## Facts

- Three Pratt brothers and a fourth person formed partnerships to build and own two shopping centers; the Pratts served as general partners.
- The partnership agreement required the general partners to contribute time and managerial services and to use their best efforts in managing the enterprise.
- The agreement provided “managerial fees” equal to 5% of gross base lease rentals plus 10% of overrides/percentage rentals.
- The agreement also stated that general partners would provide personal services without other compensation beyond the managerial fees.
- The partnerships used the accrual method and deducted the management fees as business expenses; the Pratts used the cash method and reported the fees only when received.
- The Tax Court held the fees were not deductible as separate expenses and treated them as part of the partners’ distributive shares (and alternatively discussed § 707(c)); an interest-expense aspect was later conceded by the Commissioner on appeal.

## Issues

1. Whether the management-fee arrangement constituted a transaction between the partnership and the partners “acting other than in [their] capacity as a partner” under I.R.C. § 707(a), allowing a partnership-level deduction.
2. If the fees were otherwise deductible, whether they would be characterized as “guaranteed payments” under I.R.C. § 707(c) rather than distributive shares.

## Decision

- The Fifth Circuit affirmed the Tax Court’s result that the partnerships could not deduct the management fees as separate expenses.
- The court affirmed on the ground that § 707(a) did not apply because the partners were not dealing with the partnerships in a non-partner capacity.
- Because it found no deductible payment under § 707(a), the court declined to decide whether the amounts would qualify as “guaranteed payments” under § 707(c).

## Legal Principles

- Payments labeled as “fees” to a partner are not deductible by the partnership under I.R.C. § 707(a) when the services arise from the partner’s duties as a partner and the arrangement functions as an internal allocation of partnership income.
- A partner is treated as a non-partner under § 707(a) only when the transaction is sufficiently separate from the partner’s role and rights as a partner.
- When compensation is computed as a percentage of partnership-derived receipts (e.g., rents) and is specified as the partner’s sole compensation for partner services, it indicates a distributive-share arrangement rather than a deductible expense.

## Conclusion

The court held that management fees payable to general partners under the partnership agreement were, in substance, allocations of partnership income tied to their partner status and therefore were not deductible by the partnership as payments to partners acting outside their capacity as partners under I.R.C. § 707(a).


Pratt v. Commissioner, 550 F.2d 1023 (5th Cir. 1977)