the gauntlet of section 751(b), notwithstanding Kahn and Cuenin’s

assertion that “section 751(b) is rarely invoked” in the context of liquidating

distributions.  Nevertheless, in this very limited circumstance, the issue of179

in-kind distributions under section 736(a) may arise. 

Similar considerations attend the liquidation of a partner’s

partnership interest by an ongoing partnership. Kahn and Cuenin assert that

“it is common for the liquidation of a partner to include a premium,” in

which case the premium may well constitute a guaranteed payment under

section 736(a)(2). However, since most such payments would presumably be

made in cash, the issue of in-kind guaranteed payments under section 736

would not arise. Cash payments presumably occur in the vast majority of

situations involving liquidating distributions to a single withdrawing partner

because the partnership presumably needs its assets in order to continue

conducting business. In addition, distributions of the withdrawing partner’s

pro rata share of his assets would not implicate section 736(a)(2) as discussed

above. Non-pro rata distributions could be subject to section 736(a)(2) but

would first have to work their way through the potential application of

section 751(b). 

Thus, contrary to Kahn and Cuenin’s assertion, it appears that

in-kind guaranteed payments may not be as frequently encountered in the

liquidation context as they suggest. This observation strongly cautions

against any conclusion that in-kind guaranteed payments under section 736

warrant special consideration and a possible deviation from fundamental

principles of sound tax policy.180



2006] The Lazarus Effect 401

than money) is not distributed as a § 736(a) payment. In actual practice, the business

realities of the situation may dictate the easier approach because many of the assets will

be essential to the partnership’s continuing business operation and are unlikely to be

distributed.” 2 Willis, Pennell & Postlewaite, supra note 11, at ¶ 15.06[4].

181. IRC § 736(a).

182. See supra text accompanying notes 31-39 and 156-62.

183. Kahn & Cuenin, supra note 6, at 417. Indeed, one group of early

commentators on the implications of Subchapter K noted that Ҥ 736(a) apparently

applies only to cash payments.” J. Paul Jackson, et al., supra note 44, at 1225, n.81. The

Regulations under § 736 as originally proposed provided that payments under § 736(a)

be made in cash. Prop. Regs. § 1.736-1(a)(2), available in Notice of Proposed

Rulemaking, 20 Fed. Regs. 5,871 (1955) (providing that “[a] distribution of property

does not qualify as a payment under § 736. Payments under § 736 must be in money .

. . .”). However, the final Regulations removed this requirement.

184. Presumably, Congress believed that distributions under § 736(a) were

made to the withdrawing partner in his capacity as a member (albeit a former member)

of the partnership. The fact that Congress changed the capacity analysis under § 707

from a focus on the activities of the partner giving rise to the allocation and distribution

Turning to the question of the proper treatment of in-kind guaranteed

payments under section 736, if and when they do arise, an in-depth analysis

like that provided above in the context of in-kind guaranteed payments under

section 707(c) is required. The first aspect of this analysis requires a

consideration of the language of section 736(a)(2) itself. In referring to

guaranteed payments, section 736(a) states that “payments made in

liquidation of the interest of a retired or deceased partner shall . . . be

considered . . . as a guaranteed payment described in section 707(c) if the

amount thereof is determined without regard to the income of the

partnership.”  This language appears to treat distributions that fall within181

section 736(a)(2) as guaranteed payments without regard to the issues

previously discussed concerning the application of section 707(c) when a

payment is made to a partner deemed to be acting in the capacity of a

partner.  Apparently, no consideration is to be given to the issue of risk as182

to the fact or the amount of the payment that is required for purposes of

section 707(c) as a result of the enactment of section 707(a)(2). However, we

do not believe that the capacity analysis of section 707(a)(2) should be

ignored in the context of section 736(a), particularly when considering the

treatment of in-kind guaranteed payments. 

