The Tax Cuts and Jobs Act of 2018 (TCJA) created a new opportunity for many closely held businesses in the form of an exemption from federal tax of up to 20% of qualified business income. The calculation of qualified business income and the percentage of it that can be excluded is complex. One of the interesting dilemmas presented concerns guaranteed payments made to partners for services rendered.
Many partnerships agreements (including LLCs taxed as a partnership) include a provision regarding who will receive a guaranteed payment and how much that payment will be. Because of the changes caused by TCJA this provision should be reviewed. Here’s why: While guaranteed payments are treated as ordinary income to the partner, they are also a deduction from qualified business income.
Let’s look at an example. An LLC (taxed as a partnership) owned by a husband and wife has income of $250,000 before any guaranteed payments. The LLC makes a guaranteed payment to the wife of $128,400 to maximize social security payment when she retires. In this example, the husband has separate income. By reducing the guaranteed payment by $100,000, they will realize a significant tax savings under the new TCJA provision. The following calculations assume a federal tax rate of 24%.
| Tax savings for qualified business income ((100,000 x .20) x .24) |
$4,800 |
| Savings for not paying self-employment tax (100,000 x .153) |
+$15,300 |
| Less tax savings of deduction for 50% of self-employment tax ((15,300 x .50) x .24) |
-$1,836 |
| Net tax savings | $18,264 |
This tax savings does not necessarily mean the reduction in the wife’s guaranteed payment is the appropriate action. There are numerous factors to consider including:
- Does your spouse work? (You may qualify for spousal social security)
- What return on investment do you anticipate if you invest the tax savings?
- Do you need the cash now?
- What is your life expectancy?
- Have you estimated your retirement needs?
- What other assets do you expect to have in retirement?
Remember that the calculation of social security benefits is complicated. The benefits are not linear; they have “bend points.” Consideration must be given to the fact that money which is considered self-employment income may lower the return on social security benefits.
As much as 85% of social security benefits may be taxable for high income taxpayers (currently $44,000 for married filing jointly).
When it comes to tax, investment, or retirement planning options there is no single answer that is appropriate for everyone. The question of what to do regarding guaranteed payments for services in a partnership, in particular, is complex. Hopefully, this article provides you enough information so you can discuss this issue with a qualified advisor.
The Tax Department of Gray, Gray & Gray is ready to help you address this complicated issue. Contact us at (781) 407-0300.
