Many entities (including LLCs) that are classified as partnerships for tax purposes pay guaranteed payments to partners or members who are service providers. Why so? And, are guaranteed payments taxable?
Yes, guaranteed payments are subject to taxation under federal and state laws. These payments must be reported to the IRS (Internal Revenue Service).
How are guaranteed payments taxed? Generally, guaranteed payments are treated similarly to wages. The recipient partner reports ordinary income subject to self-employment taxes, and the payor partnership claims a deduction. However, like wages, guaranteed payments paid to a partner are not eligible for the section 199A 20 percent deduction created as part of the Tax Cuts and Jobs Act of 2017. Furthermore, the guaranteed payment deduction reduces the amount of income otherwise eligible for the new section 199A 20 percent deduction available through the paying partnership.
199A could greatly impact your business
For partnerships paying guaranteed payments, it may make sense in some cases to restructure them as payments out of net profits. Net profits payments, like guaranteed payments, are generally ordinary income subject to self-employment taxes for a service partner. Also, a net profits payment reduces the amount of net income allocated to the other partners. However, payments out of net profits, unlike guaranteed payments, allow the recipient partner to potentially make use of the section 199A 20 percent deduction.
How the Section 199A Deduction Works
For example, assume Amy, Brett, and Colin are equal 1/3 partners in a law practice (an LLC classified as a partnership for tax purposes) generating $300,000 of taxable income from legal fees every year. In exchange for services, each partner is paid a $100,000 guaranteed payment, reducing the partnership’s taxable income to $0. The partners learn that none of their income is eligible for the new section 199A 20 percent deduction. In response, the partnership amends its operating agreement, providing that instead of a guaranteed payment, each partner is entitled to 1/3 of the partnership’s profits. Assuming the partnership again generates $300,000 of taxable income, each partner would be allocated $100,000 of net income. Provided each of the partners has taxable income under certain threshold amounts (generally $315,000 for married filing joint taxpayers and $157,500 for other filers), the partners are each eligible for the new section 199A 20 percent deduction, resulting in a $20,000 deduction and taxes paid on only $80,000 of the $100,0000 received.
Note: this result is achieved even though the partners participate in a specified service trade or business (as defined under new section 199A) that ordinarily does not generate income eligible for the section 199A 20 percent deduction. This is because the partners each make under the taxable income threshold amount. But a business that is not considered a specified service trade or business can benefit from converting a guaranteed payment to a net income payment even if the receiving partner has taxable income exceeding the threshold amounts. However, other limitations could apply, like the W-2 wage limitation.
In some cases, it is even possible to grant a partner a priority allocation of net profits before other partners if a partnership wishes to provide a payment preference to a partner. For example, in lieu of a $100,000 guaranteed payment, a partner could be allocated the first $100,000 of the partnership net income before income is paid to any other partner.
Next Steps for Guaranteed Payments & 199A
Partnerships considering altering payments of guaranteed payments should consult with their tax advisors and carefully consider amending agreements so that any changes do not produce unwanted economic changes. Generally, IRS rules and regulations allow partnerships to make amendments to operating agreements that are effective as of the first day of the partnership’s taxable year, provided the amendments are effectuated before the due date of the partnership’s tax return. Accordingly, calendar year partnerships may be able to amend operating agreements for the 2019 tax year (provided the amendments are made before March 15, 2020) and have the amendments be effective as of January 1, 2019.
Comparing Guaranteed Payments vs Distributions
When reviewing guaranteed payments, distributions are often discussed. How do they compare, and what are their differences?
We’ve already stated that a guaranteed payment is a promise by one member (the payor) to pay another member (the payee) a specific amount over a set period of time. Guaranteed payments are usually indexed to the LLC's performance, such as the profits that the company makes.
Guaranteed payments are considered ordinary income to their recipient (the payee). This means that they are subject to the progressive income tax, which starts at a lower rate but climbs as the amount of money earned increases. The recipient of a guaranteed payment must also pay payroll taxes, self-employment tax (which is equivalent to the employer portion of payroll taxes), and may also be subject to state income taxes.
On the other hand, a distribution occurs when an owner receives cash or property from an LLC in addition to guaranteed payments. Distributions are made when there are profits in the company, and they do not have to be indexed to distributable cash flows. An owner can also receive a distribution if the share of the profits is not enough to cover guaranteed payments. When an owner receives a distribution, they are only taxed on the portion of the money that comes from previously taxed profits, and this amount is called a “return of capital.”
To summarize, partnerships should consult with their tax advisors to determine if compensation from net income are more beneficial to the partners than guaranteed payments. Additionally, tax advisors should be consulted to consider any state and local tax ramifications resulting from a change, particularly if the partnership conducts business in multiple states.
Tax Reform is Here to Stay