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The Treasury Department is considering whether it should apply reasonable-compensation rules—an idea used to keep S corporation owners from underpaying taxes—to partners and sole proprietors as well, in light of the new tax law.
“We have gotten a number of comments about whether the statute intends in any way for that to be expanded for sole proprietorships or for partners in partnerships,” Bryan Rimmke, an attorney-adviser in Treasury’s Office of Tax Legislative Counsel, said Feb. 9. “How far we may extend that is to be determined.”
The law includes a tax break for pass-through business owners, but limits the 20 percent deduction to what the law defines as “qualifying business income.” For S corporations, the law says that reasonable compensation paid by an S corporation or guaranteed payments paid by a partnership don’t qualify for the deduction.
S corporations are required to have the shareholders who also work in the business pay themselves a “reasonable” wage and the associated self-employment taxes. But there aren’t any rules requiring partnerships to pay their active owners a guaranteed payment.
The reasonable-compensation rules for S corporations stem from the incentives their owners face to minimize the amount they pay themselves, so they can avoid self-employment taxes. The reasonable-compensation standard became well known after former House Speaker Newt Gingrich (R-Ga.) and former Sen. John Edwards (D-N.C.) reportedly minimized their income to avoid taxes.
If the Internal Revenue Service were to require all active partners in a business to have a portion of their earnings pegged as reasonable compensation, it could reduce the tax benefits pass-through owners see under the 2017 tax act ( Pub. L. No. 115-97).
Treasury Deputy Assistant Secretary for Tax Policy Dana Trier said he doesn’t intend to spend much time writing regulations that would greatly expand the scope of reasonable compensation, but said he is constrained by what the statute says.
“The statute is structurally set up to distinguish between guaranteed payments and reasonable compensation,” Adam M. Cohen, a partner at Holland & Hart LLP in Greenwood Village, Colo., said at the American Bar Association Section of Taxation meeting in San Diego. “Don’t go there.”
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