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Editorial 9 MIN READ

The general partnership, a field report from May 2020

PPP paperwork treats partners as if they had no paycheck, which is technically correct and operationally a mess

The Editors
Staff, Incorporator.org
9 min read Updated
Contents 6 sections
  1. The PPP problem, and the April 14 fix
  2. Section 199A, now that the regulations are final
  3. BBA audit regime, now that it is the floor
  4. Self-employment tax, and the 2020 wage base
  5. What to fix before September 30
  6. Sources

general partnership in May 2020 is still a creature of RUPA § 202, still taxed under Subchapter K, and still owes self-employment tax on the working partners' distributive shares. What has changed in the last twenty months is that a partnership now has to translate those facts into a Paycheck Protection Program application drafted for a world of W-2 payrolls, and the translation is not obvious.

We covered the formation trap in January 2017 and the tax-law overlay in September 2018. This piece is a field report. The § 199A regulations finalized last winter, the BBA audit regime is now on every non-small partnership's 2019 return, and partners across the country spent the last four weeks trying to reconcile their K-1s with an SBA payroll form.

The PPP problem, and the April 14 fix

Section 1102 of the CARES Act (Pub. L. 116-136, March 27, 2020) bolted a new loan program onto section 7(a) of the Small Business Act. The headline number is 2.5 times average monthly payroll, capped at $10 million, forgivable if the borrower uses the proceeds on payroll, rent, mortgage interest, and utilities over an eight-week covered period and keeps headcount and wages broadly intact. The mechanics are in section 1102(a)(2) of the Act, which amends 15 U.S.C. § 636(a) to add paragraph (36).

The mechanics presume a conventional employer. A general partnership does not pay its working partners wages. It pays them guaranteed payments under IRC § 707(c), or it pays them nothing and lets them take draws against their eventual distributive share under RUPA § 401. Either way, the money a partner lives on is not payroll; it is self-employment income reported on Schedule K-1 and taxed under IRC § 1402. The first PPP Interim Final Rule, posted April 2 and published at 85 Fed. Reg. 20811 (April 15, 2020), said as much for sole proprietors and independent contractors but was silent on the awkward middle case: a partner in a partnership that has its own PPP application.

For a week the market guessed. Some partnerships filed including their partners' guaranteed payments as payroll, some excluded them, and some filed nothing while their lenders waited for clarification. A handful of partners tried to file individual PPP applications on their own K-1 income, which at least one bank accepted and at least one declined.

The SBA resolved it on April 14. The Interim Final Rule titled "Additional Eligibility Criteria and Requirements for Certain Pledges of Loans," published at 85 Fed. Reg. 21747 (April 20, 2020), established two things that matter for general partnerships. First, a partner in a partnership may not submit a separate PPP loan application for the partner's self-employment income from the partnership. Second, the self-employment income of general active partners may be reported as a payroll cost on a PPP application filed by or on behalf of the partnership, up to $100,000 annualized per partner.

The operational translation, on the 2019 Form 1065 K-1, is net earnings from self-employment as reported in box 14, code A, reduced by section 179 deductions, unreimbursed partnership expenses, and depletion claimed on oil and gas properties, then multiplied by 0.9235 to remove the employer-equivalent share of SE tax, and capped at $100,000 per partner. Add the partnership's W-2 payroll if any, divide by twelve, multiply by 2.5, and that is the loan amount. Partnerships that had already filed on a different theory were told to work with their lenders to reconcile, which in practice meant reopening the application.

A partnership that filed before April 14 on the assumption that only W-2 wages counted left money on the table. A partnership that filed including the partners' full draws without the $100,000 cap or the 0.9235 reduction overstated the loan and now has a reconciliation problem with the lender and, eventually, with the SBA loan-review process. Both errors are common, because the § 707 guaranteed-payment habit and the partnership-draw habit live in different mental buckets, and PPP collapses them into one bucket the partnership rarely uses.

Section 199A, now that the regulations are final

T.D. 9847, published at 84 Fed. Reg. 2952 on February 8, 2019, finalized the regulations under IRC § 199A. The September 2018 article walked through the proposed regulations. The final regulations kept the architecture intact and tightened several of the questions that had been open. For a general partnership, three pieces of the final package are load-bearing in the 2019 returns the partners are filing now.

The trade-or-business definition in Reg. § 1.199A-1(b)(14) ties § 199A to § 162, as the proposed rule had. For rental real estate held in a partnership, the separately published safe harbor in Rev. Proc. 2019-38 (issued September 24, 2019) gives a rental real estate enterprise the option to treat itself as a § 162 trade or business for § 199A purposes if it meets the 250-hour annual services requirement, the separate books and records requirement, and the contemporaneous records requirement. Partnerships that hold rental real estate and intend to claim § 199A at the partner level should have those hour logs now, not in March 2021.

The aggregation rules in Reg. § 1.199A-4 moved partner-level aggregation to a separate election that follows the taxpayer across years once made, with a reporting burden on the partnership to provide each partner with QBI, W-2 wages, and unadjusted basis immediately after acquisition for each trade or business, allocated out. A partner who holds interests across several related partnerships should check whether her preparer elected aggregation on the 2018 return; the election is consistent from year to year and cannot simply be reopened.

