There are a few partnership-specific provisions in the Tax Cuts and Jobs Act (TCJA) that could impact how you compensate yourself. Specifically, if you receive a guaranteed payment, you should make sure you’re aware of how the QBI deduction works along with current IRS rules and requirements. Here’s a brief overview of where things stand.
What is a Guaranteed Payment?
Guaranteed payments from a partnership to a partner are a way to provide business owners financial stability while waiting for the partnership to become profitable. The IRS defines the term as payments to a partner in return for the time and services the partner has provided the business without regard to the income of the business. In other words, guaranteed payments are made whether the business is turning a profit or not. Guaranteed payments are a tax-deductible expense that reduces the business’s net profit.
Do Partners File a W-2 for a Guaranteed Payment?
No. While guaranteed payments are paid out like a salary, they are not subject to any payroll taxes. Instead, these earnings are reported on each partner’s Form 1040 for income tax and on their Schedule K-1 for self-employment tax.
What is the Difference Between a Guaranteed Payment and a Draw?
A draw is a regularly scheduled payment, but it’s meant to be a prepayment of profit. The draw is paid out of the member’s equity and, when a distribution is issued, the equity account is paid back with the profit share.
What is Qualified Business Income (QBI)?
Generally speaking, QBI refers to the business’s net profit, although it’s not exactly the same because it doesn’t factor in things like capital gains and losses.
What is the QBI Deduction?
The qualified business income (QBI) deduction, also known as Section 199A, is a tax deduction that allows eligible small-business owners to deduct up to 20% of their QBI on their taxes. The deduction was introduced as part of the 2017 tax reform called the Tax Cuts and Jobs Act (TCJA). The 20% deduction only applies to distributive shares of a partnership’s ordinary income and does not apply to guaranteed payments. Prior to the passage of TCJA, the income tax treatment of a distributive share of a partnership’s ordinary income, or QBI, did not differ significantly from guaranteed payments – they were taxed at essentially the same rate.
Who Qualifies for the QBI Deduction?
The QBI deduction is only available to owners of pass-through businesses, even if you’ve opted to take the standard deduction as opposed to an itemized deduction. But the limitations don’t end there. If your business is a “specified service trade or business”, your QBI deduction may be limited or disappear entirely once your total taxable income reaches a certain limit.
A specified service trade or business (SSTB) is a service-based business (other than engineering or architecture) where the business depends on the reputation or skill of its employees or owners. That’s a broad definition, but it includes law firms, medical practices, consulting firms, accountants, financial services, investment management firms, and more.
How Do Guaranteed Payments Affect Your QBI Deduction?
The partnership’s deduction for guaranteed payments will reduce the qualified business income (QBI) that is passed through to the partners. Some business partners wonder if it makes sense to reduce or not pay a guaranteed payment in order to increase QBI benefits. As with many tax questions, the answer can be complicated. For instance, it could depend on how the partnership operating agreement is written. Such a change may not have the desired economic effect and could bring additional scrutiny by the IRS.
As you can see, the QBI deduction gets complex fast. It’s another example of why it’s important to stay up to date and consult with professionals as you evaluate your options. To be sure you are making the best choices to minimize your tax liability, call Hare CPAs Business + Advisors. We serve as partners who always look out for your best interests, so you can keep your business moving forward.