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Editorial 10 MIN READ

The general partnership, revisited after a long year of tax changes

Section 199A opened a door the old partnership never had, and the new audit regime closed another most agreements still don't know about

The Editors
Staff, Incorporator.org
10 min read Updated
Contents 8 sections
  1. Section 199A, and why a partnership is suddenly interesting
  2. The trade-or-business hook, which is the threshold question
  3. Aggregation, for partnerships that operate through several entities
  4. The BBA centralized audit regime now actually applies
  5. What the partnership representative actually does, now
  6. Electing out, and why most small partnerships still should
  7. The liability rule still runs underneath everything
  8. Sources

general partnership in September 2018 is the same creature it was eighteen months ago, with two meaningful differences. Partnership income can now generate a twenty-percent federal deduction under Section 199A if the partnership carries on a real trade or business, and every partnership that cannot elect out of the new audit regime must have a partnership representative on its 2018 return whether the agreement names one or not.

We covered the formation rules and the liability trap in January 2017. Nothing in RUPA § 202 has changed. What has changed is the federal tax stack sitting on top of it. This piece is for partnerships formed before TCJA and for the growing number of accidental partnerships whose participants are about to discover, in a good way or a bad way, that 2018 is a different year to owe a share of partnership income.

Section 199A, and why a partnership is suddenly interesting

Section 199A was added to the Code by section 11011 of the Tax Cuts and Jobs Act (Pub. L. 115-97, Dec. 22, 2017). It allows a non-corporate taxpayer a deduction equal to twenty percent of qualified business income from a "qualified trade or business" conducted through a pass-through entity, subject to a wage-and-property limitation above certain income thresholds and a full disallowance for specified service trades or businesses above a higher threshold. The thresholds for 2018 are $157,500 of taxable income for single filers and $315,000 for joint filers, with phase-in ranges up to $207,500 and $415,000 respectively. Below the lower threshold the rules collapse to their simplest form: twenty percent of qualified business income, full stop.

For a garden-variety general partnership, the effect is straightforward. The partnership issues its partners K-1s showing their distributive share of partnership income. Each partner then takes a deduction on their own 1040 equal to twenty percent of that income (or the partner's taxable income less net capital gain, if less), subject to the thresholds. A two-partner consulting LLC split fifty-fifty on $300,000 of net income, owned by two single filers each with total taxable income below $157,500, produces a $30,000 deduction per partner without any wage or property test. That is a real change in the effective rate on pass-through income, and it did not exist in January 2017.

Two things are worth pinning down. First, guaranteed payments under IRC § 707(c) and reasonable compensation paid to an S-corporation shareholder are expressly carved out of QBI under § 199A(c)(4). For a partnership, that means the amount you pay yourself for services before computing distributive share is not QBI, and the structure of the partnership agreement matters: a large guaranteed-payment allocation to a working partner reduces the very income that drives the deduction. Second, § 199A does not touch self-employment tax. A general partner still owes SE tax on her distributive share of trade-or-business income under IRC § 1402 whether or not any part of it qualifies for the § 199A deduction. The deduction reduces income tax, not FICA.

The trade-or-business hook, which is the threshold question

Proposed regulations under § 199A, issued as REG-107892-18 and published at 83 Fed. Reg. 40884 on August 16, 2018, defined "trade or business" for § 199A purposes by reference to Section 162. Prop. Reg. § 1.199A-1(b)(14) provides that a trade or business is a section 162 trade or business, excluding the trade or business of performing services as an employee. That choice matters because § 162 comes with almost a century of case law on what rises to a trade or business and what does not, and Treasury explicitly did not invent a new standard.

Most operating general partnerships clear this hurdle without difficulty. A two-person design studio that bills clients, pays expenses, and files a Schedule K-1 every March is a § 162 trade or business. A multi-partner construction venture is. A family farming partnership is. What is not automatic is passive rental real estate held in a partnership with no operational activity, no agent, and no ancillary services. The proposed regulations reserved on whether rental activity alone is a § 162 trade or business and pointed back to existing case law (number of properties, day-to-day involvement, type and significance of services provided, lease terms) to decide case by case. A partnership that exists mainly to collect rent under a long-term triple-net lease should not assume it qualifies.

The specified-service-trade-or-business category is the other drop-off point. Above the threshold, income from a trade or business involving the performance of services in health, law, accounting, actuarial science, performing arts, consulting, athletics, financial services, brokerage services, investment management, trading, dealing in securities, or "any trade or business where the principal asset of such trade or business is the reputation or skill of one or more of its employees or owners," is disqualified from the deduction (subject to the phase-in). Much of what small general partnerships actually do lives in this list. Below the threshold, the SSTB rules do not bite; above it, they bite hard. For high-earning consulting partnerships, the practical upshot is that § 199A delivers nothing, and the old advice to consider converting to an S-corporation to trade off SE tax against reasonable compensation remains the relevant lever.

Aggregation, for partnerships that operate through several entities

Prop. Reg. § 1.199A-4 introduced a § 199A-specific aggregation regime that lets a taxpayer treat multiple trades or businesses as one for purposes of the wage-and-property limitation. It is not the § 469 passive-activity grouping rule. It is its own test with five requirements: the same person or group of persons must own fifty percent or more of each trade or business, that ownership must exist for a majority of the taxable year, the items must be reported on returns with the same tax year, none of the businesses may be an SSTB, and the businesses must satisfy at least two of three factors indicating a genuine operational relationship (common products or services, shared facilities or personnel, or operation in coordination with or reliance upon each other).

