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Effect of 199A on Guaranteed Payments and Income Allocation

02.26.2019

One of the Tax Cuts and Jobs Act of 2017’s major changes was the introduction of the Section 199A deduction. Section 199A provides new opportunities for strategic entity formation and tax planning. Partnership income and distribution allocations between individual partners is one area in which Section 199A should be considered when designing partner allocations. With tax returns for the 2018 tax year being prepared, now may be a good time for individuals involved in a partnership[1] to reevaluate their current partnership income allocation methods in light of the potential benefits of the new Section 199A deduction.

Section 199A

Section 199A provides individuals owning an interest in a pass-thru entity a deduction equal to 20% of  their net Qualified Business Income (“QBI”) from that entity.[2] For filers with taxable income between $157,500 and $207,500 ($315,000 to $415,000 for married filers), a wage cap begins to phase in limiting the amount of the 199A deduction that is available. The cap on the deduction that may be taken maxes out at 50% of wages paid and depreciable property owned for filers exceeding $207,500 of taxable income ($415,000 for married filers). There is also a limitation on the deduction allowable for specified service trades or businesses (such as health, law, accounting, actuarial science, performing arts, consulting, athletics, financial services and brokerage services) that begins to phase in at $157,500 ($315,000) and is completely disallowed for taxable income beyond $207,500 ($415,000). The IRS issued its final regulations on Section 199A on January 18th of this year.

QBI includes income from sole proprietorships, rental income rising to the level of a trade or business, and profit allocations from pass-thru entities such as partnerships. However, excluded from this definition are shareholder wages, guaranteed payments, and other forms of compensation for services paid to the owners.[3] Examining Section 199A in the partnership context, owners of partnership interests will now need to consider how the allocation methods of the partnership will ultimately characterize the income allocated to that individual for purposes of the 199A deduction.

Guaranteed Payments and Pro-rata Income Allocation

To understand how Section 199A affects partnership income allocations, it is important to understand the differences between guaranteed payments and typical income allocations. Under Treas. Reg. §1.707-1(c), guaranteed payments are those that are made to a partner without regard to the income of the partnership.[4] One example may be a partner being entitled to a fixed monthly payment from the partnership. This payment would not be contingent upon the partnership making a certain level of income and would be considered a guaranteed payment. For income tax purposes, this type of payment is treated as if it was made to an individual who was not a partner of the partnership. It would not qualify for the Section 199A deduction.

A pro-rata allocation of income, on the other hand, is an allocation made with regard to the income of the partnership. One example would be if a partner was entitled to a distributive share of 15% of the partnership’s income. The amount of the payment in this instance is directly dependent on the level of income of the partnership for that year. An income allocation such as this would be treated as flow-thru income from the partnership to the partner and, subject to the phase-out and other requirements of Section 199A, would qualify for the Section 199A deduction. Between the two distribution methods, the partner would be trading investment security from the guaranteed payment structure for the tax advantages of the Section 199A deduction available under a pro-rata income allocation structure.

Using Priority Allocation

A priority allocation may allow for the best of both worlds. One example of a  pure, priority allocation would be a partner receiving the first $50,000 of income of the partnership. This payment should not be considered a guaranteed payment because it is directly contingent upon the level of income of the partnership. This structure would cap the amount of the allocation and,  subject to the phase-out and other requirements of Section 199A, should still qualify for the Section 199A deduction. However, there is little guidance on whether a pure priority allocation such as this would be considered a guaranteed payment or not.

Treas. Reg. §1.707-1(c) provides a hybrid priority allocation method that would qualify for the Section 199A deduction. Example 2 of the regulation provides that a partner is to receive 30% of partnership income, but not less than $10,000. The regulation confirms that in this case so long as the partnership has $10,000 in income the allocation will not be considered a guaranteed payment.[5] This means that in high income producing years, the partner would receive his income allocation from the partnership and qualify for the Section 199A deduction. In low income years, the partner wouldn’t receive the Section 199A deduction, but would still be guaranteed a set payment from the partnership.

Partners currently receiving guaranteed payments under their partnership allocation agreement are potentially missing out on the Section 199A deduction of other income allocation methods. In the appropriate situation, a partner may be able to restructure a guaranteed payment into a form of the hybrid priority allocation described above and obtain the same cash-flow certainty of a guaranteed payment, while still taking advantage of the Section 199A deduction on the income flowing from the partnership. It is worth noting that restructuring a payment in this way would require more than just recharacterizing the payment for tax purposes. The change in allocation method may require an amendment to the partnership or LLC agreement and must still have a substantial economic effect on the partner to be respected by the IRS.

*Special thanks to Nate Patterson for his assistance on this article.

[1] A partnership includes both a state law partnership and a limited liability company (LLC) which is taxed as a partnership.

[2] IRC § 199A(a).

[3] IRC § 199A(b).

[4] Treas. Reg. §1.707-1(c).

[5] Treas. Reg. §1.707-1(c) Ex. 2.

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