Partnerships and entities taxed as partnerships, such as some LLCs, often pay partners specific amounts outside of the partnership’s usual income allocation. This is usually in the form of health insurance, retirement contributions, or additional income for specific partners operating the partnership. These additional amounts are most often reported as guaranteed payments to the receiving partner(s). Since the pass-through deduction, IRC 199A, became law, treating these items as guaranteed payments has been detrimental. Guaranteed payments, unlike partnership income, are not eligible for inclusion in the pass-through deduction. While this doesn’t affect higher earning partners in specified service businesses, it does mean partners who receive guaranteed payments are subject to income tax on 100% of that income, instead of only 80%. This begs the question, must this income be classified as a guaranteed payment, or can additional income merely be allocated to one partner instead of another?
IRC 707(c) defines a guaranteed payment as “determined without regard to the income of the partnership, payments to a partner for services or the use of capital”. As such, a surprising number of partnership payments treated as guaranteed payments shouldn’t be. The key part of IRC707(c)’s definition of what a guaranteed payment constitutes is the phrase “determined without regard to the income of the partnership”. If the payment would not be paid if the partnership is not profitable, it cannot be said to be determined without regard to the income of the partnership. Sometimes this is defined in the partnership agreement, sometimes it is annually agreed upon and the partnership agreement amended therefore, and sometimes it is merely agreed to and treated as such for administrative feasibility. Prior to Tax Year 2018, the issue was moot as there was no difference between the treatment of ordinary income and a guaranteed payment. Both were subject to tax as ordinary income and subject to self employment tax. However, now that allocated ordinary income is potentially subject to a 20% reduction before applying the income tax, payments previously treated as guaranteed payments should be reevaluated.
The most common scenarios for guaranteed payments have been manager’s fees and what is commonly termed ‘Eat What You Kill’ profit sharing arrangements (arrangements that reward each partner for what they personally contribute to a business’ income). Guaranteed payments to managing partners are intended to reward active partners additional income for their efforts. Since the partners are acting in their capacity as partners these payments cannot be treated as wages. If the partnership agreement stipulates these payments are to be made regardless of the partnership’s income the payments are properly treated as guaranteed payments. If the amounts paid are withheld in loss years or scale with income, they should not be considered guaranteed payments. Eat What You Kill arrangements reward each partner for what they personally contribute to a business’ income and will usually not be guaranteed payments. If nothing additional is ever paid to a partner in an overall loss year, it is clearly not a guaranteed payment. Further, while dependent on each partner’s personal activity, if the payment is tied to that partner’s contribution to the partnership’s income, it is arguable to never be a guaranteed payment, as this is a subcomponent of partnership income.
Retirement plan contributions should not be considered guaranteed payments. Retirement plan contributions are always tied to the partnership’s income. These contributions are not made when a business experiences a loss. Contribution amounts cannot even be determined until after the partnership’s profit and loss status has been calculated. Therefore, these should not be considered guaranteed payments.
Heath insurance payments should almost always be guaranteed payments. The Health Insurance Policies are purchased for the relevant partner(s) before the tax filing year has been completed or any Profit & Loss determination is made. Further, Health Insurance premiums are determined by factors entirely unrelated to income. Finally, the United States Treasury has provided clear guidance for the treatment of these premiums, detailed in Revenue Ruling 91-26 and Publication 541.
If not guaranteed payments, how should these payments be classified? Specific allocation appears to be the answer. While there are some complex rules in place to avoid abusive tax scenarios, allocations for substantial economic effect are acceptable. They allow partnerships to allocate their income resulting in the same income per partner without the negative tax implications, and technically incorrect status, of guaranteed payments. Achieving the desired result of an income allocation may require an annual amendment to the partnership agreement. The amendment must be made before the due date of the tax return (without extensions), but this is no different than the amendment required for changing the guaranteed payments to the partner(s) each year.
If you have any questions on specific or formula based allocation, or would like to review your recent guaranteed payments to determine if they should be otherwise classified, please feel free contact us for a consultation.
Written by Damien Falato, CPA, MST, CGMA, Tax Director
Edited by Cristina Miller