Memory Lane

You may recall how clear it became, as the bill that would become the Tax Cuts and Jobs Act (“TCJA”)[i] moved through Congress in late 2017, that C corporations were about to realize a number of tax benefits, the most significant being the introduction of a flat federal corporate income tax rate of 21 percent.[ii]

In reaction to this development, many non-corporate taxpayers who were operating through partnerships (including LLCs treated as partnerships for tax purposes[iii]) or S corporations[iv] began to wonder whether they should incorporate their business[v] or revoke their “S” election,[vi] depending on their circumstances, in order to take advantage of what was seen as the C corporation’s newfound “preferred” tax status.

Eventually, Congress added a provision to the TCJA for the benefit of individuals, estates, and trusts (“non-corporate taxpayers”) that are partners of a partnership or shareholders of an S corporation that is engaged in a qualified trade or business (“QTB”).[vii]

In general, for purposes of determining their taxable income for a taxable year, a non-corporate taxpayer is permitted, under what was then “new” Sec. 199A of the Code, to claim a deduction equal to 20 percent of the taxpayer’s share of the qualified business income (“QBI”) of the partnership’s or S corporation’s QTB for such taxable year.

The new deduction was intended to be effective for taxable years beginning after 2017 and before 2026.[viii] Because of the provision’s complexity, however, and because of ambiguity in the meaning of certain terms and in the application of certain rules, many taxpayers and advisers were unsure as to the utility of the newly-minted deduction.

The business community pressed the IRS to issue guidance and, almost eight months after the law went into effect, the IRS proposed extensive regulations,[ix] which were then finalized a few months later, in February of 2019.[x]

The Biden Tax Plan

Fast forward to the summer of 2020, that most wonderful of times – geez, it feels like yesterday.

The then-Democratic Party standard-bearer (now-President-Elect), Mr. Biden, stated that he wanted to reverse the changes made by the TCJA; however, his own tax plan called for preserving the Sec. 199A deduction for those non-corporate taxpayers making less than $400,000 during a taxable year, while phasing out the deduction for higher-income taxpayers.[xi]

Assuming this plan continues to reflect the President-Elect’s views on Sec. 199A, then many of the issues raised by taxpayers prior to the 2020 general elections, and many of the strategies suggested by their advisers, will continue to be relevant.

One of these “strategies,” which involves a gambit relating to the definition of QBI in the context of a QTB operated by a partnership, has now been a subject of inquiry by several business acquaintances, and should be addressed.

Qualified Business Income

The QBI of a QTB means, for any taxable year, the net income or loss with respect to such trade or business, provided it is effectively connected with the conduct of a trade or business in the U.S.[xii]

It is fair to say, therefore, that the QBI of a QTB reflects the profitability or entrepreneurial return of the QTB.

The foregoing may explain why the trade or business of rendering services as an employee is not treated as a QTB.[xiii] The amount payable to the employee, and the time of its payment, are generally not subject to entrepreneurial risk or fluctuation.

Because the trade or business of rendering services as an employee is not a QTB, wage income received by an employee is not QBI.

What about the case of a shareholder of an S corporation who is also employed by the corporation? Or that of a partner who works in the QTB operated by the partnership?

If the QTB is carried on through a partnership or S corporation, the Sec. 199A rules are applied at the level of the partner or shareholder, with each partner or shareholder taking into account their share of the business entity’s QBI.[xiv] For purposes of determining such QBI, one must first identify any payments made to the shareholder or partner in their capacity as a service-provider, rather than as an owner.

Compensation for Services

Certain items of income arising from the conduct of a QTB through an S corporation or a partnership are not included in determining the entity’s QBI, or its owners’ shares of such QBI. Among these items of income are the following:[xv]

  • amounts received by a shareholder-employee from their S corporation as reasonable compensation for services rendered to the corporation’s QTB;[xvi]
    • even if an S corporation fails to pay a reasonable wage to a shareholder-employee, the shareholder-employee is nonetheless prevented from including an amount equal to reasonable compensation in QBI;
  • amounts received by a partner from a partnership as guaranteed payments – i.e., determined without regard to the income of the partnership – for services rendered to the partnership’s QTB;[xvii] and
  • payments received by a partner from a partnership for services rendered by the partner to the partnership’s QTB other than in their capacity as a partner;[xviii]
    • within the context of section 199A, such payments for services are similar to, and therefore, are treated similarly as, guaranteed payments, reasonable compensation, and wages, none of which is includable in QBI.

The foregoing exclusions from QBI are derived from the rule, described above, under which the trade or business of performing services as an employee is not a QTB, even if the employee or employee-equivalent is also an owner of the employer/service recipient, and without regard to whether the latter is treated as an S corporation or as a partnership for tax purposes.