Although Kahn and Cuenin do not reiterate the point that Congress

probably gave little, if any, thought to in-kind guaranteed payments under

section 707(c), we suggest that Congress gave even less thought (if that is

possible) to in-kind guaranteed payments in the context of section 736.183

Consequently, in attempting to divine “Congressional intent” regarding the

proper treatment of in-kind guaranteed payments under section 736, we

should not disregard subsequent legislative developments under section

707.  Assuming that a “guaranteed payment” under section 736(a)(2) is184



402 Florida Tax Review [V0l.7:6

to the entrepreneurial risk surrounding the allocation and distribution should be a factor

in determining the proper application of § 736(a).

185. See supra text accompany notes 120-29 and 138-49. Unfortunately, Kahn

and Cuenin provide no such analysis in this portion of their article.

186. See supra text accompanying notes 120-23. The only modifications to

facilitate the analysis of § 736 are an increase in the fair market value of Land 1 from

$25,000 to $35,000 and a reduction in the fair market value of Land 2 from $30,000 to

$20,000.

187. IRC §§ 736(b)(1) and 731(a)(1).

limited as to risk, such a payment should presumably be treated as a payment

to a third party, requiring the recognition of gain or loss to the transferor

partnership. 

An in-depth analysis to determine the proper treatment of in-kind

guaranteed payments under section 736 next requires a consideration of

hypothetical situations and an examination of the bases and fair market

values of the partnership’s assets and the partners’ partnership interests

following the approach described above.  To do so, let us again return to185

the example posed by Kahn and Cuenin earlier in their article and described

above, but this time with certain modifications to facilitate the analysis of

section 736.  P, a general partnership, has three equal partners, A, B, and C.186

In Year 1, P has neither net income nor net loss. In addition, the partnership

has no liabilities. The bases and fair market values of the partnership’s assets

and the partners’ partnership interests are as provided in Figure 1. 

Figure 1

Partnership’s Assets and Partners’ Partnership Interests

Prior to the Liquidating Distribution

Assets    Partnership Interests 

      AB               FMV          AB     FMV   

Cash   $35,000         $35,000      A     $20,000 $30,000 

Land 1   $10,000         $35,000      B     $20,000 $30,000 

Land 2   $15,000         $20,000      C     $20,000 $30,000 

Total   $60,000         $90,000      Total     $60,000 $90,000 

In this situation, assume that on December 31, Year 1, P transfers

$35,000 to A in liquidation of A’s partnership interest, $5,000 of which is

attributable to unspecified goodwill. Section 736 requires that the $35,000

distribution be divided between that portion made in exchange for A’s

interest in partnership property under section 736(b) and that portion paid for

unspecified goodwill of the partnership under section 736(a). Consequently,

$30,000 of the $35,000 distribution would result in capital gain to A of

$10,000 ($30,000 minus A’s basis in his partnership interest of $20,000).187

Section 736(a)(2) would apply to the remaining $5,000 distribution, which



2006] The Lazarus Effect 403

188. IRC § 734(b)(1)(A). A basis adjustment under § 734 is allocated among

the partnership’s assets in accordance with the rules under § 755. The Regulations under

§ 755 provide that a basis adjustment resulting from gain recognized by a withdrawing

partner under §§ 736(b)(1) and 731(a)(1) is allocated only to capital gain property. Regs.

§ 1.755-1(c)(1)(ii). The adjustment is then allocated among the capital gain properties

in proportion to their respective amounts of unrealized appreciation but only to the

extent of each property’s unrealized appreciation. Regs. § 1.755-1(c)(2)(i). Assuming

that Land 1 and Land 2 in the example are capital assets, the $10,000 basis adjustment

under § 734 would be allocated $8,333 to Land 1 ($10,000 basis adjustment times

($25,000 appreciation in Land 1/$30,000 total appreciation in Lands 1 and 2) and $1,667

to Land 2 ($10,000 basis adjustment times ($5,000 appreciation in Land 2/$30,000 total

appreciation in Lands 1 and 2). See 2 Willis, Pennell & Postlewaite, supra note 11, at

¶ 13.05[8].

would be treated as a guaranteed payment under section 707(c) resulting in

ordinary income of $5,000 to A. The distribution would result in $15,000 of

gain for A, $10,000 of capital gain and $5,000 of ordinary income. 

