Guaranteed Payment and how it is taxed?

Guaranteed Payments Internal Revenue Service defines it as guaranteed payments are those made by a partnership to partners that are determined without regard to the partnership's income. A partnership treats guaranteed payments for services, or for the use of capital, as if they were made to a person who is not a partner. This treatment is for purposes of determining gross income and deductible business expenses only. For other tax purposes, guaranteed payments are treated as a partner's distributive share of ordinary income. Guaranteed payments are not subject to income tax withholding.

Guaranteed payments made to partners for organizing the partnership or syndicating interests in the partnership are capital expenses. Generally, organizational and syndication expenses are not deductible by the partnership. However, a partnership can elect to deduct a portion of its organizational expenses and amortize the remaining expenses. Organizational expenses (if the election is not made) and syndication expenses paid to partners must be reported on the partners' Schedule K-1 as guaranteed payments.

Minimum Payments If a partner is to receive a minimum payment from the partnership, the guaranteed payment is the amount by which the minimum payment is more than the partner's distributive share of the partnership income before taking into account the guaranteed payment.

Example:

Under a partnership agreement, Divya is to receive 30% of the partnership income, but not less than $8,000. The partnership has net income of $20,000. Divya's share, without regard to the minimum guarantee, is $6,000 (30% × $20,000). The guaranteed payment that can be deducted by the partnership is $2,000 ($8,000 − $6,000). Divya's income from the partnership is $8,000, and the remaining $12,000 of partnership income will be reported by the other partners in proportion to their shares under the partnership agreement.

If the partnership net income had been $30,000, there would have been no guaranteed payment since her share, without regard to the guarantee, would have been greater than the guarantee.

Self-employed health insurance premiums Premiums for health insurance paid by a partnership on behalf of a partner, for services as a partner, are treated as guaranteed payments. The partnership can deduct the payments as a business expense, and the partner must include them in gross income. However, if the partnership accounts for insurance paid for a partner as a reduction in distributions to the partner, the partnership cannot deduct the premiums.

A partner who qualifies can deduct 100% of the health insurance premiums paid by the partnership on his or her behalf as an adjustment to income. The partner cannot deduct the premiums for any calendar month, or part of a month, in which the partner is eligible to participate in any subsidized health plan maintained by any employer of the partner or the partner's spouse.

Including payments in partner's income: 

Guaranteed payments are included in income in the partner's tax year in which the partnership's tax year ends.

Example 1

Under the terms of a partnership agreement, Erica is entitled to a fixed annual payment of $10,000 without regard to the income of the partnership. Her distributive share of the partnership income is 10%. The partnership has $50,000 of ordinary income after deducting the guaranteed payment. She must include ordinary income of $15,000 ($10,000 guaranteed payment + $5,000 ($50,000 × 10%) distributive share) on her individual income tax return for her tax year in which the partnership's tax year ends.

Example 2.

Sam is a calendar year taxpayer who is a partner in a partnership. The partnership uses a fiscal year that ended January 31, 2007. Sam received guaranteed payments from the partnership from February 1, 2006, until December 31, 2006. He must include these guaranteed payments in income for 2007 and report them on his 2007 income tax return.

Payments resulting in loss.   If guaranteed payments to a partner result in a partnership loss in which the partner shares, the partner must report the full amount of the guaranteed payments as ordinary income. The partner separately takes into account his or her distributive share of the partnership loss, to the extent of the adjusted basis of the partner's partnership interest.

Reporting of Guaranteed Payment for tax purposes

The partnership generally deducts guaranteed payments as a business expense. They are also listed on the partnership return. The individual partner reports guaranteed payments on as ordinary income, along with his or her distributive share of the partnership's other ordinary income.

Timing Considerations

For tax purposes, timing consideration is also an important factor. Guaranteed payments are always ordinary income to the receiving partner and must be included in taxable income for his or her tax year within which ends the partnership tax year in which the partnership deducted such payments as paid or accrued according to its method of accounting. This allows some tax deferral opportunities.

