If you are in a partnership (or an LLC taxed as a partnership), two significant tax changes may give you cause to review – and possibly revise – your partnership agreement.
The first tax change has been a long time coming. The Bipartisan Budget Act of 2015 created a replacement for audit rules for “large partnerships.” However, the new rules apply to all partnerships – even though the IRS did not issue the final version of the regulations until January 2018. While the new procedures were designed to make it easier and faster for the IRS to audit partnerships, there is an important change. Any back payments, penalties, or fines will be billed to the current partnership, even if there was a change in partners. Plus, the tax will be set at the highest corporate or individual tax rate. The good news is that this effect can be mitigated with proper planning, including changes to the partnership agreement. This new procedure is effective for years beginning on or after January 1, 2018.
A second development derives from the recently enacted Tax Cuts and Jobs Act of 2017 (TCJA), which created a deduction of up to 20% on “qualified business income” for pass-through entities, including most partnerships, LLCs taxed as partnerships, and S Corporations. The calculation of the deduction is complicated, as is the definition of qualified business income. A determining factor for partnerships is the treatment of guaranteed payment for services for a partner (or salary for an employee/shareholder) which reduces the amount of qualified business income that can be applied to the deduction.
Partnerships must weigh whether it is in their best interest of their partners to receive guaranteed payments for services, which would be subject to being taxed at ordinary income rates plus self-employment tax, or to go without guaranteed payment and take advantage of the deduction. (It is also important to remember that a portion of Social Security benefits may be taxable.) Complicating matters is the fact that guaranteed payments are generally used in calculating the amount of Social Security a taxpayer will eventually receive. There are additional complications to consider as well. So deferring or avoiding taxes may not always be the best route to take.
Guaranteed payment for services are frequently included in a partnership agreement. So if the partnership decides to forego guaranteed payments, it may require a change in the agreement.
Where to start? Consult with a qualified tax advisor to see how your current partnership agreement will be affected by these tax changes. The issues are very complex. Determining what is best for the partners requires taking many things into consideration.
We will discuss each of these issues in more depth in future articles.
For more information about the complex – but vitally important – choices, please contact Gray, Gray & Gray’s Tax Department at (781) 407-0300.