For partnerships this is less of an intramural question and more of a question at the partner level. Aggregation is an individual's election under the proposed rule, not the partnership's, and a partner who holds interests in several related partnerships has a real planning choice to make on her 2018 return. The partnership's job is to report the per-partner information that makes the election possible: QBI, W-2 wages, and unadjusted basis of qualified property, each allocated out to each partner. That reporting did not exist on the 2016 Form 1065. For 2018 it does, and a partnership whose tax preparer is still on autopilot from last year will fail its partners on this.

The BBA centralized audit regime now actually applies

The other 2018 development is the one we flagged in February 2017: the Bipartisan Budget Act of 2015 (Pub. L. 114-74, § 1101) replaced TEFRA with a centralized partnership audit regime at IRC §§ 6221 through 6241, effective for partnership tax years beginning after December 31, 2017. That clock has now struck. Every partnership with a calendar tax year is in its first BBA year, and the 2018 Form 1065 filed in early 2019 is the first return on which the new rules bite.

Two pieces of Treasury guidance stood up between then and now. On January 2, 2018, the IRS finalized regulations under § 6221(b) governing the election out of the centralized regime for partnerships with 100 or fewer eligible partners (T.D. 9829). On August 9, 2018, the IRS finalized regulations under § 6223 governing the designation and authority of the partnership representative (T.D. 9839, 83 Fed. Reg. 39331). The second one is the one most general partnerships will interact with first, because it is what every 2018 Form 1065 is going to require.

What the partnership representative actually does, now

Under final Reg. § 301.6223-1, the partnership must designate a partnership representative on its return each year. The representative may be any person, including an entity. An entity representative must appoint a designated individual to act on its behalf. Both the representative and, if applicable, the designated individual must have "substantial presence in the United States," which the regulation defines as a United States taxpayer identification number, a United States street address, a United States area-code telephone number, and availability to meet in person with the IRS in the United States at a reasonable time and place.

The representative's authority under § 6223(b) is the wide part. The partnership and every partner are bound by the representative's actions in an examination, an administrative adjustment request, a judicial proceeding, or a settlement. Partners do not get statutory notice from the IRS. They do not get a statutory right to participate. They do not get to opt out of a settlement the representative signs unless the partnership agreement says otherwise and they can enforce it in court against the representative personally, which is a much worse remedy than the rights TEFRA used to give them.

For a general partnership with no written agreement, which is a non-trivial share of the universe, this is a serious exposure. A partnership that files Form 1065 without a designated representative invites the IRS to designate one for the partnership under Reg. § 301.6223-1(f), and whoever that is becomes the binding voice of the partnership for that tax year.

Electing out, and why most small partnerships still should

Under § 6221(b) and T.D. 9829, a partnership with 100 or fewer partners during the taxable year may elect out of the centralized regime annually on a timely-filed return, provided every one of its partners is an eligible partner. Eligible partners, for the count and for eligibility, are individuals, C corporations, S corporations, foreign entities that would be C corporations if domestic, and estates of deceased partners. Partnerships as partners, trusts (including grantor trusts and revocable living trusts), disregarded entities, and nominees all break eligibility.

For a two-person or three-person general partnership whose partners are natural persons, the election out should be the default. It pushes audits back to the partner level, where the partners actually pay the tax, and it avoids the single biggest operational trap in the new regime: the mismatch between the reviewed year (when the underpayment arose) and the adjustment year (when the partnership writes the check at the highest individual rate). The price is that each partner can be audited individually, which for a small partnership is a price worth paying.

The election is not free of traps. Admitting a new partner who is a trust, a partnership, or a single-member LLC during the year breaks eligibility for the year. A family partnership whose partners include grantor trusts cannot elect out. A two-person joint venture where one side holds through a disregarded entity cannot elect out unless the entity's owner is substituted in as the named partner. A pro forma partnership agreement clause prohibiting ineligible transferees is, for 2018 and beyond, cheap.

The liability rule still runs underneath everything

Nothing in the 2018 federal-tax stack softens the RUPA liability rule. Partners remain jointly and severally liable under RUPA § 306(a) for all partnership obligations, and purported partners are still on the hook under RUPA § 308 to third parties who relied on the representation. Martin v. Peyton and Byker v. Mannes still read the same way they did eighteen months ago. The § 199A deduction is a federal tax benefit sitting on top of a state-law entity whose defining feature is that it does not protect its owners from each other's contracts or torts.

For two people actually deciding in September 2018 whether to operate together through a general partnership or through a multi-member LLC taxed as a partnership, the math has not moved. Both get the same pass-through treatment and the same shot at § 199A. Only the LLC puts a corporate veil between partnership liabilities and the partners' houses. The annual fee for that veil in most states is in the low hundreds of dollars. For a partnership that is making enough money to care about § 199A, it is roundoff error.

Where the math has moved is for partnerships that already exist, operate, and file. Those partnerships needed a representative on their 2018 return, may or may not want to elect out, and have a materially different deduction analysis to run on the same income statement they ran in 2017. The accidental partnerships are still accidental. They are now accidental in a slightly more expensive tax environment, with a federal audit regime that binds them to a representative they almost certainly have not named.

Sources

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