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Partnership advantage over S Corp practice setup with 199A deduction?

Home Tax Reduction Partnership advantage over S Corp practice setup with 199A deduction?

  • Avatar jacoavlu 
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    argh – After talking with our CPA I thought this was a non-issue. Our CPA is/was of the opinion that partnership guaranteed payments would be required, akin to reasonable S corp salary. But WCI’s post today brings this question right back to the forefront for me. Pertinent from the post today:

    Sec. 199A Tip #5: Confirm Partnership Agreement Updated

    Hopefully, if you’re a partner in a group practice, the partnership has already updated its partnership agreement for Sec. 199A.

    If that hasn’t yet happened, gosh, you want to talk with your partners and get on this.

    The big issue here? The qualified business income amount you use to calculate the 20% deduction only includes the business income amount shown in box 1 of your K-1. You do not get a Sec. 199A deduction for any guaranteed payments you receive from the partnership.

    For example, suppose your group practice produces per partner profits of $200,000. Further suppose that the partnership makes a $15,000-per-month guaranteed payment to each partner, or $180,000, over the course of the year.

    In this case, the Sec. 199A deduction equals 20% of the $20,000 that’s leftover from the $200,000 in profits after the $180,000 of guaranteed payments. This means a $4,000 Sec. 199A deduction and maybe $1000 to $1600 in federal tax savings.

    Consider the case where a partnership just skips the guaranteed payments and instead just distributes $15,000 each month to partners. In this case, the Sec. 199A deduction equals 20% of the full $200,000. This means a $40,000 Sec. 199A deduction and maybe $10,000 to $16,000 in federal tax savings.

    Sec. 199A Tip #6: Reconsider any Subchapter S Election

    If you operate your practice as an S corporation, talk with your tax advisor about whether or not you should revoke your Subchapter S election or terminate your entity classification.

    Most smart Subchapter S elections should still make sense. Especially if shareholder-employees save Social Security taxes due to the Subchapter S status.

    Shareholder-employees saving only Medicare or net investment income taxes (NIIT), however, face a more complicated riddle. The Subchapter S election in these cases saves less payroll tax or NIIT.

    Further, because Subchapter A shareholder-employee wages don’t count as qualified business income, the S election reduces the size of the Sec. 199 deduction.

    The Finance Buff's solo 401k contribution spreadsheet: https://goo.gl/6cZKVA

    #163074 Reply
    DMFA DMFA 
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    Why do partnership payments *have* to be guaranteed?  I don’t suppose there’s a way to “guarantee” them without actually being “guaranteed payments,” like the guest-poster says?

    "I like money." - Frito Pendejo (Idiocracy)

    [Not a financial professional (yet), lawyer, or employee of The White Coat Investor]

    #163110 Reply
    Avatar jacoavlu 
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    Why do partnership payments *have* to be guaranteed?  I don’t suppose there’s a way to “guarantee” them without actually being “guaranteed payments,” like the guest-poster says?

    Click to expand…

    It seems that with regards to the QBI deduction physician S corps are at a clear disadvantage compared to sole proprietorships and partnerships, when around that critical $315k level of taxable income. The ship has almost certainly sailed already for 2019 but I’m hoping some of this is clarified through tax season. Certainly a QBI deduction of $60k (20% of 300k partnership distribution after $0 guaranteed payments) is way better than $10k (20% of a 50k distribution after 250k S corp salary) and may be worth the hassle of S corp dissolution.

    The Finance Buff's solo 401k contribution spreadsheet: https://goo.gl/6cZKVA

    #163112 Reply
    DMFA DMFA 
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    Why do partnership payments *have* to be guaranteed?  I don’t suppose there’s a way to “guarantee” them without actually being “guaranteed payments,” like the guest-poster says?

    Click to expand…

    It seems that with regards to the QBI deduction physician S corps are at a clear disadvantage compared to sole proprietorships and partnerships, when around that critical $315k level of taxable income. The ship has almost certainly sailed already for 2019 but I’m hoping some of this is clarified through tax season. Certainly a QBI deduction of $60k (20% of 300k partnership distribution after $0 guaranteed payments) is way better than $10k (20% of a 50k distribution after 250k S corp salary) and may be worth the hassle of S corp dissolution.

    Click to expand…

    I mean, Stephen L Nelson, CPA, the author of the WCI blog post certainly seems to think so.  I think his explanation is plausible.  His publication record is p impressive, but I’d have to look at the IRC/CFR section for how partnerships are required to structure payments.  I think this would require everyone to redo and re-sign their contracts waiving any “guaranteed payment,” and I’m not sure everyone would be content to do so.  As far as filing the tax forms, a 1065 doesn’t seem *too* terribly different from an 1120S, so I’m not certain whoever does your books would have *too* much work cut out for them…

    "I like money." - Frito Pendejo (Idiocracy)

    [Not a financial professional (yet), lawyer, or employee of The White Coat Investor]

    #163117 Reply
    Avatar jacoavlu 
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    The primary barrier would be dissolution of the S corp and the tax implications of that. Stephen touched on that in our conversation in the blog post comments. I don’t have a good handle on S corp basis and potential gains taxes from a dissolution, as Stephen brought up fair market valuation, goodwill. If only it was so simple as a reorg/tax free merger from S corp to partnership…

    The Finance Buff's solo 401k contribution spreadsheet: https://goo.gl/6cZKVA

    #163119 Reply
    DMFA DMFA 
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    https://www.law.cornell.edu/uscode/text/26/707

    IRC §707(c): “Guaranteed payments: To the extent determined without regard to the income of the partnership, payments to a partner for services or the use of capital shall be considered as made to one who is not a member of the partnership, but only for the purposes of section 61(a) (relating to gross income) and, subject to section 263, for purposes of section 162(a) (relating to trade or business expenses).”