Because these items are determined without regard to the payor-entity’s income – i.e., they are not subject to entrepreneurial risk – Congress and the IRS determined that these payments should not be considered part of the owner-payee’s QBI.

In order to ensure this result – and to ensure that the payments are treated in the same manner as if they had been made to some unrelated party in exchange for services – it is necessary that the business entity deduct the amount paid in determining its QBI and, thus, the payee-owner’s share of such entity’s QBI.

Thus, the S corporation’s QBI is reduced by deducting the amount of the compensation paid to the shareholder, if it is properly allocable to the corporation’s QTB and is otherwise deductible (e.g., not required to be capitalized) for income tax purposes, and the partnership’s QBI is reduced by deducting the amount of the guaranteed payment if it is properly allocable to the partnership’s QTB and is otherwise deductible for income tax purposes.

A “Workaround?”

It appears that some folks have concluded that the above rule, as it relates to guaranteed payments by a partnership to a partner, is overly restrictive in that it limits the recipient-partner’s Sec. 199A deduction by omitting the payment from the partner’s QBI and by deducting the payment from the partnership’s income for purposes of determining its QBI, and the partner’s share thereof.

The fact that the legislative history, the statute, the preamble to the proposed regulations, and the final regulations all confirm that this is the intended result, does not appear to have dissuaded some from suggesting what is described as an alternative approach to structuring the payment by a partnership to a partner who provides services to the partnership.

A cursory examination of the suggested approach, however, recalls the aphorism that “calling something by a different name does not make it so.” In other words, in substance, the payment by a partnership to a partner in consideration of the partner’s services remains a “guaranteed payment” for purposes of Sec. 199A if the amount of the payment is not dependent upon the income of the partnership.

Priority Allocation

Specifically, these folks have asked whether the payments to a partner for services rendered to the partnership may instead be “structured” as a priority profit allocation, rather than as a guaranteed payment.

Under this arrangement, the partner who renders services to the partnership receives from the partnership a priority “distribution” of an amount equal to what otherwise would have been payable to the partner for their services.[xix] The partnership makes a corresponding and matching allocation of partnership income to the partner.

After the service-providing partner has received an aggregate amount of current and, if necessary, liquidating distributions, equal to the amount of their “priority” allocation – basically, what would have been the aggregate amount of their guaranteed payments – then all subsequent distributions by the partnership to the partners follow the partners’ adjusted capital accounts.

A variation on this approach provides that the service-providing partner be allocated a percentage of partnership income, subject to a floor – i.e., what would otherwise have been their guaranteed payment for services – expressed as a fixed dollar amount. Relying on one of guaranteed payment rules,[xx] proponents of this approach take the position that the partner will be treated as having received a guaranteed payment only to the extent the amount of the floor exceeds the partner’s allocable share of partnership income; however, if this share exceeds the floor, then no portion of the amount received by the partner is a guaranteed payment.

Framework for Analysis

Before considering the approaches described above, a quick review of how the Code treats allocations and distributions from a partnership to a partner who renders services to the partnership may be in order.

In general, such an allocation or distribution may be treated as: (1) a distributive share of partnership income; (2) a guaranteed payment; or (3) a transaction in which a partner provides services to the partnership other than in their capacity as a partner.

A partnership allocation that is determined with regard to partnership income, and that is made to a partner for services rendered by the partner in their capacity as a partner, is generally treated as a distributive share of partnership income.[xxi] This would cover, for example, a partner in a service-intensive business (say, a law firm).

To the extent the amount payable to a partner is determined without regard to the income of the partnership, the payment to the partner in consideration of the partner’s services is considered as made to a person who is not a partner – i.e., as a guaranteed payment.[xxii] A partner who is guaranteed a minimum amount for its services is treated as receiving a fixed payment in that amount.

If a partner performs services for a partnership and receives a related direct or indirect allocation and distribution, and the performance of the services and the allocation and distribution, when viewed together, are properly characterized as a transaction occurring between the partnership and a partner acting other than in its capacity as a partner, the transaction will be treated as occurring between the partnership and one who is not a partner.[xxiii] On the other hand, if the “distribution” to the service provider does not depend on an allocation of an item of income, then the payment is unrelated to partnership income and is treated as a guaranteed payment.

How is This Different?

If I understand the first of the approaches described above, it is grounded in the fact that the partnership’s transfer of a specified amount to the service-provider-partner is labeled and reported as a distribution of an amount equal to such partner’s priority interest in the net profit of the partnership.

