Guaranteed Partner Payments and Income Tax Planning in Three Steps

The partnership salary rule is already a head-scratcher. Once partners feel the full impact of the 2017 Tax Cut and Jobs Act in the spring of 2019, the rule will be confusing as well. The planning is quite complex, but the end payoff – a 20 percent deduction – is very had to pass up.

This provision is a new one, so there is very little guidance. It applies to most businesses except C Corporations which pays double taxes. Other business associations are pass-through entities which only pay a single level of income tax.

Step One: Organizational Qualifications

Section 199A’s intent is clear. The TCJA gives substantial breaks to many individuals, and the government does not want to exclude small businesses.

The revised Section 199A allows partnership partners, LLC members, and other pass-through tax entities to claim the 20 percent deduction on all QBI. The Code broadly defines Qualified Business Income as any net income except capital gains.

Step Two: Type of Business Qualifications

Don’t miss this qualification, because it may sink a number of businesses.

To claim the 199A deduction, the entity must not be a Specified Service Trade or Business. SSTBs are the following types of entities:

  • Health,
  • Law,
  • Accounting,
  • Actuarial science,
  • Performing arts,
  • Consulting,
  • Athletics, and
  • Financial services, investing or investment management.

Under IRS rules, an SSTB is also “any trade or business where the principal asset is the reputation or skill of one or more of its employees.” That catch-all probably applies to most of the small businesses in the United States.

Before your clients in these industries get sinking feelings in the pit of their wallets, the income qualification rules may come to the rescue. The SSTB prohibition is inapplicable if the taxpayer’s AGI is below the listed thresholds.

Step Two: Income Qualifications

The deduction limit is 50 percent of all the organization’s W-2 wages or 25 percent of W-2 wages plus 2.5 percent of the unadjusted cost basis. Married filers who earn less than $315,000, or single filers who earn less than $157,500, are eligible for the deduction.

In most cases, payroll is an organization’s largest expense. So, most partnerships should have no problem meeting the 50 percent threshold. Furthermore, the IRS counts shared employees or workers at other locations for 199A purposes. In other words, the Service wants you to take this deduction. You just have to figure out how to claim it.

Be advised that special rules apply to co-ops.

Step Three: Claiming the Deduction

If the business is a sole proprietorship and it qualifies under the above income section, the taxpayer just needs to claim the deduction. It does not matter if the taxpayer itemizes or takes a standard deduction. Section 199A applies either way. That is good news. The TCJA doubled the standard deduction and scaled back a few itemized deductions. So, observers expect fewer than 10 percent of taxpayers to itemize beginning in the spring of 2019.

Partnership partners and LLC members usually receive guaranteed payments. The entity makes these transfers whether it is in the black or not. Since these transfers are not W-2 wages, they are exempt from the self-employment tax.

But with the advent of Section 199A, it may be beneficial to reclassify these salary payments as payments from net profits. The bad news is that these transfers are subject to the self-employment tax. The good news is the reclassification enables the entity to take advantage of 199A, assuming it qualifies under the aforementioned steps. It’s just a matter of crushing the numbers.

The TCJA means major changes for 2019 income tax returns. Reach out to us to get the support you need.

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