Boost QBI: Pay Partners and LLC Members Preferred Returns

With all that’s been going on, it’s easy to forget that it’s Section 199A season again. Yes, we’re talking about that lovely 20 percent deduction.

Are you compensating yourself and your fellow partners or LLC members with so-called guaranteed payments? If so, you may benefit from the following information about those payments and the preferred return option.

What Is a Guaranteed Payment?

A guaranteed payment is a payment by a partnership to a partner that’s determined without regard to the partnership’s net income.

Guaranteed payments can be for services rendered by a partner to the partnership or for the partnership’s use of the partner’s capital. Guaranteed payments made in exchange for services to a partnership are often called “partner salaries,” which is a misnomer because partners are not considered employees for most federal tax purposes.

Guaranteed payments are treated as ordinary income. Guaranteed payments to an individual partner from a partnership that’s considered to be engaged in a trade or business count as self-employment income.

At the partnership level, guaranteed payments generally count as deductible expenditures in calculating the amount of the partnership’s ordinary net business income or loss. The net income or loss is then allocated under the partnership agreement to the partners, reported on their respective Schedules K-1, and ultimately reported on their individual personal returns.

What Is a Preferred Return?

Good question. There is no specific tax-law definition of what constitutes a preferred return paid by a partnership to a partner.

But for purposes of this analysis, we will define a preferred return as a preferential allocation of partnership net income to a service-providing partner before the remaining partnership net income is allocated to all partners via the standard allocation arrangement specified by the partnership agreement—which is usually based on the partners’ percentage ownership interests. Preferred returns that meet this definition may also be called “priority profit allocations.”

Whether it is called a “preferred return” or a “priority profit allocation,” the key point is that we are talking about a payment to a partner that

• is based on a specific allocation of partnership net profit, and
• is not based on the partner’s ownership percentage, and
• comes before any allocation of partnership net profits based on ownership percentages.

Such payments will usually constitute ordinary income and will be subject to self-employment tax when received by an individual partner.

And such payments will effectively reduce the amount of partnership net income that remains to be allocated to the partners based on the standard allocation arrangement specified by the partnership agreement.  

The QBI Deduction Factor

Here’s where it gets interesting. For 2018-2025, you as an individual partner can potentially deduct up to 20 percent of your share of a partnership’s qualified business income (QBI), subject to limitations based on your income level and the type of business.

Guaranteed payments don’t count as QBI. To add insult to injury, a partnership’s deductions for guaranteed payments reduce the partnership’s QBI, which in turn can reduce allowable QBI deductions for you and the other partners. Ugh!

In contrast, a preferred return of partnership net income that constitutes a share of the partnership’s QBI counts as QBI, as long as the preferred return is a not a disguised payment for services rendered to the partnership.

Tax-saving strategy. To maximize QBI deductions for you and the other partners, consider replacing guaranteed payments that don’t count as QBI with preferred return payments that do count as QBI.