The new Tax Cuts and Jobs Act (TCJA) created the Section 199A deduction that allows a partner to potentially take a 20 percent deduction of their qualifying business income (QBI) subject to certain limitations.

Code Section 199A(c)(4)(B) provides that QBI does not include any Code 707(c) payments (i.e. guaranteed payments) to a partner for services rendered to the partnership’s trade or business.

What does this mean for partners receiving guaranteed payments under the 199A regime?

Assume the partnership had $1,000,000 of QBI before any partner compensation and $600,000 of guaranteed payments to partners.  Under this scenario, (without regard to any other limitation included in Section 199A such as the wage limitation), the partners would realize taxable income in total of $1,000,000, and the QBI would be $400,000 with a corresponding $80,000 deduction.

What if, instead of guaranteed payments, the payments for services rendered were structured as priority returns of profits?

Using the same facts as above, the partners in total would continue to realize taxable income of $1,000,000, but the QBI now becomes $1,000,000 with a corresponding $200,000 deduction.

Each partner would continue to get the same income and cash as they had with guaranteed payments, but they would now enjoy an additional $120,000 deduction!

With respect to this technique, the question of “reasonable compensation” under Code 199A(c)(4)(A) presents itself and provides that QBI shall not include “reasonable compensation paid to the taxpayer by any qualified trade or business of the taxpayer for services rendered with respect to the trade or business…”.  Would Treasury attempt to impute reasonable guaranteed payments to partners (thereby reducing QBI and the corresponding deduction) if there were no longer guaranteed payments indicated?  Treasury and the IRS believe “reasonable compensation” is limited to the compensation of S corporation shareholders’ employees  If they were to extend the concept beyond S corporations, a partnership could be required to apply the concept to its partners regardless of amounts guaranteed and would violate the rule that states that a partner cannot be an employee of that partnership.  Thus, proposed regulation 1.199A-3(b)(2)(ii)(H) provides that QBI does not include reasonable compensation paid by an S corporation but does not extend this rule to partnerships.

Of course there are other elements to consider before the priority return of profits method is employed.  Will the partnership have enough in profits year to year to ensure that the partners receive cash and income in the same manner as guaranteed payments?  If they were to have a bad year, would the partnership be able to collect the cash back from the partners that was over-distributed by the end of the year?  Would the partners feel comfortable that their payments are no longer guaranteed? How does this affect any self-employment tax planning or wage limitations?

If structuring guaranteed payments as priority return of profits for services rendered would be beneficial to your partnership, your partnership agreement must be amended.  Under Code 761(c), you would have until March 15, 2019 to amend a partnership agreement for the calendar year 2018.