Taxpayers clamored for guidance under the new Qualified Business Income (QBI) deduction from the moment it was introduced by the new tax law. Among those most interested were partners and partnerships who were contemplating changes to partner compensation arrangements that might maximize the QBI deduction. The IRS unveiled proposed regulations on August 8 that provide answers to lingering questions, favorably resolve potential pain points, and minimize popular planning strategies. To the chagrin of taxpayers, planning strategies for partner compensation were among those strategies targeted in the proposed regulations. But as the proposed regulations answer this question, they propel an older and still unresolved question about partner compensation under Section 707(a) to the forefront.
Partner Compensation Types in General
There are a number of arrangements a partnership may use to compensate its partners (in this context, partnerships include LLCs and partners include LLC members). Common among these are guaranteed payments to partners. Guaranteed payments are described under Section 707(c) and are made to a partner in his or her capacity as a partner for services or for the use of the partner’s capital. Particularly, guaranteed payments are determined without regard to partnership income, which distinguishes them from other allocations of partnership income.
For example, a partner’s performance of legal services on behalf of a law firm partnership in exchange for the first $250,000 of partnership profits is contingent on the existence of profits, and therefore is not a guaranteed payment. If the partner were paid $250,000 for such legal services regardless of partnership profits, that is a guaranteed payment. In either case, this result is dependent on performance of services in the capacity as a partner.
Although guaranteed payments and distributive shares of partnership income may both entail compensation for “partner-capacity” services, there are important distinctions between them. For example, a distributive share of partnership income might include capital gain items, a clear benefit for a service provider who is normally subject to ordinary tax rates and self-employment taxes. On the other hand, guaranteed payments for services will always be subject to ordinary tax rates and self-employment taxes.
When a partner performs services other than in his or her capacity as a partner, a different set of rules under Section 707(a) apply. Under Section 707(a), it makes little difference whether partner compensation is based on partnership income because the partner is subject to ordinary tax rates and self-employment taxes either way. But when partner compensation is based on partnership income, it can be important to ascertain whether services are performed in the capacity as a partner (i.e., whether Section 707(a) applies). The historical significance of this distinction primarily lies in the capital gain potential described previously. The proposed regulations for the QBI deduction raise the stakes of this distinction even further.
Partner Compensation under the Proposed Regulations
There are rules established in the proposed regulations concerning types of income eligible for the QBI deduction. The proposed regulations do not treat any type of guaranteed payment (whether for services or for the use of capital) as eligible QBI.In recognition of this potential problem, taxpayers and planners wondered previously whether a priority allocation of partnership income would be eligible for the QBI deduction.A priority allocation of partnership income conceivably would provide a partner his or her desired compensation while steering clear of a guaranteed payment category that is ineligible for the QBI deduction. A priority allocation of partnership income also might unlock capital gains rates when not covered by Section 707(a). The proposed regulations address this topic.
Prop. Reg. Sec. 1.199A-3(b)(2)(ii)(J) provides that QBI does not include:
Any payment described in section 707(a) received by a partner for services rendered with respect to the trade or business, regardless of whether the partner is an individual or [a relevant pass-through entity].
Partner compensation provided for services in the capacity as a partner and that is based on partnership income would not be described under Section 707(a). This result might unlock capital gains rates inherent in the distributive share of partnership income. When the distributive share of partnership income consists of ordinary tax rate items, such income would be eligible for the QBI deduction. Suffice it to say, a determination of whether these services are rendered in the capacity as a partner is critical to the tax consequences of the partner compensation.
Unfortunately, this determination has been a murky one for decades, and the potential QBI deduction makes it all the more important now. Neither the law nor any finalized regulations provide guidance on this question.However, legislative history elaborates on five factors to consider in determining whether a partner performs services in his or her capacity as a partner (Senate Comm. on Finance, 98th Cong., 2d Sess., Deficit Reduction Act of 1984, S. Prt. No. 169, at 227-228).Of the five factors, the first is described as the most important: Is the payment subject to an appreciable risk as to amount, such as a significant entrepreneurial risk as to both the amount and the probability of payment?
The existence of a significant risk indicates the partner is acting in his or her capacity as a partner.Conversely, where there is limited risk as to amount and payment, an allocation and distribution resembles a fixed fee and indicates non-partner capacity.
Proposed regulations under Section 707(a) would provide definitive guidance on this question. These proposed regulations were issued back in 2015, but have not yet been finalized.The proposed Section 707(a) regulations would incorporate the five factors from the legislative history to assist with this determination.Regarding the first and most important factor, Prop. Reg. Sec. 1.707-2(c)(1) provides a list of sub-factors that would indicate a lack of entrepreneurial risk, and therefore that the partner is not acting in his or her capacity as a partner:
- A capped allocation of partnership income if the cap is reasonably expected to apply in most years;
- An allocation for one or more years under which the service provider's share of income is reasonably certain;
- An allocation of gross income;
- An allocation that is predominately fixed in amount, is reasonably determinable under all the facts and circ*mstances, or is designed to assure that sufficient net profits are highly likely to be available to make the allocation to the service provider; or
- An arrangement in which a service provider waives its right to receive payment for the future performance of services in a manner that is non-binding or fails to timely notify the partnership and its partners of the waiver and its terms.
The other four factors in both the legislative history and in the proposed regulations under Section 707(a) include:
- A transitory partner status,
- A proximity in timing to the performance of services and the purported allocation of partnership income,
- A facts and circ*mstances test to indicate whether the transaction was tax-motivated, and
- A small value in the partnership interest compared to the amount of the purported allocation of partnership income.
Under the proposed regulations and legislative history, these five factors, with the first factor being the most significant, are used to determine whether services are rendered in the capacity as a partner, and classified accordingly under Section 707(a). Therefore, insufficient entrepreneurial risk with respect to partner compensation mean it is treated under Section 707(a).
Summary
A priority allocation of profits that is determined to be made other than in the capacity as a partner would be QBI-eligible, or potentially subject to an allocation of partnership profits that consists of capital gain items.The proposed regulations under Section 199A provides clearly that Section 707(a) payments are not QBI-eligible, but does not provide any further insight about making the all-important distinction regarding Section 707(a) payments. Moreover, the proposed regulations under Section 199A amplify the importance of this distinction.
Practically, however, a partner desiring certainty about his or her compensation may be unlikely to restructure guaranteed payments (not dependent on partnership income) as some form of compensation that is contingent on partnership income. Until clarity emerges on this issue, be cautious when attempting to restructure guaranteed payments as a priority allocations of profits.For more information about the QBI deduction and how guaranteed payments relate, please contact your local CBIZ MHM tax professional.
Related Reading
- The Impact of the New Tax Law on Pass-Through Entities
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