As many readers who are business owners will know, section 199A of the Internal Revenue Code (the IRC) provides owners of “pass-through businesses” (i.e., sole proprietorship, S corporations and entities taxable as partnerships) with an annual federal income tax deduction of up to 20% of their share of the net income of their business. The importance of the section 199A deduction is huge; for many businesses, it can make the difference between business success and failure.
Furthermore, although section 199A is due to expire at the end of 2025, both the U.S. Senate and the House have just introduced bills that will make section 199A permanent. In my view, it is virtually certain that these bills will pass, since they will benefit at least 17 million business owners who are receiving section 199A deductions.
However, now and in the future, your section 199A deduction will depend on your “threshold amount” under that section. For 2020, the section 199A threshold amount is $326,600 for married couples and $163,300 for most people who file separately. For people (probably including most readers of this column) whose threshold amounts are at or below these amounts, their deductions will be a full 20% of their shares of their net business income.
But during 2020, many New Hampshire entities taxable as partnerships – which include almost all New Hampshire multi-member LLCs, limited partnerships and state-law general partnerships – have shared their business income among their owners by paying them salaries (called “guaranteed payments” in partnership tax terms). The problem for these businesses is that these salaries are expenses that reduce their net business income and thus their section 199A deductions. And, for New Hampshire tax purposes and other purposes, many New Hampshire businesses have paid virtually all of their business income beyond non-owner-compensation as salaries.
If your company paid its owners substantial salaries in 2020 and thus reduced their 2020 section 199A deductions, is there any solution? The answer is yes. Incredibly, IRC section 761(c) (one of my favorite of all of the thousands of provisions in the IRC) provides effectively that entities taxable as partnerships can validly amend their partnership agreements (including, in the case of multi-member LLCs taxable as partnerships, their LLC agreements) retroactively to Jan. 1, 2020. These amendments will provide that amounts paid by these businesses to their owners under their partnership agreements as salaries shall not be treated salaries under these agreements, but rather, as distributions of the profits of their businesses. These distributions are not expenses for federal income tax purposes and will not reduce net business income.
Furthermore, if the partnership agreements of these businesses don’t already provide for “consent” or “dissolution” provisions that will protect their owners from the 5% New Hampshire Interest and Dividends Tax (the I&D Tax), business owners can effectively amend their partnership or LLC agreements, retroactive to Jan. 1, 2020, to so provide. Indeed, even apart from section 199A considerations, their partnership agreements should probably so provide even just for I&D Tax purposes alone.
Before you and your co-owners make the above amendments in your partnership agreements, you should make sure that the resulting federal tax benefits will outweigh Investment Retirement Account considerations, Self-Employment Tax consideration and New Hampshire tax considerations. But I suspect that if you do the arithmetic, you’ll find that even on this net basis, section 761(a) will be a magic bullet.
(John Cunningham is a Concord, NH lawyer of counsel to McLane Middleton, P.A. His practice is focused on LLC formations, general business and tax law, advising clients under IRC section 199A, and estate planning. His telephone number is (603) 856-7172, his e-mail address is lawjmc@comcast.net, and the link to his website is www.llc199A.com.)