The guaranteed payment would also generate a $5,000 deduction for

the partnership. The $5,000 deduction would reduce the remaining partners’

bases in their partnership interests by $2,500. Following the liquidating

distribution, the bases and fair market values of the partnership’s assets and

the partners’ partnership interests would be as provided in Figure 2A. 

Figure 2A

Partnership’s Assets and Partners’ Partnership Interests

Following the Liquidating Distribution

Assets    Partnership Interests 

      AB               FMV          AB     FMV   

Land 1   $10,000         $35,000      B     $17,500 $27,500 

Land 2   $15,000         $20,000      C     $17,500 $27,500 

Total   $25,000         $55,000      Total     $35,000 $55,000 

Importantly, the $10,000 of gain previously inherent in each

partner’s partnership interest has been preserved, but, as can be seen, the

liquidating distribution has generated a mismatch between the aggregate

inside bases of the partnership’s assets and the aggregate outside bases of the

partners’ partnership interests. If P files a timely election under section 754,

the partnership will be permitted to adjust the basis of Land 1 and Land 2 by

$10,000, the amount of gain recognized by A that was attributable to that

portion of the distribution made in exchange for A’s interest in partnership

property under section 736(b).  This adjustment would re-establish an188

equivalence between the aggregate inside bases of the partnership’s assets

and the aggregate outside bases of the partners’ partnership interests as

shown in Figure 2B.



404 Florida Tax Review [V0l.7:6

189. IRC § 732(b).

Figure 2B

Partnership’s Assets and Partners’ Partnership Interests

Following the Liquidating Distribution and 

Section 734 Adjustment

Assets    Partnership Interests 

      AB               FMV          AB     FMV   

Land 1   $18,333         $35,000      B     $17,500 $27,500 

Land 2   $16,667         $20,000      C     $17,500 $27,500 

Total   $35,000         $55,000      Total     $35,000 $55,000 

Instead of a $35,000 cash distribution to A in liquidation of his

partnership interest, assume that P transfers Land 1 to A in liquidation of A’s

partnership interest. Section 736 again requires that the $35,000 distribution

be divided between that portion made in exchange for A’s interest in

partnership property under section 736(b) and that portion paid for

unspecified goodwill of the partnership under section 736(a). Consequently,

Land 1 would have to be bifurcated between the section 736(a) and the

section 736(b) portions of the transaction. A would receive 6/7ths of Land 1

(hereinafter referred to as “Land 1A”) with a fair market value of $30,000 in

exchange for his interest in partnership property and would take a basis in

Land 1A of $20,000, his basis in his partnership interest.  If A subsequently189

disposes of this portion of Land 1A for $30,000, A will realize and recognize

$10,000 of gain.

Section 736(a)(2) would apply to the remaining 1/7th portion of

Land 1 (hereinafter referred to as “Land 1B”). Land 1B would be treated as a

guaranteed payment under section 707(c), resulting in ordinary income of

$5,000 to A. In this case, A would have income of $5,000 as a result of the

guaranteed payment and $10,000 of gain preserved in Land 1A. Because this

gain equals that in the prior example involving a $35,000 distribution of

cash, we would expect that A takes a basis in Land 1B equal to its fair

market value of $5,000 so that no further gain or loss would be realized and

recognized on a subsequent disposition of Land 1B for $5,000. A fair market

basis in Land 1B is consistent with both Kahn and Cuenin’s proposed

treatment of guaranteed payments as well as an entity approach to guaranteed

payments. 

Like a cash distribution, the guaranteed payment would also generate

a $5,000 deduction for the partnership. The $5,000 deduction would reduce

both of the remaining partners’ bases in their partnership interests by $2,500.

The interesting question, however, is the effect on the partnership of the

$5,000 guaranteed payment in addition to the $5,000 deduction. Under Kahn

and Cuenin’s proposal, P would not recognize gain on the transfer.



2006] The Lazarus Effect 405

190. IRC § 734(b)(2)(B). This basis adjustment would be solely allocable to

Land 2. IRC § 755; Regs. §§ 1.755-1(c)(1)(i) and 1.755-1(c)(2)(ii).

