Tax Reminder: Guaranteed Payments vs. W2 Wages

Originally posted on our CPA Eats Blog and reproduced here in its entirety.

We see it all the time. The end of the year comes along and we get a detailed list of what you’ve paid in wages throughout the year. There, front and center, is a W2 being paid to a partner. Let’s take a closer look at this picture.

Though the two terms “Guaranteed Payment” and “W-2 Wages” might seem interchangeable as far as a partner is concerned, they are not. Over many years, the consensus of the Courts and the IRS has been that payments to partners should be classified as GP and not as wages. Revenue Ruling 69-184 best articulated this when it established that, “Bona fide members of a partnership are not employees of the partnership…Remuneration received by a partner from the partnership is not ‘wages’ with respect to ‘employment’ and therefore not subject to the taxes imposed by the Federal Insurance Contributions Act (FICA) and the Federal Unemployment Tax Act (FUTA)…” In other words, a partner should not receive a W2 for “wages” because the partner is not, by rule of law, an “employee.”

Guaranteed Payments (GP) are typically established in the Operating Agreement and are designed to ensure a partner receives a certain minimum amount of money in exchange for his/her services or use of capital. Often, these are paid in lieu of a 'salary' to partners, but sometimes they're paid irregularly throughout the year. The GPs are not income-dependent i.e. they will be paid out even if they create a loss on the partnership books.

But why does this matter, you ask? We'll stick to the bigger reasons here…

First and foremost, according to the IRS, it is just not the correct way to report payments to partners.

Secondly, reporting payments to partners as wages instead of as a GP can result in incorrect employment tax calculations. It can also impact proper calculation of your QBI deduction, affect state apportionment and affect compliance with benefit plan rules and payment of benefits for partners. Also, while a GP creates self-employment income and adds the burden of self-employment tax to the partner, it also creates opportunities for additional deductions. For instance, if the partner is required to pay expenses out of pocket - like for maintaining a home office or travelling for partnership business - and he/she is not reimbursed by the partnership, those deductions can lower the self-employment income (those deductions would be disallowed and lost if the partner was an “employee”).

So, to report these payments properly and avoid the pitfalls incumbent with reporting them on a W2, they should not be called “wages” and should be reported as a separate GP line item on your Income Statement. A GP will still be a deduction for the partnership but will be reported on the partner’s K-1 instead of on a W2. On the individual level, the employment tax will be paid on the Form 1040 and the payments will show up on the Schedule E.

TL;DR: Cutting through all the tax talk, your most important takeaway is this - Partners Get Paid Via Guaranteed Payments, Not Via W-2! If you have a partner who has been receiving a W2 in 2021, please let us or your payroll company know ahead of December 31st so we can help get any corrections made while we still have time before year end.

As always, if you have any questions about these rules, please reach out to us so we can help, and stay tuned to our newsletter and blog for ongoing updates and helpful tips to make your tax season as smooth as it can be.