The SSTB rules in Reg. § 1.199A-5 kept the reputation-or-skill category narrower than the proposed rule had suggested. The final rule limits it to endorsement income, licensing of image or likeness, and appearance fees. A small professional partnership whose principal asset is reputation in the colloquial sense is therefore not, for § 199A purposes, a reputation-or-skill SSTB; it may still be a consulting or health or law SSTB on the main list, which is the more common disqualifier.

For a two-partner consulting partnership with 2019 QBI of $300,000 split evenly, each partner single and under the 2019 income threshold of $160,700 (phase-in to $210,700), the § 199A deduction is still a clean twenty percent at the partner level. Above the threshold the SSTB disallowance for consulting takes the deduction to zero. Those two outcomes have not changed. What the final regulations gave the working partner is clearer instructions for everything in between.

BBA audit regime, now that it is the floor

The centralized partnership audit regime under the Bipartisan Budget Act of 2015 (Pub. L. 114-74, § 1101) applies to partnership taxable years beginning after December 31, 2017. The 2019 Form 1065, which most partnerships are filing this spring or extended to September, is the second return under the regime. A partnership that cannot elect out under IRC § 6221(b) (generally, fewer than 100 eligible partners, all of whom are individuals, C-corporations, S-corporations, estates, or foreign equivalents, with no partnership, trust, or disregarded-entity partners) is in the regime by default.

Two items deserve attention in 2020. The partnership representative under IRC § 6223 must be designated each year on the return, must have a substantial presence in the United States, and has sole authority to bind the partnership and its partners in an IRS examination. The representative's acts cannot be overridden by the partnership agreement; state-law provisions that attempt to cabin the representative's authority are effective only as between the partners, not against the IRS. Partnership agreements drafted before 2018, and a surprising number drafted after, still name a "tax matters partner" and defer to § 6231 as it read before the BBA. That label has no federal effect for post-2017 years.

The push-out election under IRC § 6226 lets the partnership, within forty-five days of a final partnership adjustment, push the adjustments out to the reviewed-year partners rather than paying an imputed underpayment at the partnership level. For any partnership whose partner composition has changed between the reviewed year and the adjustment year, the push-out is almost always the right election. Agreements that do not contemplate it force a negotiation at exactly the wrong time.

Rev. Proc. 2020-23, released April 8, 2020, gave eligible BBA partnerships a temporary alternative: instead of filing an administrative adjustment request under § 6227 to take advantage of retroactive CARES Act relief (QIP bonus depreciation, NOL carrybacks, interest deduction changes under amended § 163(j)), a partnership that filed Form 1065 and issued K-1s for 2018 or 2019 before April 8, 2020 may file an amended return and amended K-1s, checking "Amended Return" on page 1 and writing "FILED PURSUANT TO REV PROC 2020-23" at the top, with the same notation on the attached partner statements. The window closes September 30, 2020. For a partnership that had depreciable improvements miscoded as 39-year property under the TCJA drafting error, this is the path to the refund; the AAR path pushes the benefit to the 2020 return and costs most partnerships a year.

Self-employment tax, and the 2020 wage base

The Social Security Administration announced the 2020 OASDI contribution and benefit base as $137,700, up from $132,900 in 2019. For a general partner with net earnings from self-employment above that threshold, the 12.4 percent Social Security portion of SE tax stops at the base, and only the 2.9 percent Medicare portion (with the 0.9 percent additional Medicare tax above $200,000 for single filers, $250,000 joint) continues. The maximum combined SE tax for a partner hitting the full base in 2020 is $17,074.80 on the Social Security portion, plus uncapped Medicare.

This matters for two planning moves that come up routinely in general partnerships. A working partner receiving a large guaranteed payment pays SE tax on that payment; a partner receiving the same economic amount as an allocation of ordinary partnership income also pays SE tax, because IRC § 1402(a) sweeps in a general partner's distributive share. Trying to relabel guaranteed payments as draws to avoid SE tax does not work for a general partner. The lever for actually reducing SE tax on a stable partnership with predictable distributions is conversion to an S-corporation at the state-law level, not re-characterization at the § 707 level, and that conversion comes with its own § 199A wage-limitation tradeoffs above the income threshold.

What to fix before September 30

Three things are specific to 2020 and close this year. PPP applications filed before April 14 on an incorrect payroll theory should be reconciled with the lender now, before the loan funds or before the forgiveness application starts. Amended 2018 or 2019 Form 1065 returns taking retroactive CARES Act benefits under Rev. Proc. 2020-23 must be filed by September 30, 2020; the partnership and its preparer should decide in June whether the amendment is worth the effort, not in August. Partnership representatives for 2019 must be properly designated on the return; a partnership extending Form 1065 to September should not use the extension as an excuse to defer the agreement amendment that names a real representative with real authority.

None of this is exotic. It is the ordinary compliance tax on a structure that never required a filing fee and still does not. A general partnership in 2020 costs nothing to form, nothing to maintain at the state level in most jurisdictions, and a meaningful amount of attention to keep from drifting out of compliance with the federal rules that do apply. The attention is the cost.

Sources

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