Following the liquidating distribution, the bases and fair market values of the

partnership’s assets and the partners’ partnership interests are as provided in

Figure 3A. 

Figure 3A

Partnership’s Assets and Partners’ Partnership Interests

Following the Liquidating Distribution

Assets    Partnership Interests 

      AB               FMV          AB     FMV   

Cash   $35,000         $35,000      B     $17,500 $27,500 

Land 2   $15,000         $20,000      C     $17,500 $27,500 

Total   $50,000         $55,000      Total     $35,000 $55,000 

As in the prior example, the $10,000 of gain previously inherent in

each partner’s partnership interest has been preserved, but, as can be seen,

the liquidating distribution has generated a mismatch between the aggregate

inside bases of the partnership’s assets and the aggregate outside bases of the

partners’ partnership interests. If P filed a timely election under section 754,

the partnership would be permitted to reduce the basis of Land 2 by $11,429,

the difference between the adjusted basis of Land 1A in the hands of the

partnership (6/7th of the $10,000 basis or $8,571) and the adjusted basis of

Land 1A in the hands of A ($20,000).  Unfortunately, this adjustment alone190

would not be sufficient to re-establish an equivalence between the aggregate

inside bases of the partnership’s assets and the aggregate outside bases of the

partners’ partnership interests as shown in Figure 3B. 

Figure 3B

Partnership’s Assets and Partners’ Partnership Interests

Following the Liquidating Distribution and 

Section 734 Adjustment

Assets    Partnership Interests 

      AB               FMV          AB     FMV   

Cash   $35,000         $35,000      B     $17,500 $27,500 

Land 2   $  3,571         $20,000      C     $17,500 $27,500 

Total   $38,571         $55,000      Total     $35,000 $55,000 

Assume, however, that the partnership is required to recognize gain

in connection with the transfer of Land 1B in satisfaction of the guaranteed

payment. In this case, the amount of gain would be $3,571 ($5,000 fair



406 Florida Tax Review [V0l.7:6

191. IRC § 734(b)(2)(B). This basis adjustment would be solely allocable to

Land 2. IRC § 755; Regs. §§ 1.755-1(c)(1)(i) and 1.755-1(c)(2)(ii).

market value of Land 1B minus its basis of $1,429 (i.e., 1/7th of $10,000)).

The gain would be divided equally between B and C (i.e., $1,785.50) and

would result in an increase in the bases of their partnership interests.

Consequently, the bases of the remaining partners’ partnership interests

would be adjusted for the deduction generated by the guaranteed payment

and for the gain recognized. Consequently, the bases and fair market values

of the partnership’s assets and the partners’ partnership interests would be as

shown in Figure 4A. 

Figure 4A

Partnership’s Assets and Partners’ Partnership Interests

Following the Liquidating Distribution

Assets    Partnership Interests 

      AB               FMV             AB       FMV   

Cash   $35,000         $35,000      B     $19,285.50 $27,500 

Land 2   $15,000         $20,000      C     $19,285.50 $27,500 

Total   $50,000         $55,000      Total     $38,571.00 $55,000 

In this case, the proper amount of gain has been preserved in the

partner’s partnership interests, $8,214.50 ($27,500 fair market value minus

$19,285.50 adjusted basis), which, with the $1,785.50 of gain recognized by

each partner on the transfer of Land 1B, results in a total gain of $10,000.

This is the same amount that existed for each partner prior to the liquidating

distribution. Unfortunately, the liquidating distribution again results in a

mismatch between the aggregate inside bases of the partnership’s assets and

the aggregate outside bases of the partners’ partnership interests. However, if

P filed a timely election under section 754 in this situation, the partnership

would be permitted to reduce the basis of Land 2 by $11,429, the difference

between the adjusted basis of Land 1A in the hands of the partnership (6/7th

of the $10,000 basis or $8,571) and the adjusted basis of Land 1A in the

hands of A ($20,000).  With such an adjustment, an equivalence between191

the aggregate inside bases of the partnership’s assets and the aggregate

outside bases of the partners’ partnership interests would be restored as

shown in Figure 4B.



