Tax Treatment of Guaranteed Payments to Partners: Impact of IRC 199A, Section 707 Payments, Priority Allocations

The Section 199A QBI deduction provides tax planning opportunities for owners of pass-through entities, with some limitations. Tax counsel must recognize fundamental mechanisms in structuring partnership income and distribution allocations between partners to maximize the benefits of the Section 199A deduction in light of its treatment of guaranteed payments.

QBI is the net amount of qualified items of income, gain, deduction, and loss from any qualified trade or business. However, it excludes amounts received as guaranteed payments from a partnership and payments received by a partner for services under Section 707. Under Section 199A and its regulations, these payments are not considered QBI to the recipient partner and are thus not eligible for the pass-through deduction.

Further, the payments are not W-2 wages when calculating the partnership's wage-based limits as required by 199A. These changes effectively end the usefulness of guaranteed payments as a means of compensating partners beyond the allocation of net income.

Owners of partnership interests must consider alternative allocation methods for the partnership and its impact on the characterization of income for purposes of the 199A deduction. Among the available options are using special or priority allocations to impacted partners instead of guaranteed payments or setting up a lower-tier partnership and structuring the payment as W-2 wages to the indirect partner. Each of these structures can have severe consequences for both the recipient and the remaining partners, so advisers need to know the implications of these strategies.

Listen as Joseph C. Mandarino, Partner at Smith Gambrell & Russell, provides practical guidance on mitigating the impact of Section 199A on partnerships with guaranteed payment structures.