Boost QBI: Pay Partners and LLC Members Preferred Returns

Do you operate your business as a partnership or as an LLC that’s treated as a partnership for federal income tax purposes?

Are you compensating yourself and your fellow partners or LLC members with so-called guaranteed payments?

This article explains why you should consider paying preferred returns instead of guaranteed payments.

The first thing to know is that the federal income tax rules for LLCs treated as partnerships for tax purposes and their individual members are the same as the rules for partnerships and their individual partners. So, throughout this article, we will refer to partnerships and partners with the understanding that the same tax implications apply to LLCs treated as partnerships and their members.

Also, throughout this article, partners and LLC members are assumed to be individual taxpayers.

With those thoughts in mind, let’s first cover some necessary background information. Here goes.

What Is a Guaranteed Payment?

A guaranteed payment is a payment by a partnership to a partner that’s determined without regard to the partnership’s net income.

Guaranteed payments can be for services rendered by a partner to the partnership or for the partnership’s use of the partner’s capital. Guaranteed payments made in exchange for services to a partnership are often called “partner salaries,” which is a misnomer because partners are not considered employees for most federal tax purposes.

Guaranteed payments are treated as ordinary income. Guaranteed payments to an individual partner from a partnership that’s considered to be engaged in a trade or business count as self-employment income.

At the partnership level, guaranteed payments generally count as deductible expenditures in calculating the amount of the partnership’s ordinary net business income or loss. The net income or loss is then allocated under the partnership agreement to the partners, reported on their respective Schedules K-1, and ultimately reported on their individual personal returns.

What Is a Preferred Return?

Good question. There is no specific tax-law definition of what constitutes a preferred return paid by a partnership to a partner.

But for purposes of this analysis, we will define a preferred return as a preferential allocation of partnership net income to a service-providing partner before the remaining partnership net income is allocated to all partners via the standard allocation arrangement specified by the partnership agreement—which is usually based on the partners’ percentage ownership interests. Preferred returns that meet this definition may also be called “priority profit allocations.”

Whether it is called a “preferred return” or a “priority profit allocation,” the key point is that we are talking about a payment to a partner that 

• is based on a specific allocation of partnership net profit, and 
• is not based on the partner’s ownership percentage, and 
• comes before any allocation of partnership net profits based on ownership percentages.

Such payments will usually constitute ordinary income and will be subject to self-employment tax when received by an individual partner.

And such payments will effectively reduce the amount of partnership net income that remains to be allocated to the partners based on the standard allocation arrangement specified by the partnership agreement.

The QBI Deduction Factor

Here’s where it gets interesting. For 2018-2025, you as an individual partner can potentially deduct up to 20 percent of your share of a partnership’s qualified business income (QBI), subject to limitations based on your income level and the type of business.

Guaranteed payments don’t count as QBI. To add insult to injury, a partnership’s deductions for guaranteed payments reduce the partnership’s QBI, which in turn can reduce allowable QBI deductions for you and the other partners. Ugh!

In contrast, a preferred return of partnership net income that constitutes a share of the partnership’s QBI counts as QBI, as long as the preferred return is a not a disguised payment for services rendered to the partnership. (See the SIDEBAR at the end of this article for information on the disguised payment for services issue.)

Tax-saving strategy. To maximize QBI deductions for you and the other partners, consider replacing guaranteed payments that don’t count as QBI with preferred return payments that do count as QBI. Consider the following example.

Example—Replacing Guaranteed Payment with Preferred Return

The Albacore Partnership is a service-providing business with four equal individual partners. Albacore has $900,000 of net income and $900,000 of QBI before considering the impact of any guaranteed payments or preferred return payments.

Under the current partnership agreement, Alex (the main mover and shaker) is entitled to a $100,000 guaranteed payment for the year in question, which reduces Albacore’s net income and QBI to $800,000.

Under this arrangement, Alex would recognize $300,000 of taxable income from the partnership ($100,000 guaranteed payment plus $200,000 from his 25 percent share of the remaining $800,000 of partnership net income). His QBI before considering any limitations that might apply at his personal level would be $200,000 because the guaranteed payment does not count as QBI.

If the partnership agreement is amended to give Alex a preferred return equal to 11.11 percent of Albacore’s net income in place of the guaranteed payment, he would still have $300,000 of taxable income from the partnership ($100,000 preferred return based on 11.11 percent of partnership net income plus $200,000 from his 25 percent share of the remaining $800,000 of partnership net income). His QBI before considering any limitations that might apply at his personal level would be $300,000 because the preferred return payment counts as QBI.

