Distributions in Excess Question

Technical topics regarding tax preparation.
#1
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Hello,

I have a client that is a MMLLC taxed as a partnership. We are cleaning up the books for 2022 and 2023. These guys have not setup a salary, so as of right now all payments received have been anticipated as income distributions, not guaranteed payments. They are currently splitting all income roughly, 1/3 to each. The only debt is a small credit card.

However, it appears that they are paying the one partner about 5% more than the other partners or so and have paid out pretty much all the left over income in the company once they finish a project. What this has caused is for each partner to have distributions in excess due to the small credit card and the one partner receiving more than his ownership %.

As long as the partners are okay with this, I believe that taking distributions in excess of basis is a more favorable position than allocating a salary and losing out the QBID on that income as well as having to pay SE tax on the guaranteed payments (especially for those received to the one partner whose payments are higher than his ownership %)

Can anyone give me any reason against suggesting that they just keep it as is as long as the current payment structure is within the terms of their operating agreement?
 

#2
JAD  
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warnickcpa wrote:Hello,
I believe that taking distributions in excess of basis is a more favorable position than allocating a salary and losing out the QBID on that income as well as having to pay SE tax on the guaranteed payments (especially for those received to the one partner whose payments are higher than his ownership %)



Partners/members don't take salary. Use guaranteed payments or allocations of income. Both are subject to SE, based upon my understanding of OP. It's not like you have a choice as to whether or not to pay SE on earned income.

I make my entities keep capital accounts proportionate to ownership in order to avoid potential deemed sale rules involving hot assets. I simply tell them that if they don't keep it proportionate, they are going to pay me a fortune. You can accomplish this by paying the one partner a guaranteed payment and allocating everything else according to ownership %. Perhaps use that process in 2023 to bring everything back in proportion.
 

#3
MilesR  
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I think it is okay if the partnership agreement has a deficit restoration obligation and the one partner must (eventually) repay his distributions to restore a negative capital account. If they don't have such an agreement, then this partner is getting money he'll never have to repay and then this distribution has no substantial economic effect under the 704(b) regs.

To have income follow economic reality, you could possibly make the 5% extra he got a guaranteed payment so that the distributions work out to being equal and the extra money he got was not "free."
 

#4
KoiCPA  
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I would start by investigating why they're paying one partner 5% more. If they're doing it to represent the fact that he's putting in more labor, then it's looking like guaranteed payments and quacking like guaranteed payments, so it probably is.

Also investigate what the operating agreement says. It's quite common for partnerships to have operating agreements that either require equal distributions or that require a particular vote of the members to do it, and it's even more common for partners to forget that operating agreements matter.

Otherwise, I'd echo what JAD says. Unequal distributions are certainly allowed, but they result in all kinds of outcomes that taxpayers have trouble understanding, let alone predicting.
 

#5
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Thanks for the responses! I definitely didn't mean to say salary with the meaning of a W-2, what I meant was that they are not receiving guaranteed payments or at least not attempting to. The reason why I wanted to avoid the guaranteed payments was due to them not being eligible for the QBID.

From what I'm gathering from the posts above is that it makes most sense to keep the distributions in alignment with ownership % and anything received above that would be considered guaranteed payments to avoid the distributions in excess and other complicating factors.
 

#6
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Alternatively, you could just allocate more income to the other partner, maintain your full QBID (if applicable), and get to the same spot. That's probably more consistent with the economics of the arrangement anyway.
~Captcook
 

#7
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It's not like you have a choice as to whether or not to pay SE on earned income.


But there might be a question as to whether or not the income is “earned” in the first place, in light of the type of LLC (manager-managed vs member-managed) and certain language in the operating agreement. See our discussions on the Castigliola case.

in order to avoid potential deemed sale rules involving hot assets.


If you’re talking about Sec 751(b), you’d have to explain yourself, assuming there was no ordinary income shift (which follows from the assumption that no one’s equity position changed).

I think it is okay if the partnership agreement has a deficit restoration obligation


The whole point of an LLC is to limit liability. So we won’t be seeing a DRO here. But I do agree with the comments about economic effect…for the most part. What you really mean to say is the “allocation” wouldn’t have economic effect. The tax rules can’t change what gets distributed, but what they can address is the tax allocations of income/loss to see if they line up with the economics (i.e., the distributions). But you’re right. It would be odd of one guy gets 52.50% of the distributions, but only gets an income allocation of 50%. That doesn’t line up.

I also agree with figuring out why the disparity exists.
 

#8
JAD  
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Jeff-Ohio wrote:
It's not like you have a choice as to whether or not to pay SE on earned income.


But there might be a question as to whether or not the income is “earned” in the first place, in light of the type of LLC (manager-managed vs member-managed) and certain language in the operating agreement. See our discussions on the Castigliola case.


I did make simplifying assumptions - it sounded to me like everyone was working, generating income in the business, but the allocation was a bit off. If true, I think SE is tax is due.

in order to avoid potential deemed sale rules involving hot assets.

If you’re talking about Sec 751(b), you’d have to explain yourself, assuming there was no ordinary income shift (which follows from the assumption that no one’s equity position changed).



You have a point. I was thinking about one partner receiving more than his share of distributions, causing a change in equity % mathematically, but here one person is receiving more income and more cash and presumably at the end ownership is still 1/3 each.
 


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