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Do Guaranteed Payments Guarantee That You Pay More Tax?

DO GUARANTEED PAYMENTS GUARANTEE THAT YOU PAY MORE TAX?

Understanding the 199A Deduction

The 199A deduction is one of the greatest things since sliced bread for this tax season.  And why not, it is a brand new shiny 20% deduction.  Now let's face it, getting the deduction is not as easy as picking-up a loaf of bread at the super market.  First, if you are an employee, then you don't qualify for the deduction.  You have to be a business owner or investor, such as a sole proprietor, shareholder or partner in a pass-through business or investor in a Real Estate Investment Trust (REIT).  You will also need to have ordinary income (not capital gain or other investment income) from your business or investment.  At that point, you could be home free if your taxable income is $157,500 or less for single filers or $315,000 or less if you are married filing a joint return.

If your income meets those thresholds you have a couple more hurdles to overcome.  First, are you in a dreaded Specified Service Trade or Business (SSTB)?  What does it mean to have an SSTB?  It really means you may not get the 199A deduction.  Taxpayers owning an SSTB won't get the deduction at all once their taxable income exceeds the phaseout amounts. If the taxpayer is married filing jointly the phaseout is between $315,000 – $415,000 and for single filers the phaseout is between $157,500 to $207,500. Those dreaded SSTBs are:

  • health—i.e., medical services by physicians, nurses, dentists, and other similar health care professionals, but not services not directly related to health care, such as the operation of spas and health clubs
  • law
  • accounting
  • actuarial science
  • performing arts, but not services by persons other than performing artists, such as promoters or broadcasters
  • consulting
  • financial services
  • brokerage services
  • investing and investment management
  • trading
  • dealing in securities, partnership interests, or commodities
  • the business of promoting or endorsing
Please note, engineering and architecture have been specifically excluded from classification as SSTBs under 199A.

If your trade or business is not an SSTB and your taxable income is over threshold phaseouts, there is a separate limitation before receiving the 199A deduction.  That limitation deals with W-2 wages and Unadjusted Basis Immediately after Acquisition (UBIA). Taxpayers above the phaseout threshold are limited to the higher of the following two calculations:

  1. 50% of the W-2 wages paid by the business
  1. 25% of the W-2 wages paid by the business plus 2.5% of the unadjusted basis of the business qualified property immediately after acquisition.

So, we have hurdles to overcome, but what does that have to do with guaranteed payments?  Glad you asked. Guaranteed payments are a specific allocation of cash not related to the amount of ownership of the partnership.  Similar to wages for a nonowner. I hope you recall that I mentioned the 199A deduction is based on the amount of ordinary income you have from your business.  The ordinary income when defined more precisely by the IRS is called Qualified Business Income (QBI).  It does not include capital gains or shareholder wages and more importantly, it does not include guaranteed payments.  Here is an example of the impact of guaranteed payments on the 199A calculation.

Example 1

I am a member (Member A) of an LLC taxed as a partnership.  For 2018, the partnership allocates ordinary income to Member A - $50,000 based on Member A’s ownership in the partnership. In addition, Member A also receives a guaranteed payment of $50,000. The pass-through ordinary income of $50,000 and guaranteed payment of $ 50,000 represent the total of $100,000 from the LLC.  How does that work for the 199A deduction?

Ordinary Income

 $50,000

Guaranteed Payment

$50,000

Total Taxable Income

$100,000

Eligible for 199A deduction (Guaranteed payment excluded)

$50,000

Tentative Deduction ($50,000 x 20%)

$10,000

Taxable Income after 199A deduction ($100,000 minus $10,000)

$90,000

Okay.  Not bad.  I'm getting a $10,000 deduction I didn't get before. Maybe I should be happy and move forward.  But let's look at the example with a modification.

 

Example 2

Instead of $50,000 pass-through income and $50,000 guaranteed payments, let's pass-through $100,000 of income and no guaranteed payments.

Ordinary Income

 $100,000

Guaranteed Payment

$0

Total taxable Income

 $100,000

Eligible for 199A deduction (No guaranteed payment to exclude)

 $100,000

Tentative Deduction ($100,000 x 20%)

$20,000

Taxable Income after 199A deduction ($100,000 minus $20,000)

 $80,000

Wow, that adjustment doubled the 199A deduction by reducing the guaranteed payments and with an offsetting increase to ordinary income.  How can a member/partner do that? Well, since the guaranteed payment is a special allocation and not related to the ownership, “Is there an alternative that allows cash to be specifically allocated”?  Glad you asked again. 

There is the priority profit allocation. The priority profit allocation is a specific allocation of profit not based on ownership, and since it is a priority allocation it is accounted for before the allocation that is based on ownership. Since this an allocation of ordinary income, it is not excluded from the 199A deduction. What's the catch?  Well, first the entity has to generate consistent profit. If there is no profit to allocate, that won't get any cash in the partner/member pocket as with a guaranteed payment. Second, your operating or partnership agreement must allow for this type of profit allocation. Third, the new allocation must have substantial economic effect.  This may affect the economic arrangement among the owners.

As illustrated by the two examples, guaranteed payments reduce a taxpayer's allowable 199A deduction, which in turn increases taxable income and the tax bill.  Ultimately, by incorporating the priority profit allocation and working with your accountant and attorney you can plan to take advantage of the 199A deduction.

Please contact a Herbein team member for assistance in understanding the 199A deduction and whether you, as a business owner or investor, can benefit from this deduction.

Article written by Charles A. Bezler. For additional information contact us at info@herbein.com