Okay. This Tuesday? I’ve got a tax strategy for partnerships. A strategy that can save individual partners thousands in taxes annually. Maybe even starting this year.
The strategy? Convert guaranteed payments to qualified business income, or QBI. Which should cut someone’s income taxes by about a quarter.
Accordingly, this week, the Tax Strategy Tuesday blog post discusses this gambit. And its mechanics. And note that at the end of this post, additional information resources appear.
Tip: If you’re interested in other tax strategies, click here: Tax Strategy Tuesday.
But let’s start by giving a nutshell description of the strategy…
Convert Guaranteed Payments into QBI Tax Strategy in Nutshell
You perhaps know this, but if a partnership pays a partner some amount and calls that disbursement a guaranteed payment, the partner pays income taxes on the full amount.
Example: Dolly works as a physician in a group medical practice operating as a partnership. As a partner, she receives a $300,000 guaranteed payment for her work. Dolly pays income taxes on the $300,000.
The tax accounting works differently, however, if the partnership allocates and then pays out profit shares to partners.
Why? Because tax law (through 2025) gives partners in partnerships a special “qualified business income” deduction equal to twenty percent of the qualified business income, or QBI. And a profit allocation counts as qualified business income. Guaranteed payments don’t count.
Example: James, a physician in a different group medical practice, also earns $300,000. But his partnership doesn’t use guaranteed payments in its accounting. Rather, the partnership allocates profits to James and then pays out profits as distributions. James therefore pays income taxes on only eighty percent of the $300,000, or $240,000. His taxable income drops from $300,000 to $240,000 due to the $60,000 QBI deduction.
A final quick point about this tax strategy. Partly the problem this blog post describes reflects a legacy of accountants taking shortcuts. Before 2018? It didn’t matter that bookkeepers and accountants incorrectly labeled payments to partners as guaranteed payments. That made the accounting easy. But often the partnership didn’t really have guaranteed payments.
Tricks that Convert Guaranteed Payments into Qualified Business Income Tax Strategy Work
Okay, the obvious basic trick for making the convert-guaranteed-payments-to-QBI strategy work? Not using guaranteed payments.
That means, per tax law, saying partners get paid out of profits. And not saying some amount gets paid to a partner regardless of profits.
Also, all the internal documentation that describes and controls and documents how partner profits get allocated? And then paid out to partners? That stuff all needs to tell the same story. (A partnership’s attorney quarterbacks this process, including the key step of updating the partnership agreement.)
But get the mechanics right, and the results work wonderfully. And get sloppy and cut corners? Ouch.
Referencing the earlier examples, if Dolly’s partnership says she gets that $300,000 no matter what happens, no matter the firm’s profitability, that $300,000 is a guaranteed payment.
But if the partnership updates its partner compensation agreements to say that partners can plan on a $25,000 month distribution (so $300,000 for the year but subject to partnership cash flows and profits) and then people get allocated profits based on the management committee’s allocation of profits at year-end, that subtle difference converts the guaranteed payments into profit allocations.
Voila. The partner gets a twenty percent qualified business income deduction, or QBI deduction.
Possible Tax Savings from Convert Guaranteed Payments Tax Strategy
The savings a taxpayer enjoys from this strategy? Equal to the new QBI deduction times the taxpayer marginal federal tax rate.
For example, if a taxpayer earns about $330,000 in qualified business income and gets a $65,000 QBI deduction—that’s about as large as someone in a specified service trade or business can get—that saves the taxpayer about $16,000 in federal taxes each year.
Note: A specified service trade or business is basically a white collar or white coat professional. The QBI deduction for these taxpayers phases out once the taxpayers income reaches a threshold amount. For married taxpayers in 2021, the phase-out threshold begins at roughly $330,000 of taxable income.
Partners in non-specified-service-trades-or-businesses may get a larger deduction. For example, a partner in a non-specified-service-trade-or-business with $2 million of qualified business income may get a $400,000 QBI deduction. That $400,000 QBI deduction probably saves the partner around $150,000 in taxes.
Most partners earn five figure or low six figure incomes, however. In these more typical cases, the savings generated by the QBI deduction drop. For example, on $50,000 of QBI, the deduction equals $10,000. And if the marginal tax return equals 12 percent, the tax savings run $1,200 annually.