2006] The Lazarus Effect 407

192. Referring to Subchapter K, the legislative history to the 1954 Code

provided that “[i]n general, the proposed statutory treatment retains the existing scheme

of regarding the partnership as merely an income-reporting, and not a taxable, entity.”

H.R. Rep. No. 83-1337, at 65 (1954)), reprinted in 1954 U.S.C.C.A.N. 4017, 4091; S.

Rep. No. 83-1622, at 89 (1954), reprinted in 1954 U.S.C.C.A.N. 4621, 4722. In

addition, the House conference committee report stated:

 

Both the House provisions and the Senate amendment provide for the

use of the “entity” approach in the treatment of the transactions

between a partner and a partnership which are described above. No

inference is intended, however, that a partnership is to be considered

as a separate entity for the purpose of applying other provisions of the

internal revenue laws if the concept of the partnership as a collection

of individuals is more appropriate for such provisions.

 

H.R. Rep. No. 83-2543, at 59 (1954), reprinted in 1954 U.S.C.C.A.N 5280, 5319-20.

See Rev. Rul. 89-85, 1989-2 C.B. 218 (stating that “Subchapter K of the Code is a blend

of the ‘aggregate’ and ‘entity’ treatment for partners and partnerships”).

Figure 4B

Partnership’s Assets and Partners’ Partnership Interests

Following the Liquidating Distribution and 

Section 734 Adjustment

Assets    Partnership Interests 

      AB               FMV             AB       FMV   

Cash   $35,000         $35,000      B     $19,285.50 $27,500 

Land 2   $  3,571         $20,000      C     $19,285.50 $27,500 

Total   $38,571         $55,000      Total     $38,571.00 $55,000 

This analysis demonstrates that, if the adjustment under section 734

is to achieve its objective of re-establishing an equivalence between the

aggregate inside bases of the partnership’s assets and the aggregate outside

bases of the partners’ partnership interests, it can only do so if the transfer of

an in-kind guaranteed payment under section 736(a)(2) results in gain or loss

recognition by the transferor partnership. Thus, a strong argument can be

made that the policy goals and structure of Subchapter K are best

implemented if the partnership is required to recognize gain or loss on the

transfer of an in-kind guaranteed payment under section 736(a)(2). 

V. CONCLUSION 

In enacting Subchapter K, Congress specifically noted that it was not

adopting either the aggregate or the entity theory of partnerships but was

combining the two theories and using one or the other depending on the

circumstances involved.  Unfortunately, it is not always obvious which of192



408 Florida Tax Review [V0l.7:6

193. Kahn & Cuenin, supra note, 6, at 417.

these two theories Congress intended to apply in a particular context. The

difficulties are acutely presented when considering transactions between a

partner and a partnership. 

Kahn and Cuenin have engaged in a valiant attempt to probe the

difficulties of discerning the proper tax treatment of in-kind guaranteed

payments. They conclude that the transfer of property by a partnership to a

partner as a guaranteed payment does not result in gain or loss recognition by

the partnership. They also conclude that the recipient partner takes a fair

market value basis in the transferred property and that the recipient partner’s

basis in his partnership interest is reduced by the partner’s share of the

deduction generated by the guaranteed payment but is not otherwise affected

by the transfer of the property. Their first conclusion is consistent with the

aggregate theory of partnerships, while their second and third conclusions are

consistent with the entity theory of partnerships. Their analysis thus results in

an odd combination of both the aggregate and entity theories to explain the

tax treatment of a single transaction, which they claim is reflective of the

Congressional refusal to adopt one theory to the exclusion of the other.193

We reject Kahn and Cuenin’s first conclusion and disagree with

portions of their subsequent analysis. Although they address the question

presented through an examination of the statutory language and policy

objectives of section 707(c), problems involving the application of

Subchapter K, or any section therein, cannot be resolved through a narrow

focus on the language and application of one section or subsection but must

rest on a consideration of how each section and subsection fits within the

overall statutory framework. In addition, that framework has evolved over

time through legislative, administrative, and judicial action in response to

problems and difficulties that have arisen in its application. Rather than

resorting to the original Congressional intent underlying one section of

Subchapter K for guidance, a consideration of the Congressional intent

underlying other subsequently enacted sections may require a modification

of what might otherwise have been the applicable law. 

