Understanding qualified business income deduction eligibility
Small business owners received a substantial benefit with the passage of the Tax Cuts and Jobs Act in December 2017. Owners of pass-through entities, including shareholders in S corporations, partners in partnerships and sole proprietors, are now eligible for a 20% deduction on “qualified business income.” Not all income qualifies for the deduction, however. One type of income, guaranteed payments, is not eligible for the deduction. But careful analysis to ensure that items are correctly classified, as well as possible restructuring of this income, could allow organizations to benefit from the new deduction.
The Tax Cuts and Jobs Act provides that, for tax years beginning on or after January 1, 2018, partners in partnerships are eligible to claim a deduction on their individual returns for their “combined qualified business income amount,” with a maximum deduction equal to 20% of taxable income (with adjustments for cooperative dividends and net capital gains). The “combined qualified business income amount” is equal to 20% of qualified business income from each “qualified trade or business.” Nearly all trades and businesses are “qualified.” There is an exception for “specified service trades or businesses,” which refer to “any trade or business involving the performance of services in the field of health, law, accounting, actuarial science, performing arts, consulting, athletics, financial services, brokerage services, or any trade or business where the principal asset of such trade or business is the reputation or skill of one or more of its employees or owners.” Partners in those types of businesses are not eligible to take advantage of the new qualified business income deduction unless their income is below a certain threshold.
“Qualified business income” eligible for the deduction is virtually all ordinary income from the trade or business, with one significant exception for partners in partnerships – guaranteed payments. A partner in a partnership is eligible to include his or her distributive share of partnership income in arriving at his or her qualified business income deduction. A guaranteed payment is generally deductible for federal income tax purposes by the partnership. In determining each partner’s distributive share of the partnership’s income, however, the recipient partner is specifically prohibited from including the amount of the guaranteed payment in determining his or her qualified business income for purposes of the new deduction.
Accordingly, partners in partnerships are subjected to the worst possible treatment for purposes of the new deduction – their distributive share of partnership income, which is eligible for the deduction, is reduced because of the partners’ share of all guaranteed payments from the partnership, but the recipient partner’s income is not increased by the amount of the received guaranteed payment.
This result can be avoided with some careful analysis, in some circumstances, or some careful planning in others. Before the passage of the Tax Cuts and Jobs Act, close examination of the issue was not always warranted. But because guaranteed payments are not eligible for the deduction as a distributive share is eligible, close examination should be undertaken to ensure that the tax benefit is maximized.
In some circumstances, a careful review of the partnership or operating agreement may reveal that what is believed to be a guaranteed payment is not one at all, but rather a priority class of distributive share that would not be deductible by the partnership as a guaranteed payment. This would increase the partnership’s income (and each partner’s distributive share), making it eligible qualified business income for purposes of the new deduction.
In other circumstances, the partnership or operating agreement clearly identifies such items as guaranteed payments. With thorough planning and consideration, however, this does not have to be the result. The partnership or operating agreement may be modified to restructure guaranteed payments as a priority or special allocation of partnership income, allowing all partners in the partnership to receive the benefits of the new qualified business income. This modification can be made relatively easily and provide benefits that will last from January 1, 2018 through December 31, 2025.
Careful examination and planning in this area may not only provide federal tax benefits, but may also provide a state tax reduction, as well. For partners with income taxed by the State of Ohio, guaranteed payments are not eligible for the small business income deduction unless the partner owns 20% of the partnership, while a partner’s distributive share of partnership income is eligible for the small business deduction. A partner can claim a deduction for up to $250,000 of small business income, and is entitled to a flat 3% tax rate for small business income exceeding this amount for Ohio, so there may be additional benefits to restructuring guaranteed payments under Ohio tax law as well.
If you are a partner in a partnership for federal income tax purposes, and are unsure how the new deduction may impact you, contact Brett Bissonnette, JD, CPA, at (513) 424-7693 or any of the skilled tax advisors at Clark Schaefer Hackett.
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