    So that’s what you get regardless of what the partnership returns.  You’d have to make your income contingent on whatever the partnership has made.  Here’s an interesting article on the subject from The CPA Journal, originally from 1995 but re-printed in Sep 2017:

    Is It a Guaranteed Payment?

    IRC Sec. 707(c) is very clear on the criterion for a guaranteed payment: Payments to a partner for services or for the use of capital are guaranteed payments to the extent they are determined without regard to the income of the partnership. But what about certain minimum payments that coordinate with a partner’s distributive share? For example, suppose the ABC Partnership agreement states that Partner B is to receive 20% of partnership income as determined before taking into consideration any guaranteed payments, but not less than $13,000. Further suppose the income of the partnership is $100,000, so B is entitled to receive $20,000 as her distributive share (20% of $100,000). In this case, no pan of this amount is considered a guaranteed payment. But, if the partnership income had been only $30,000 instead of $100,000, then $6,000 (20% of $30,000) would be Partner B’s distributive share, and the remaining $7,000 payable to B would be a guaranteed payment.

    The IRS View. There has been some confusion and disputes about what the phrase “income of the partnership” means. The IRS itself hasn’t helped. Although the wording of IRC Sec. 707(c) is quite clear that for a distribution to be a guaranteed payment it must be “determined without regard to the income of the partnership,” the IRS blithely chose to ignore this wording in an important revenue ruling in 1981 (Rev. Rul. 81-300, 1981-2 CB 143).

    The ruling dealt with the classification of management fees paid to partners of a partnership formed to purchase, develop, and operate a shopping center. The partnership agreement provided that the partners must contribute their time, aerial abilities, and best efforts to the partnership, and in return for their managerial services, each will receive a fee of 5% of the gross rentals received by the partnership. These amounts were to be paid to the partners in all events. After an extensive analysis of the law, especially the very pertinent wording of IRC Sec. 707(c), the IRS noted that “although a fixed amount is the most obvious form of guaranteed payment, there are situations in which compensation for services is determined by reference to an item of gross income. Such compensation arrangements do not give the provider of the service a share in the profits of the enterprise, but are designed to accurately measure the value of the services provided.” It goes on to say, therefore, that “the term guaranteed payments should not be limited to fixed amounts. A payment for services determined by reference to an item of gross income will be a guaranteed payment if, on the basis of all facts and circumstances, the payment is compensation rather than a share of partnership profits.”

    The IRS stated it will look toward all relevant facts especially – 1) the reasonableness of the payment for the services provided and 2) whether the method used to determine the amount of payment would have been used to compensate an unrelated party for the services.

    The Courts’ View. The courts have not treated the language of IRC Sec. 707(c) so lightly. In Pratt v. Commissioner USTC, 64 TC 203, CCH Dec. 33, 189 (1975), the partners’ compensation was based upon gross rentals. The partners argued that “gross rentals” are not the same as “income” for the purpose of determining whether distributions are guaranteed payments. The court stated, “the parties make some argument as to whether payments based on gross rentals should be considered as payments based on ‘income.’ In our view there is no merit to such distinction.” Since the payments were tied in some way to partnership income, the court rejected, out of hand, that they could be considered guaranteed payments.

    …so again, this would take some contract and accounting gymnastics, and I’m not sure how it’d go over.  Seems like a risk.  I think one might do better just to reduce one’s “guaranteed payment” than eliminate it and have a higher distributive share.

    "I like money." - Frito Pendejo (Idiocracy)

    [Not a financial professional (yet), lawyer, or employee of The White Coat Investor]

    #163127 Reply
    Avatar jacoavlu 
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    Our CPA is expecting a technical corrections bill in the coming weeks with clarification on several QBI deduction issues, possibly including this guaranteed payments – partnership issue.

    The Finance Buff's solo 401k contribution spreadsheet: https://goo.gl/6cZKVA

    #163272 Reply
    Avatar jacoavlu 
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    Status: Physician, Small Business Owner
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    Joined: 03/01/2018

    Bringing this back from the dead in case anyone interested wants to chat about it. I’ve further solidified my opinion that if I could snap my fingers and convert my S Corp practice to a partnership I’d do so immediately. But it seems it can be quite a hassle to make the transition so it’s an exploration as to whether the juice is worth the squeeze.

    The Finance Buff's solo 401k contribution spreadsheet: https://goo.gl/6cZKVA

    #179772 Reply
    Avatar docnews 
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    Interesting thread.

    I foresee s corps with profit under $415k going away so in some ways CPAs might lose money. I’m in a state that taxes s corps like c corps at the state level so never considered it. S corps are not free to setup and are not a do it yourself project.

    #179868 Reply

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