Kahn and Cuenin appear to have neglected to follow their initial

reliance on the language of section 707(c) that guaranteed payments should

be treated as payments to “one who is not a member of the partnership but

only for the purposes of section 61(a) . . . and . . . section 162(a).” Their

reading of the statutory language led them to the conclusion that the transfer

of property by a partnership to a partner as a guaranteed payment does not

result in gain or loss recognition by the partnership, treating the transfer

instead as a distribution of partnership property. They then deviated from the

statutory language and concluded that the recipient partner takes a fair

market value basis in the transferred property and that the recipient partner’s

basis in his partnership interest is reduced only by the partner’s share of the



2006] The Lazarus Effect 409

194. See text accompanying notes 140-49.  

195. Staff of the Joint Comm. on Tax’n, “Options to Improve Tax Compliance

and Reform Tax Expenditures,” supra note 4, at 170-73.

deduction generated by the guaranteed payment, results contrary to the

treatment of the transfer as a distribution of partnership property. They do so

because they believe that a different result will not properly account for the

income attributable to the recipient partner as a result of the basis adjustment

that would otherwise be required. 

As we have demonstrated above, however, Kahn and Cuenin failed

to consider all of the basis adjustments that a transfer of property in

satisfaction of a guaranteed payment would trigger.  Under the modified194

aggregate approach, which we believe is reflective of the original

Congressional intent regarding the treatment of guaranteed payments, the

consistent treatment of a guaranteed payment as an allocation of partnership

income and a distribution of partnership property, with all of the associated

basis adjustments required under Subchapter K, would indeed preserve the

proper amount of income for the recipient partner. The complex analysis and

combined application of aggregate and entity theories of partnerships

proposed by Kahn and Cuenin appears unnecessary to the resolution of the

questions that they raise. 

Kahn and Cuenin also overlook the impact that the enactment of

section 707(a)(2)(A) made on the question of the capacity in which the

partner is acting for purposes of section 707. Twenty years ago, we asserted

that section 707(a)(2)(A) had effectively repealed section 707(c) because the

economic risk analysis that it employed in determining the capacity in which

a partner is acting is fundamentally inconsistent with the former capacity

analysis upon which guaranteed payments under section 707(c) could be

distinguished from payments under section 707(a)(1). As a result, virtually

all payments that had previously been categorized as guaranteed payments

are instead properly categorized as payments under section 707(a)(1), for

which the entity approach is indisputably applicable. With respect to in-kind

“guaranteed payments,” the entity approach requires that the partnership

recognize gain or loss on the transfer, the recipient partner take a fair market

value basis in the transferred property, and the recipient partner’s basis in his

partnership interest be reduced only by the partner’s share of the deduction

generated by the payment. The Congressional failure to recognize the

effective repeal of section 707(c) and erase its language from Subchapter K

creates a source of confusion and complexity, a trap for the unwary. 

Fortunately, the staff of the Joint Committee on Taxation has finally

recognized that a small step in the name of tax reform and simplification can

be taken by explicitly repealing section 707(c).  The fact that the staff’s195

recommendation has taken 20 years since we first proposed the explicit

repeal of section 707(c) demonstrates how difficult it is to “kill” a subsection



410 Florida Tax Review [V0l.7:6

196. Unfortunately, the actual repeal of § 707(c) will require somewhat more

than one sentence of statutory language as some conforming amendments and

modifications of those provisions currently referring to guaranteed payments or § 707(c)

will also be necessary. See IRC §§ 168(h)(6)(G), 267(e)(4), 514(c)(9)(E)(ii)(II), 706(a),

736(a)(2), 736(b)(1), 1402(a)(13), 2701(c)(1)(B)(iii), and 7519(d)(5).

of the Code (much less an entire section), even a subsection whose only

effect is the promotion of needless confusion and complexity. The

Committee staff should draft the required language (one sentence should be

all that is necessary) and urge the committees of Congress to act on its

recommendation before someone breathes new life into a provision whose

time and usefulness has clearly passed.196