Our client is a Pennsylvania-based commercial real estate firm specializing in brokerage services, property management, lease administration and consulting. The firm’s ownership structure is a partnership with three equal partners. It has been a tax client of Baker Tilly Advantage (Advantage) since 2015.
During a tax-planning meeting following the release of the Tax Cuts and Jobs Act (TCJA), Advantage tax advisors discussed how the client could benefit from some of the new provisions, specifically, section 199A. Under the new regulation, eligible taxpayers may take a deduction of up to 20 percent of qualified business income (QBI) from partnerships, S corporations and sole proprietorships.
To determine if each partner would be able to take advantage of this opportunity, Advantage tax advisors had to gain a better understanding of their compensation structure.
Up until this point, the partners were being compensated via a base salary and also receiving guaranteed payments based on a bonus compensation formula, which were paid out as an expense of the partnership. The guaranteed payments are considered wage-like income so they do not qualify for the QBI deduction mentioned above.
However, reclassifying their guaranteed payments as payments from net profits means they would be considered ordinary income and, thus, eligible for the 20 percent QBI deduction.
In order to determine whether remaining under the current structure or reclassifying the payments would offer the most tax savings for the client, Advantage tax advisors performed a modeling analysis. It was determined that reclassifying the payments as ordinary income (approximately $750,000) would result in a deduction of $150,000 ($750,000 x 20 percent deduction) in total.
By restructuring the partners’ operating agreement and reducing their taxable income by $150,000, Advantage tax advisors were able to reduce their tax liability by $50,000 to $60,000 (given the 37 percent estimated tax rate). We anticipate the client will benefit from this savings annually — as long as section 199A is in effect.
For more information on this topic, or to learn how Baker Tilly Advantage specialists can help, contact our team.