Guaranteed payments to an S Corp, pass through, and QBI

[jasdlm]

S Corp is member of a partnership.  The partnership has always issued a K1 with income on line 1.  This year, the partnership issued the S Corp a K1 with almost $200k income on Lin 4 - guaranteed payments.  I'm stumped.

1)  If the Guaranteed Payments flow through to the partners shareholders (2), the partnership has a substantial loss, because the income is part of what they use to determine their S Corp salaries.  (They are physicians; the partnership is an umbrella that some patient fees go through and are passed on; I'm not certain why because there is also substantial direct patient billing in the S Corp.)

2)  If I simply count the $200k as S Corp worldwide income (avoiding the loss issue), I then set up for a QBI calculation; how does that reconcile with the fact that the income was 'guaranteed payments'.  This seems like the right solution, but the QBI issue is gnawing at me.

I found a thread that Abby & Lion responded to in February of 2021, but the question was posed by a non-tax professional, and there wasn't much discussion.

Thanks in advance for any thoughts!

Edited March 13, 2022 by jklcpa
clarity

[Lee B]

Good Luck with this one. Over the years I have observed that other professionals have a tendency to think they are the smartest person in the room

and when someone sells them on a convoluted tax savings scheme like this they jump all over it!

 

[jasdlm]

Just reading my original post.  Should read 'if the guaranteed payments flow through to the shareholders' in number 1.  Sorry.

 

[kathyc2]

I'm not 100% sure I'm following what you are saying, but you need to remember than the partnership and the S-corp are separate entities. 

If the partnership paid money to the S, then the payment needs to be either 1)an ordinary business expense, 2)a guaranteed payment or 3)a distribution.   What does the partnership agreement say about payments to the S? 

[jasdlm]

I don't have the partnership agreement, and I don't do the partnership return.   I made a typo in the original post; I apologize.  This year, for some reason, (The S corp has been getting a k1 from the partnership for the entire time I've been doing the return), the income, instead of coming through on line 1 of the K1 from the partnership (return I don't do) to the S corp (return I do), it came through on line 4.  The question is essentially whether I have to pass that income on to the S corp shareholders on line 10H (other income) not eligible for QBI and creating a loss in the S corp.

Sorry to be unclear. 

[jklcpa]

Found these, maybe will help:

https://www.tingwimberlycpa.com/2019/07/qbi-issue-when-your-s-corp-is-a-partner-in-a-partnership/#:~:text=Guaranteed payments are not qualified,income from an S corporation.

https://bradfordtaxinstitute.com/Content/QBI-and-Self-Employment-Tax-Savings-for-S-Corp-as-a-Partner.aspx

[jasdlm]

Thank you, Judy!  That's what I was afraid of, unfortunately.  I really appreciate it!

[jasdlm]

Hello, again.  One more question (long shot).  I want to run my logic (or lack thereof) by some of you:  If the salaries paid to the shareholders were greater than the guaranteed payments from the partnership (they were) then would it be fair to argue that the guarantee payments paid the salaries (retaining all the same characteristics) and the other patient fees received directly by the S-Corp were what composed the s-corp profits?

Trying to think outside the box but take a defensible, reasonable position.

Thanks for any thoughts.  I might be too caught up in this.

[jklcpa]

Were you able to see the entire Q&A from the Bradford Tax link I shared? It had an example, but when I went to look at it from the link this morning I couldn't see it.  If that happened to you or anyone else, perhaps seeing the entire example will help, so I did c&p into the box below.  I also put in the calculations at the bottom as referenced by the notations to the footnotes. Sorry if the formatting is bad.

The way I see it after looking at the examples below, the only way the S corp shareholders could have QBI coming from the S corp is if the net profit of the S corp itself (after owner salaries and other expenses allocated to that portion of the "activity") exceeds the guaranteed payments flowing from the partnership (after the S corp's expenses allocated to that portion of the "activity")

Quote

June 2019

Q&A: QBI and Self-Employment Tax Savings for S Corp. as a Partner

Question

I own 100 percent of my S corporation.

