Qualified Business Income Deduction - Different Entity Types - Which One is Best For You?


Should we reclassify from a partnership to an S Corporation?


This was the text I recently received from a client. You may be asking what type of entity would be best from your business from a tax perspective now that the tax law has changed.  The answer, of course, depends on your facts and circumstances, but let me give you something to think about.

The Qualified Business Income Deduction

To make this point I will limit this discussion to the Qualified Business Income (QBI) Deduction for taxpayers who qualify to take the full 20% deduction on their personal returns. For this situation I looked at the scenarios for a Partnership, an S Corporation, and a C Corporation. And I will also address the situation for a Sole Proprietor.

All other things being equal, profit and payments to owners, partners, and shareholders, the issue comes down to how the payments to owners, partners, and shareholders are treated for the QBI deduction.

Sole Proprietor

For a Sole Proprietor the QBI deduction is 20% of his Qualified Business Income in this comparison. The amount of money he takes out of the business generally does not affect the deduction or his taxes.

Partnership

For a Partnership the money taken out of the business by the partners can affect the deduction if they are considered Guaranteed Payments (GPs). This is really the heart of the tax situation for the partners on their personal tax returns. Guaranteed Payments are not included in Qualified Business Income on which a partner can receive a deduction based on his share of the QBI. Therefore, the larger your Guaranteed Payments are the lower your deduction will likely be.

Here is a CPA Journal article about Guaranteed Payments to Partners that may help you to understand the technical definition and the practical application as well as the lack of clarity about the definition for tax purposes.

The key here (for now) is the definition that GPs are amounts paid to partners for services that are without regard to income. It is advisable for a partnership to have a written agreement as to how much  the partners will receive in Guaranteed Payments and how they are determined. Be careful to word the agreement in a way that you can maximize the QBI deduction but also provide for the needs of the partners in the event of a loss for the year.

In the past it was possible that Guaranteed Payments were simply taxable to the partners and, like regular income to partners who are active in the business, it was and still is subject to Self Employment Taxes in most cases. Now that the tax law has changed, and because of the QBI deduction, the GPs do matter from a tax standpoint so it is important to understand what GPs are and how they are reported on the partnership return.

S Corporation

When it comes to the QBI deduction based on QBI from an S Corporation there are no GPs but there are required reasonable salaries to the shareholders that are active in the operations of the business. These salaries, like Guaranteed Payments, are not included in Qualified Business Income upon which the deduction is calculated.

What is a reasonable salary is not defined. However, they could be determined based on what you would reasonably pay someone else to do the same work and that could depend on the profitability of of the business as well. As you can see from the above referenced article, Guaranteed Payments are not defined with the same reasonable amount standard.

S Corporation Versus Partnership QBI Deduction Implications

Our discussion assumes equal payments to owners, partners, and shareholders. However, payments to partners can be Guaranteed Payments or Partner Distributions while payments to shareholders of S Corporations can be Salaries (W-2 income) or Shareholder Distributions. All of the active partners income and GPs are generally considered Self Employment Income and are subject to Self Employment Taxes while Shareholder Distributions generally are not subject to employment taxes. The other important point is that both Guaranteed Payments and salaries to active shareholders are not included in QBI while Partner Distributions and Shareholder Withdrawals do no affect QBI.

 What does this mean from an income tax perspective? For a sole proprietor, assuming all of his net income is QBI, then he could get a QBI deduction based on all of his net income. For a partnership in the same situation the partners QBI deduction could be less than the sole proprietor because of their Guaranteed Payments. For the shareholders of an S Corporation their QBI deduction could be less because of the salaries paid to shareholders. The deduction for shareholders of an S Corporation could also be less than the deduction for partners of a partnership if they receive more in salaries than the partners received in Guaranteed Payments. So because of the different standards for payments to Partners and Shareholders the QBI deduction available to Partners and Shareholders could be different.

C Corporation

When it comes to a C Corporation the new tax law provides for a new 21% flat tax rate for C corporations. There is no QBI deduction for dividends paid to stockholders of a C Corporation. These dividends are also taxable to the stockholders on their personal returns.

A Comparison

To figure out which structure now gives you the best tax advantage you would need to look at income taxes on income from different entity types, payroll taxes on W-2 income, Self Employment Taxes on self employment income, and Corporate Taxes and taxes on dividends received from C Corporations. It is complicated and will depend on your individual facts and circumstances.

For my client that sent me the text, I ran a comparison for these different entity types and overall taxes would be lower for a a partnership than for an S Corporation, and if he were a sole proprietor it would have been even lower.

Summary

To clarify, as things currently stand a partnership could benefit from a tax standpoint by having GPs as small as possible. It is probably advisable for the partnership to have a written agreement that details how much the partners guaranteed payments will be and how they are calculated. You should discuss this with your CPA to develop a plan to address this issue.

What should you do when the tax law is not clear?

What should you do when the tax law is not clear? Document, document, and document again your position and your argument for it. On a few occasions I have spoken with IRS agents about situations that were not clearly addressed in the tax law and each time they mentioned to make sure to document your decision and for me to keep a copy in my file.

Your Situation

The type of entity with which you do business will likely make a difference from a tax standpoint. The illustration above is simplified and the QBI deduction has many limitations and thresholds that could affect your situation. It is complicated and has gotten more complicated with the new tax law.

For my client, I developed a comparison for different entity types to determine which would provide the best result from an income tax standpoint. I would be happy to become your CPA and discuss your situation with you and develop strategies accordingly. I suggest you contact me using my email address below to setup a time for a phone conversation.

Jeff Haywood, CPA
The CPA Superhero
jeff.jhtaxes@gmail.com
217-923-8007
twitter.com/thecpasuperhero


References:

CPA Journal: Avoiding Costly Mistakes on Guaranteed Payments to Partners

Forbes: The New 'Qualified Business Income Deduction' Varies Based on Your Business Type - Or Does It?

Be careful when reading about tax law and its application, including my articles, because the wording and definitions are such a challenge and are influenced by writers perspective, specifically his own clients situations that he is mindful of and other situations the writer is not thinking of. The point is talk to your CPA about your situation and circumstances and don't rely on or make conclusions based on articles you read, including articles form irs.gov, because concepts and definitions are not very clear, and of course, they are subject to change. Now is the time to be having discussions about your situation and developing strategies for you and your business. Again, contact me using my information above to discuss your situation. I help business owners all over the U.S. and in foreign countries with their tax returns.

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