Editor: Anthony Bakale, CPA
Historically, the income tax treatment of a distributive share of partnership ordinary income did not differ significantly from that of partnership guaranteed payments. Assuming that partners were comfortable with the underlying partnership economics, they were likely largely indifferent regarding the classification, as both categories of income were taxed at ordinary income rates and, if the partner actively participated in the business, both categories of income were subject to self-employment tax.
However, this changed with the passage of the law known as the Tax Cuts and Jobs Act (TCJA), P.L. 115-97. The TCJA added Sec. 199A, which allows a qualified business income (QBI) deduction for individual and trust taxpayers that receive passthrough-entity income. For partnerships (including limited liability companies treated as partnerships for federal income taxes), the QBI deduction applies to a distributive share of partnership income but does not apply to partnership income paid out as a guaranteed payment for services rendered to the partnership's trade or business (Sec. 199A(c)(4)(B)). Sec. 199A now presents a clear, important distinction between these two forms of partnership income.
Because of this disparate treatment, many partnerships have restructured their operating agreements to convert guaranteed payments into priority profit allocations (see Parikh et al., "Trade Guaranteed Payments for Net Profits to Gain From QBI Deduction," 50 The Tax Adviser 828 (December 2019)). While this type of restructuring potentially alters the partnership economics, most partners will prefer to receive a distributive share of partnership income, as it can qualify as QBI and will allow the partner to claim the Sec. 199A deduction if he or she otherwise qualifies.
However, for certain partners, the presumed preference for receiving a distributive share of income (including a priority profit allocation) may need further evaluation to determine how it coordinates with various international tax provisions. Ultimately, the specific circumstances of each partner will determine which type of partnership income provides the most favorable income tax result.
US trade or business requirement
For Sec. 199A purposes, QBI includes qualified items of income, gain, deduction, and loss, i.e., to the extent these items are effectively connected with the conduct of a U.S. trade or business (within the meaning of Sec. 864(c)) and are includible or allowed in determining taxable income for the tax year (Sec. 199A(c)(3)(A)). This determination is made by substituting "qualified trade or business (within the meaning of Sec. 199A)" for "nonresident alien individual or a foreign corporation" or for "a foreign corporation" each place it appears in Sec. 864(c).
Income sourcing — guaranteed payments
The sourcing of wages and personal services income is generally determined by where the services are performed (Sec. 861(a)(3); Sec. 862(a)(3); Regs. Sec. 1.861-4; Regs. Sec. 1.862-1(a)(1)(iii)). Other factors, such as the residence of the service recipient, the place of contracting, and the time and place of payment are irrelevant.
The legislative history further provides that a guaranteed payment received by a partner is considered foreign earned income if it is: (1) fixed in amount, (2) paid for services performed by the partner in a foreign country, and (3) payable regardless of whether the partnership has any profits (Sec. 707(c); Rev. Ruls. 81-300 and 81-301). The Tax Court in Miller, 52 T.C. 752 (1969), and the Court of Claims in Carey, 427 F.2d 1014 (Ct. Cl. 1970), held that a guaranteed payment to a partner working outside the United States qualified as foreign-source compensation for purposes of the Sec. 911 exclusion. In Private Letter Ruling 7939005, the IRS followed Miller and Carey and allowed a guaranteed payment to the managing partner of a foreign office to qualify for the Sec. 911 exclusion.
Income sourcing — distributive share of partnership income
The source and character of a distributive share of partnership income is determined at the partnership level (Sec. 702(b); Regs. Sec. 1.702-1(b); Rev. Rul. 67-158). Therefore, income that does not qualify as a guaranteed payment is considered foreign income only to the extent of the partnership's foreign-source income, regardless of the residence or location of the recipient partner.
If a partnership is engaged in a trade or business in the United States, generally all sales, services, or manufacturing income from U.S. sources is considered effectively connected income (ECI) (Secs. 864(c)(3) and (c)(2)). The exception to this is inventory sold for use outside the United States through a foreign fixed place of business that materially participated in the sale (Sec. 865(e)(2)(B)).