My S corporation is a partner in various partnerships and receives a combination of guaranteed payments and ordinary pass-through income from those partnerships.

I draw a salary from the S corporation for the services I perform for these partnerships.

The S corporation pass-through income to me qualifies for the Section 199A deduction, right? I’m below the taxable income threshold.

Answer

We’ve got news for you—some good, some bad. Let’s start with the bad news.

One part of the pass-through income from your S corporation isn’t qualified business income (QBI) and won’t qualify for the Section 199A deduction.

Problem

Guaranteed payments are not QBI.1

The non-QBI guaranteed payment rule applies whether the partner receives the payment as an individual or as pass-through income from an S corporation.2

QBI S Corporation Partnership Example

Let’s walk through your S corporation’s situation to show you how this works:

• Your S corporation received guaranteed payments of $75,000 (75 percent of gross income).
• Your S corporation received pass-through income of $25,000 (25 percent of gross income).
• Your S corporation has $30,000 of net income after your salary and other expenses that it will show as pass-through income to you.

Assuming your S corporation expenses are equally allocable to both the guaranteed payments and the pass-through income,

• $22,500 of the S corporation net income is not QBI (75 percent of $30,000), and
• $7,500 of the S corporation net income is QBI (25 percent of $30,000).

Your Section 199A deduction without the S corporation would be $4,647,3 and it is $1,5004 with the S corporation. Assuming a 24 percent marginal tax rate, the reduced Section 199A deduction costs you $755.5

But that’s only part of the story. You must consider what you saved in self-employment taxes.

Self-Employment Tax Savings

With your S corporation strategy, you saved $4,239 in self-employment taxes on the $30,000 of S corporation pass-through income to you.6

Net Savings

Overall, you come out ahead with your S corporation strategy as you have it. You save $4,239 in self-employment taxes and give up $755 in Section 199A deduction cash. Your net cash savings with your S corporation as a partner are $3,484.

Improving the Solution

Consider the following two options to increase your Section 199A deduction from your S corporation:

1. Reduce or eliminate guaranteed payments from the partnerships, and receive the income as pass-through income.
2. Consider special allocations of partnership tax items in lieu of guaranteed payments.

We recommended these same potential solutions in Q&A: How to Calculate and Improve Your QBI from a Partnership.

Be careful with partnership special allocations—the allocations must have what the tax law calls “substantial economic effect” to be valid.7 Before going down this road, you should consult a tax advisor who is well versed in partnership tax law.

Takeaways

If a partnership pays you with guaranteed payments, the guaranteed payments do not produce Section 199A deductions.

You may have heard that you can get around this rule and also save self-employment taxes by having your S corporation be the partner. Half of this is possible:

• You can save self-employment taxes with the S corporation as a partner.
• Your use of the S corporation won’t turn a guaranteed payment into QBI.

Your only options to claw back your Section 199A deduction with the S corporation as a partner are to

• reduce or eliminate the partnership’s guaranteed payments, and take the income pro rata based on ownership percentage; or
• use a special allocation of partnership tax items.

Keep the S corporation self-employment tax savings in mind when considering your partnership activity. Often the savings can make the S-corporation-as-a-partner strategy well worth it. But as always, run the numbers for your particular situation to be sure.

1. IRC Sec 199A(c)(4)(B)
2. Reg sec 1.199A-3(b)(2)(ii)(l)
3. QBI is $25,000 less $1,766 or $23,234, and 20 % of $23,234 is $4,647. The $4,647 reduction is the allocated deduction for 1/2 of S.E. tax
4. 20% of $7,500
5. 20% of ($4,647 - $1,500)
6. $30,000 x 15.3% x 92.35%
7. IRC sec 704

 

[jasdlm]

Thanks so much!  I wasn't able to see this from the link, so I really appreciate you posting it.  Very helpful.

[jklcpa]

Yes, I could see it clearly from my tablet and phone but the desktop link required a log in.