How is that different from a guaranteed payment? In both cases, the partner is singled out for a payment from the partnership to which the other partners are not entitled. In both bases, the partner is entitled to a fixed amount – whether as “compensation” or as a “priority payment” – before other partners may participate. In both cases, the basis for distinguishing the payee-partner from the other partners is the fact that the payee-partner rendered services to the partnership. In both cases, the transfer to the partner in effect reduces the net income remaining to be allocated among all the partners: by way of a deduction in the case of the guaranteed payment, and by way of a “special allocation” of partnership net income in the case of the distribution.[xxiv]

As for the alternative described above, which relies on a hybrid approach of a “percentage interest subject to a floor,” the IRS stated in the preamble to proposed partnership regulations issued in 2015 that the treatment of this arrangement under the guaranteed payment rules was inconsistent with the concept that an allocation must be subject to significant entrepreneurial risk in order to be treated as a distributive share of partnership income.[xxv] Accordingly, the IRS proposed to modify the rule to provide that the entire amount of the floor would be treated as a guaranteed payment regardless of the amount of the income allocation.[xxvi]


The payments under the priority allocation schemes described above should be treated as guaranteed payments made in exchange for the partner’s services, within the meaning of the Code’s partnership rules. Accordingly, they should also be treated as guaranteed payments under Sec. 199A, and should not be treated as QBI to the recipient partner.


[i] Pub. L. 115-97.

[ii] IRC Sec. 11(b).

[iii] Reg. Sec. 301.7701-2 and Reg. Sec. 301.7701-3.

[iv] IRC Sec. 1361.

[v] IRC Sec. 351. See Rev. Rul. 84-111. Many states now have conversion statutes (e.g., DE).

[vi] IRC Sec. 1362.

[vii] IRC Sec. 199A.

[viii] That’s right – the provision was (and remains, at least for now) scheduled to sunset after 2025.

[ix] REG-107892-18, 83 FR 40884.

Also in 2018, as part of what was called “Tax Reform 2.0”, the House Ways and Means Committee proposed that Sec. 199A be made permanent.

However, following the November 2018 mid-term elections, in which the Democrats picked up 40 seats in the House, wiping out the Republicans’ majority in that chamber, it appeared that Sec. 199A’s tenure would be relatively short.

[x] More than a year after 199A’s passage. TD 9847, 84 FR 2952.

[xi] .

[xii] IRC Sec. 199A(c).

[xiii] IRC Sec. 199A(d).

[xiv] IRC Sec. 199A(f).

[xv] IRC Sec. 199A(c)(4).

[xvi] IRC Sec. 162; Reg. Sec. 1.199A-3(b)(2)(ii)(H). Under Rev. Rul. 74–44, S corporations must pay shareholder-employees ‘‘reasonable compensation for services performed.’’ Otherwise, S corporation shareholders who are employed by or otherwise provide services to the corporation could avoid employment taxes simply by not causing the corporation to pay them a fair salary in consideration of their services. Tell me, who works for free?

[xvii] IRC Sec. 707(c); Reg. Sec. 1.199A-3(b)(2)(ii)(I).

Under Rev. Rul. 69-184, a partner of a partnership cannot be an employee of that partnership.

[xviii] IRC Sec. 707(a).

Section 707(a) addresses arrangements in which a partner engages with the partnership other than in their capacity as a partner. Any payment described in Sec. 707(a) that is received by a partner for services rendered with respect to the trade or business is not included in QBI. However, the partnership’s deduction for such payment will reduce the partnership’s QBI if such deduction is properly allocable to the trade or business, and is otherwise deductible for income tax purposes. Reg. Sec. 1.199A-3(b)(2)(ii)(J).

[xix] Presumably the amount for which the partner negotiated in exchange for their services.

[xx] Reg. Sec. 1.707-1(c), Ex. 2.

[xxi] IRC Sec. 704.

[xxii] IRC Sc. 707(c).

Likewise, the Regulations provide that payments made by a partnership to a partner for services rendered in their capacity as a partner, are considered as made to a person who is not a partner – for the limited purpose of the partner’s inclusion of such payment in their income and the partnership’s deduction of the payment in determining its net income – to the extent such payments are determined without regard to the income of the partnership. 1.707-1(c).

[xxiii] IRC Sec. 707(a)(2)(A).

[xxiv] Both approaches direct a specific amount to a single partner, to whom this amount is taxed, and both approaches deduct this amount from the remaining partnership income before allocating this income among all of the partners.

[xxv] Which is required for QBI treatment.

[xxvi] IRS Proposed Regulations (REG-115452-14) on Disguised Payments for Services. The proposed regulations modify Ex.2 of Reg. Sec. 1.707-1(c).

These rules have not yet been finalized.