Trade guaranteed payments for net profits to gain from QBI deduction

Editor: Marcy Lantz, CPA

The law known as the Tax Cuts and Jobs Act (TCJA), P.L. 115-97, added Sec. 199A, which allows a qualified business income (QBI) deduction that can provide valuable tax savings to individual taxpayers who receive income from passthrough entities, such as S corporations, partnerships, and sole proprietorships. The QBI deduction, however, cannot be applied to partnership income paid in the form of guaranteed payments to a partner for services rendered to the partnership’s trade or business (Sec. 199A(c)(4)(B)).

On the other hand, payments out of net profits, unlike guaranteed payments, are taken into account in determining the QBI deduction. Therefore, partnerships making guaranteed payments may want to consider restructuring them as priority profit allocations.

Background: Guaranteed payments

Sec. 707 discusses transactions between a partner and the partnership, and in particular Sec. 707(c) introduces the concept of guaranteed payments into the law and states the following regarding guaranteed payments:

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).

Payments meeting this definition are considered as made to a person who is not a partner. Historically, many partnerships for tax purposes have made guaranteed payments to partners or members who provide services. For the purpose of guaranteed payments under Sec. 707(c), it does not matter whether the services performed are within the partner’s scope of responsibility as a partner as long as these payments are not contingent upon the income of the partnership. For the partner, the payments are ordinary income and are subject to self-employment tax. For the partnership, these payments are generally deductible under Sec. 162, and the payments are treated as an expense to the entity and generally pass through as a deduction to the entity’s partners. In this way, the guaranteed payment for a partnership or an LLC is like a salary to a shareholder-employee in an S or a C corporation.

Background: Sec. 199A

The TCJA reduced the top tax rate of domestic C corporations from a tiered structure with a top rate of 35% to a flat 21%. To provide a similar benefit to passthrough entities, for tax years beginning after Dec. 31, 2017, and before Jan. 1, 2026, Sec. 199A allows a deduction to a noncorporate taxpayer, including a trust or estate, that has qualified business income (QBI) from a partnership, S corporation, or sole proprietorship. In general (and before any other limitations), the deduction is the lesser of (1) the “combined qualified business income amount” of the taxpayer, or (2) 20% of the excess, if any, of the taxable income of the taxpayer for the tax year over the net capital gains for the tax year.

Sec. 199A and guaranteed payments

Sec. 199A(c)(4)(B) provides that QBI does not include any guaranteed payments to a partner for services rendered to the partnership’s trade or business. Furthermore, the guaranteed payment deduction reduces the amount of income otherwise eligible for the QBI deduction, and the guaranteed payments are not treated as W-2 wages for the partnership’s calculation of wage-based limits under Sec. 199A. Taking all three of these changes together makes the usefulness of guaranteed payments minimal and potentially harmful.

The good news is that payments out of net profits, unlike guaranteed payments, allow the recipient partner to use the QBI deduction. As such, for partnerships making guaranteed payments, it may make sense in some cases to restructure them as priority profit allocations. The priority profit allocation is a specific allocation of profit that is not based on ownership and is accounted for before any allocation based on ownership. These payments, like guaranteed payments, are generally ordinary income subject to self-employment taxes for a service partner while the payment reduces the amount of net income allocated to the other partners.

Example: Partnership ABC has $2 million of QBI split evenly among four partners, which includes an $800,000 deduction for guaranteed payments to Partner A. Under this scenario (without regard to any other limitation included in Sec. 199A), Partner A would realize taxable income of $1,300,000, but the QBI would only be $500,000 with a corresponding $100,000 deduction on her individual return.

If, instead of guaranteed payments, the payments to Partner A for services rendered were structured as a priority profit allocation, the following would be the result:

The four partners in total would realize taxable income of $2,800,000, but Partner A would get the first $800,000 as a priority profits allocation with the remaining $2 million split evenly among the four partners. Partner A would still receive $1,300,000 of taxable income but would now have $1,300,000 of QBI with a corresponding $260,000 QBI deduction on her individual return.

Partner A would continue to get the same income and cash as she had with the guaranteed payments, but she would now enjoy an additional $160,000 deduction. At the highest individual income tax rate of 37%, Partner A has a potential savings of $59,200.

Considerations

There are other things to consider before removing guaranteed payments from the partnerships. As the payments now must be in line with the income of the partnership, some of these considerations include:

• Will the partnership have profit every year to ensure that the partners receive cash and income in the same manner as guaranteed payments? If there are no profits in a particular year, the partner(s) would not get a priority profits allocation.
• Does the new allocation have a substantial economic effect?
• If the partnership were to have a bad year, would it be able to collect the cash back from the partners that was over-distributed by the end of the year?
• Would the partners feel comfortable that their payments are no longer guaranteed and that they could potentially not get any additional payment at year end?

If the partnership looks at these considerations and decides that it wants to remove guaranteed payments in favor of a priority profits allocation, the partnership must amend the partnership agreement. Generally, Sec. 761(c) allows a partnership to amend the partnership agreement to be effective as of the first day of the partnership’s tax year, provided the amendments are effectuated before the due date of the partnership’s tax return. The partnership has until March 15 to amend a partnership agreement for the previous calendar year, but it is always best practice to amend the agreement as soon as possible.

EditorNotes

Marcy Lantz, CPA, CSEP, is a partner with Aldrich Group in Lake Oswego, Ore.

For additional information about these items, contact Ms. Lantz at 503-620-4489 or mlantz@aldrichadvisors.com.

Unless otherwise noted, contributors are members of or associated with CPAmerica Inc.