Example

Say for instance, a partnership is on a fiscal year ending September 30 where as a partner is on a calendar year. If the partner receives a guaranteed payment in December 2003, it would have to be included in the partner's income for 2004, not 2003. This is the partner's fiscal year within which the partnership's taxable year ends in which it deducted the payment. In effect, the payment is deemed to have been made in September 2004. Of course, it's a two way street: If the partnership were on an accrual basis with a calendar year ending December 31, 2003, and it made a guaranteed payment to a partner in January 2004, but accrued the payment on December 31, 2003, the partner must include the payment in his or her 2003 income.

Business Taxes

Certain local taxing jurisdictions impose a tax on unincorporated businesses operating within their jurisdictions. Like the New York City Unincorporated Business Tax (UBT) that is imposed on the business income of every unincorporated business that is carried on - wholly or partly - in New York City or even if it does not maintain an office in New York City.

Unincorporated businesses includes trades, businesses, professions, and occupations that are conducted by, engaged in, or in the process of being liquidated by an individual, partnership, limited liability company, fiduciary, association, estate or trust.

The tax is levied on both sole proprietorships and partnerships. Few activities are exempt from the UBT like a person or entity, other than a dealer, who is only engaged in the purchase, holding, and sale of property for its own account (such as in the case of investment activities) and a person or entity that is an owner, lessee, or fiduciary, and which is engaged in holding, leasing, or managing real property for its own account.

Guaranteed payments are always income for services rendered to the receiving partner. Therefore, they are deemed to be self-employment income, which after allowing for expenses, is subject to the UBT as well as self- employment Social Security.

Example:

BC is a real estate partnership that owns two apartment houses. Partner A provides services for which she wishes to be rewarded with $40,000 per year and this is structured as a guaranteed payment. Assume the net rental income of the partnership is $25,000 before any guaranteed payments, and the partners divide income/losses equally.

Partner A would report the net amount of $35,000 in two different pieces. The $40,000 guaranteed payment is self-employment income, which after expenses, would be subject to self-employment tax. In addition, this net amount is subject to any local business taxes such as the UBT. The $5,000 loss is part of A's distributive share and would be reported on Schedule E as an active real estate rental loss and as such would be deductible against other items of income unless A's AGI is too high. Each of the other partners would show a loss of $5,000 as his distributive share.

If we assume A has $10,000 of expenses against the guaranteed payment of $40,000, the net of $30,000 will be subject to both the UBT and self- employment Social Security. Assuming the rates to be 5% and 15.3% respectively, these additional taxes would come to $6,090.

Partnership transfer issue in line with Guaranteed payment

Under IRC Sec. 721 no gain or loss is recognized to a partnership or any of its partners when a contribution of property is made to the partnership in exchange for a partnership interest. Additionally, under IRC Sec. 731, in the case of a distribution from a partnership to a partner, no gain is recognized to a partner except to the extent the distribution exceeds the partner's adjusted basis of his or her interest in the partnership.

Example:

Mike, a partner in the Eden partnership, owns an asset that cost him $6,000 and that is now worth $10,000. He contributes this asset to the partnership in exchange for an additional $10,000 partnership interest. Shortly thereafter, he receives a $4,000 cash distribution from the partnership. Mike has "will get appreciated gain, but will not be taxed on it.

To help deal with this situation, amendment was made in IRC Sec. 707(a)(2)(B) known as the "disguised sale rules." This section covers situations where there is a direct or indirect transfer of money or other property by a partner to a partnership followed by a transfer of money or other property by the partnership to the partner (or another partner). When the transactions, viewed together, are properly characterized as a sale or exchange of property, they shall be treated either as transactions between a partnership and a partner not acting in his capacity as a partner or as between two partners not acting within the partnership.

Guaranteed payments for services should not be affected by these rules as they should be clearly mentioned in the partnership agreement as compensation for particular services rendered and not payments related to any contribution of property to the partnership. Even with these payments, however, it would be wise to keep the payments reasonable and explicitly state how they were determined.

The most care should be taken with guaranteed payments for the use of capital. There is a presumption that a guaranteed payment for the use of capital is a true guaranteed payment and not a disguised sale. The presumption will be sustained as long as the amount is reasonable and the relevant acts and circumstances clearly show that a disguised sale has not taken place.