Turbocharging the Convert Guaranteed Payments into QBI Strategy
Most often, a taxpayer really shouldn’t have to “do” anything to get this strategy to work. Or to work better. Though in a few cases, and as noted earlier, working the strategy sometimes requires the partnership agreement to be updated.
Example: A twenty-partner law firm pays equal shares of the profit to partners. Usually, that share runs roughly $450,000 a year. The partnership K-1 that goes to partners shows about $80,000 of deductions for pension, self-employed health insurance and self-employment taxes. Partners all average another $40,000 in itemized deductions. Which means even though the law firm surely is a specified service trade or business, each partner (at least in this example) should annually get roughly a $65,000 tax deduction and save roughly $16,000 in taxes.
By the way, if a partnership has bungled the accounting for profit allocations, a solution exists. The partnership just amends its 2018, 2019 and 2020 1065 tax returns. And then the partners amend their 1040 tax returns for the same years. (This error, sadly, happens more often that you would guess.)
Limits to Strategy
Typically, high income partners working in a specified service trade or business (basically a white-collar or white-coat profession) lose their ability to easily use the qualified business income once their adjusted gross income rises above, say, $225,000 if single and above $450,000 if married.
Note: The specified service trade or business label only matters as married taxpayers’ taxable income rises above $329,000 and as a single taxpayer’s taxable income rises above $164,900. These taxable income thresholds probably roughly equate to adjusted gross incomes that are at least $50,000 to $100,000 higher due to common tax deductions.
These specified-service-trade-or-business partners can still get the deduction onto their returns. But the deduction requires more work either in the partnership’s accounting. Or on the partners’ individual tax returns.
Example: Dolly the physician mentioned earlier sees her partnership profit triple to $900,000. Her spouse, however, manages the family’s rental property portfolio and creates roughly a $400,000 annual business loss using depreciation. When the couple adds their other adjustments and deductions to their federal return, the taxable income drops below the threshold where specified service trade or business status matters.
How This Tax Strategy Can Blow Up
Bad bookkeeping and internal documentation that mislabels distributions as guaranteed payments surely undermines the strategy.
And then if a partnership agreement historically made use of guaranteed payments? Obviously, the partnership and its partners need to update that agreement.
One other practical matter may torpedo this tax strategy. Partners may find it unacceptable to explicitly bear the risk of fluctuating incomes. Or their families may find it unacceptable.
Example: Three engineers named Hillary, Laura, Michelle consistently generate $1,500,000 in profits from their engineering services partnership. And the agreement between these three women? They evenly share the profits as they evenly share the work. Thus each partner earns $500,000 annually. On its face, this arrangement does not use guaranteed payments and so generates potentially as much as $500,000 a year of qualified business income and possibly a $100,000 QBI deduction. However, it may be that one of the partners or one of the partner’s spouses wants to call the distributions “guaranteed.” Even though of course, they probably aren’t really guaranteed. But that label just, well, “feels” safer.
The Convert Guaranteed Payments into Qualified Business Strategy Works Best for These Taxpayers
The convert guaranteed payments into QBI tax strategy works well for high-income partners. Especially when the partnership doesn’t operate a specified service trade or business.
As noted, partners in specified service trades or businesses face some challenges if their tax returns show high incomes. But regularly, even these folks benefit from treating partnership profits as allocations of profit rather than guaranteed payments paid regardless of profits.
Other Information Sources
The Internal Revenue Code section that describes how guaranteed payments work appears here: Section 707. The related regulations start here: Reg. Sec. 1.707. Someone working with this tax strategy needs to know well what these bits of tax law say.
We’ve also got some blog posts that discuss in more detail how partnerships make the convert-guaranteed-payments-into-QBI tax strategy work: This blog post for example provides a backgrounder on the Section 199A deduction as well as discussion of common ways the Section 199A deduction gets bungled: Section 199A Rookie Mistakes.
This blog post explains the detailed mechanics: Salvaging Partnership Section 199A Deductions.
Finally, this blog post shows how the specified-service-trade-or-business rules sometimes work differently than one might guess: Physician Section 199A Deductions Can Work (If You Know The Rules). Note that this same sort of workaround commonly exists for firms in other categories that initially seem to be disqualified from Section 199A.
Finally, and as always, taxpayers want to discuss a strategy like this with their tax advisor. He or she knows the details of your specific situation. And this plug for our CPA firm: If you don’t have a tax advisor who can help, onboarding info appears here and you can contact us here: Nelson CPA.
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