Bottom line. Under either arrangement, the other three partners would each have $200,000 of taxable income from the partnership (from their 25 percent shares of the remaining $800,000 of partnership net income), and their QBI before considering any limitations that might apply at their personal levels would be $200,000 each. So, the preferred return arrangement benefits Alex’s tax situation, by increasing his QBI, without any adverse tax side effects for the other partners. Great!

Deadline Alert: You May Need to Amend Your Partnership Agreement by March 15

If you and the other partners decide to replace guaranteed payments with preferred return payments, you should amend the partnership agreement to make that change.

The general rule is that for an amendment to a partnership agreement to be effective for federal income tax purposes as of the first day of the partnership’s tax year, the amendment must be made by no later than the due date (not including any extension) of the partnership’s Form 1065 for that year. 

If your partnership uses the calendar year for tax purposes, as most do, the due date for filing Form 1065 for the partnership’s 2020 tax year is March 15, 2021. Yikes! You may have to act fast to put in an amendment that has any impact on your allowable QBI deduction for 2020 (the tax return you are about to file).

Takeaways

The potential tax advantage of paying preferred returns to partners instead of guaranteed payments is bigger QBI deductions for recipient partners.

If you’re interested in the preferred return strategy, you should amend your partnership agreement accordingly, and you must do it quickly to have any impact on your allowable QBI deduction for 2020.

If you decide to amend your partnership agreement to implement the preferred return strategy, include language that will minimize the risk of the IRS reclassifying purported preferred return payments as guaranteed payments or disguised payments for services that won’t count as QBI. (See the SIDEBAR below.) Address this issue with your partnership’s tax advisor.

Finally, don’t forget that there are potential limitations on your allowable QBI deduction that depend on your personal taxable income level and your type of business. These limitations might negate the otherwise beneficial effect of replacing guaranteed payments with preferred return payments. If so, the preferred return payment strategy is only of theoretical interest.

SIDEBAR: Avoiding the Disguised Payment for Services Issue

To the extent provided in yet-to-be-released final IRS regulations, a disguised payment for services is deemed to occur when:

• a partner’s rendering of services to the partnership is followed by a related allocation of income and a distribution, and
• the transactions, when viewed together, are properly characterized as a payment from the partnership to a third party who is not acting as a partner.

Such a disguised payment for services will not count as QBI.

So far, the IRS has not issued final regulations on the disguised payment for services question. But the IRS has issued proposed regulations on the issue that would become effective when and if they are issued in the form of final regulations.

While the proposed rules may indicate what the IRS is thinking, taxpayers are not bound by them.

For what it’s worth, the proposed rules include a list of factors that may indicate that an arrangement is a disguised payment for services. In the context of preferred return payment arrangements, the listed factors can be evaluated as follows.

Lack of Entrepreneurial Risk

If a purported preferred return payment arrangement lacks significant entrepreneurial risk, it might be a disguised payment for services.

For instance, if a partner is virtually certain to receive a purported preferred return payment of a fixed dollar amount, the arrangement may lack entrepreneurial risk. But preferred return payments that are based on partnership net income would seem, by definition, to have the requisite entrepreneurial risk.

(If we have learned anything in the past year, it’s that a business’s net income level is no sure thing. Right?)

Transitory Interest

If the service provider would hold (or be expected to hold) the partnership interest for only a short duration, a purported preferred return payment might be a disguised payment for services.

Timing of Allocation and Related Distribution

If the service provider would receive a purported preferred return allocation and a related distribution within a time frame in which a non-partner would typically expect to receive payment for services, the purported preferred return payment might be a disguised payment for services.

Tax Benefits

If the service provider is a partner primarily to obtain tax benefits that wouldn’t otherwise be available, a purported preferred return payment might be a disguised payment for services.

Small Partnership Interest

If the service provider’s interest in partnership profits is small compared with a purported preferred return payment, the purported preferred return payment might be a disguised payment for services.

Bottom line. The most important factor listed in the proposed regulations is the entrepreneurial risk factor. In case of an IRS audit, a purported preferred return payment arrangement that lacks significant entrepreneurial risk will probably be viewed as a disguised payment for services. As such, it will not count as QBI.

But an arrangement that has the requisite significant entrepreneurial risk probably won’t be viewed as a disguised payment for services unless the other factors indicate to the contrary.

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