Capitalized Guaranteed Payments

[vbwilks]

Our LLC pays each partner guaranteed payments. Some of the GPs for services are for business activity and some are for rental activity. Of course, the TurboTax for Business GP entry page provides two boxes for me to separate the GPs by activity type. Some of our GPs for each type of activity are true expenses, while some belong in capital accounts. For the rental activity, this is not a problem as TT does not automatically deduct the GPs. So, I can enter the GPs that are expenses under each property (and more or less ignore capitalized GPs for rental activity).

However, TT automatically includes all business activity GPs as a deduction on Form 1065, pg. 1, line 10. How can I deduct only the business GPs that should be deducted (not including capitalized GPs) but include all business activity GPs (including capitalized GPs) on Schedule K?

[tagteam]

You might very well have to resort to entry in Forms Mode.

I will also page @Rick19744 since you have two different types of activities. 

[Rick19744]

I guess I need some more facts as I'm not real clear on the end goal:

• Guaranteed payments (GP) are paid to a partner (member) and are determined independent of the partnership's (LLC) operating results.
• These amounts are paid for providing services or capital to the partnership / LLC.
• These GPs are reported on the partners tax return in the year they are deducted by the partnership.
• GPs are always ordinary income to the respective partner / member
• Guaranteed payments do not impact the capital account of a partner / member
• Since you have active trades and businesses, I need to understand why some GPs need to be capitalized

[vbwilks]

The business activity is flipping houses. The partner receives guaranteed payments for his construction services, which are part of our basis/investment in each property.

[tagteam]

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@vbwilks wrote:

The business activity is flipping houses. The partner receives guaranteed payments for his construction services, which are part of our basis/investment in each property.

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That is easily understood but it still does not address the following bullet point posted by @Rick19744:

• Since you have active trades and businesses, I need to understand why some GPs need to be capitalized

[vbwilks]

Let me try to explain again as that is the only bullet point I was attempting to address.

If my partner provides labor working on 123 Pine St., then we capitalize his labor as part of our basis in 123 Pine St. We would not effectively get to deduct that cost until the year in which we sell 123 Pine St.

[tagteam]

While we wait for @Rick19744 to respond, note two bullet points in his post, which stated, Guaranteed payments do not impact the capital account of a partner / member and GPs are always ordinary income to the respective partner / member.

Hence, the conclusion I draw from @Rick19744's post, as well as the law and Regs, is that capitalizing guaranteed payments for services rendered by a partner is not the proper tax treatment.

[vbwilks]

Quite frankly, I am not a tax professional and it may not be correct. However, as I understand proper treatment:

Because it is regular income to the partner, it needs to show up on Schedule K. Because the business should treat it as a capital expense deductible upon sale of the asset, it should not show up on pg. 1. This is the precise problem I am struggling with.

I feel certain that some guaranteed payments for business activity should be capitalized. Pub. 541 addresses organizational costs: "Guaranteed payments made to partners for organizing the partnership or syndicating interests in the partnership are capital expenses. Generally, organizational and syndication expenses are not deductible by the partnership...Organizational expenses and syndication expenses paid to partners must be reported on the partners' Schedules K-1 as guaranteed payments.

[Rick19744]

Thanks for the additional details.

The issue with the guaranteed payment(s) is no different than a business start-up paying out wages and issuing W-2's.  In both cases, the respective individual will recognize ordinary income at the time of payment.

In the business start-up situation, while the employees will be issued W-2's and report that income on their respective 1040, the amount will not be deductible by the company until the business actually starts.  Those cost will be accumulated and then amortized under Section 195.

The guaranteed payments are exactly the same; there are two components, (1) the payment of the guaranteed payment to the partner (member), AND, (2) the timing of the deduction for the business.

In both examples the company will need a book-to-tax adjustment (M-1) to adjust for this.

In both cases you will have an M-1 on the tax return for expenses on the books not on the return.

This won't impact the payment of the guaranteed payment to the member, just as it doesn't impact the wages paid to an employee of a start-up.  Both recognize ordinary income when paid.

In your example, you will need to generate an M-1 as follows:

Dr. Construction-in-Progress

Cr. Guaranteed payments

This will adjust for the capitalization of the guaranteed payment you are referring to.  It doesn't change the actual amount of guaranteed payment to the member, it just adjusts to arrive at the correct bottom line.

Then when the house is sold you will need to adjust the guaranteed payment (with a debit) to arrive at the result that matches the guaranteed payment paid out to the member.  This entry then addresses the timing of the deduction to the company for the tax return.

As noted previously, guaranteed payments are paid out regardless of the income / loss of the business.  The payment and timing of the deduction are separate.

[vbwilks]

Thanks very much for considering this issue. Can you suggest the best way to handle that in TT?

[Rick19744]

Since I am not in a Windows environment, I don't have access to the Business software (thankfully).

I am sure that @tagteam can provide assistance on how to accomplish the journal entry in TT to arrive at the correct bottom line.

[tagteam]

Yes, this is (clearly) going to require entering Forms Mode and, more than likely, one or more overrides. 

This scenario is somewhat beyond the capability of the program in Step-by-Step Mode.

[Rick19744]

@tagteam does the TT Business software allow for making an M-1?

While it may not adjust as noted in my prior response, can a preparer just go directly into the M-1 section and include an amount on line 4 of the M-1 section?

If that is possible, then the OP will just need to do the reverse once the house is sold.

While it may not agree to the actual books and records, it arrives at the correct tax result.

[tagteam]

@Rick19744 

Yes, in direct response to your question. 

In Forms Mode, there is an M-1 worksheet and the program allows direct entry on Schedule M-1.

[Rick19744]

Ok.  Then for @vbwilks you will need to go into forms mode M-1 section and locate the line 4 (expenses on books not on return) and enter the amount you believe should be capitalized.

This only applies if the sale of a house straddles the tax years for when guaranteed payments are made.

Then the following year, when the house is sold, you will once again need to go into the forms mode M-1 section and enter the same amount as prior year except on line 7 (expenses on the return not on books).