US expatriate partner performing work outside the US
U.S. citizens and residents are generally subject to tax on their worldwide income. U.S. individuals living abroad may be able to reduce or eliminate their U.S. income tax obligation through the Sec. 911 foreign earned income exclusion (FEIE). Sec. 911 allows qualified individuals a gross income exclusion for all or a portion of their foreign earned income if they meet specific requirements for foreign country residency or physical presence. For these purposes, foreign earned income is defined as foreign-source earned income that is earned during a period the individual qualifies to claim the FEIE.
As stated earlier, guaranteed payments are sourced based on where the related services are performed. In contrast, a distributive share of partnership income is sourced based on the underlying partnership activity, meaning that at least some (if not most) of the income from a U.S. partnership would likely be considered U.S.-source and therefore ineligible for the FEIE. As such, an expatriate working outside the United States will generally prefer guaranteed payments over a priority profit allocation, as guaranteed payments would clearly be considered foreign-source income that is eligible for the benefits of the FEIE.
Nonresident aliens in general
In contrast to the treatment of U.S. citizens and residents, the United States has limited tax jurisdiction over nonresident alien individuals. A nonresident alien is subject to U.S. tax on U.S.-source fixed, determinable, annual, or periodical (FDAP) income as well as ECI (Secs. 871(a) and (b)(1)). The United States does not have jurisdiction to tax the foreign-source income of nonresident aliens, and, for that reason, a nonresident alien performing services outside the United States will generally not be subject to U.S. tax, as his or her foreign-source income will generally avoid the U.S. tax regime.
Nonresident alien performing services inside the United States: Nonresident partners who are present and working in the United States will find it difficult to avoid U.S. tax. Nonresident partners of a U.S. partnership will generally be subject to U.S. tax on their partnership income, whether paid as guaranteed payments or as a distributive share of partnership income. Guaranteed payments are considered U.S.-source if the services are performed within the United States. The sourcing rules will provide that some (if not most) of a distributive share of income would be considered U.S.-source income to the extent of the partnership's U.S.-source income.
A nonresident alien individual partner in a U.S. partnership would generally prefer that income be classified as a distributive share of partnership income rather than a guaranteed payment because a distributive share of income will be considered QBI and therefore be eligible for the Sec. 199A deduction. If guaranteed payments were received, they would be subject to U.S. tax without the benefit of the Sec. 199A QBI deduction.
Nonresident alien performing services outside the United States: Nonresident alien partners who want to avoid U.S. tax obligations will generally prefer foreign-source income because the United States does not have the jurisdiction to tax foreign-source income of a nonresident alien. Due to the sourcing rules discussed earlier, a nonresident alien individual partner in a U.S. partnership who is performing services outside the United States would generally prefer guaranteed payments, as this would clearly be considered foreign-source income and would therefore avoid the U.S. tax regime.
If the income was instead considered a distributive share of partnership income, the source would be determined at the partnership level, meaning that at least some of it would likely be U.S.-source ECI and therefore subject to U.S. tax (albeit eligible for the Sec. 199A QBI deduction).
Carefully consider potential effects
Sec. 199A has created potentially significant differences in the tax treatment between guaranteed payments and the distributive share of partnership income. This dynamic becomes even more nuanced when international tax provisions intersect these rules. In particular, the income-sourcing rules may create situations in which certain partners would clearly prefer guaranteed payments while others would prefer a distributive share of partnership income. Because of this, partnerships should carefully examine the potential effects on all partners before restructuring current agreements.
Anthony Bakale, CPA, is a tax partner with Cohen & Company Ltd. in Cleveland.
For additional information about these items, contact Mr. Bakale at email@example.com.
Unless otherwise noted, contributors are members of or associated with Cohen & Company Ltd.