If you are a partner in a partnership, you can’t also draw a salary from that partnership.
I see that mistake a lot in my tax world. If you’re a shareholder in an S Corp that you work in that has a profit, you have to take a salary. You must. If you don’t, there can be some bad consequences.
But if you’re a partner in a partnership (or multi-member LLC that has not made a tax election), you can NOT take a salary. It seems kind of counter intuitive. Why MUST you do something in one case that you can NOT do it in the other?
Regardless, that’s the way it is. If you’re a partner, you can’t draw a paycheck.
Let’s look at whether this is a grey area. In 1939, the IRS Code was pretty specific. A partner cannot b e an employee. Then came the 1954 Code changes. The rule was still the same. A partner cannot draw a salary. We’ve then seen a whole bunch of court cases that withhold this same argument, such as Wilson, Armstrong, GCM 34001, GCM 34173 and Revenue Ruling 69-184, issued in 1964.
It’s pretty clear, and also pretty widely ignored.
Not anymore. It just become even more important. To understand why, we need to take a look at the Trump Tax Plan and specifically Section 199A, the 20% income reduction.
If you have a pass-through entity that makes $200,000, would you rather pay tax on $200,000 or $160,000? (Hopefully, you just said $160,000) That’s why paying attention to these rules are so important now. Slip up, and you lose that 20% income reduction.
When your total taxable income is over $315,000 (married, filing jointly) or $157,500 (single), your next question is whether you have a Specified Service Trade or Business (SSTB). That’s another topic for another blog. For more information, search for the term and you’ll see past blogs on the subject.
A pass-through SSTB has a second income threshold of $415,000 (married, filing jointly) or $207,500 (single). Between the first and second taxable income amount, an SSTB possible reduction is phased out or is calculated from the wage limitation rule.
I’ll explain the wage limitation in a second.
If your pass-through is not a SSTB, then you just have the one income threshold, $315K/$157.5K. Above this limit and your possible income reduction is subject to the wage limitation rule.
This is where the partner in a partnership question is so important. It’s the wage limitation rule.
The amount you can take as a reduction is subject to the greater of 50% of W-2 wages paid (includes the guaranteed payments made to a partner) or 25% of W-2 wages/guaranteed payments + 2.5% of qualified business depreciable assets.
In order to use the W-2 wages/guaranteed payments for the calculation, they need to be accurately calculated. And you can bet the IRS is going to be watching.
Because you can’t use a W-2 salary you take from your partnership for this calculation, if you try to qualify this way you’ve just incurred a bunch of payroll taxes for nothing. Plus, since there is now a clear red flag, you can bet that the IRS is going to be following up to disallow the expense deduction. Lost deduction = more tax. And of course, penalties and interest will be close behind. The IRS has a new gold mine.
A partner in a partnership cannot take a salary. You instead take a guaranteed payment. That is reported on your K-1. You owe self-employment tax of 15.3% on the amount reported. It’s earned income. You can also have a pension plan based on that income. There is no W-2. There is no quarterly or annual payroll tax required for it.
We’re all having to hone our basic accounting and tax skills with the new Trump Tax Plan changes. Things have changed. Don’t assume anything is the same.
To get up to speed quickly, pick up your copy of Taxmageddon 2018: How to Brace for the Trump Tax Plan at www.Taxmageddon2018.com.