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Fred Asks

I have a customer who reports guaranteed payments on their 1040 Schedule E. However, the partnership tax return info indicates the customer does not have any partnership interest. All of the K-1s provided are for other individuals and add up to 100%. There is not a K-1 for the customer. 

The 2019 Schedule E indicates “XYZ LLC Guaranteed payments – services $43,248” in passive income. In 2018 it shows “XYZ LLC $69,729.00,” also in passive income.

Robert Says

Sometimes the tax return is not correct. Other times, there is missing information. This could be either.

What are guaranteed payments?

First, some background. The IRS defines guaranteed payments as those made by a partnership to a partner for services or for the use of capital to the extent such payments are determined without regard to the income of the partnership. The guaranteed payments received are bundled in with any share of ordinary income (or loss) on page 2 of Schedule E. They are deductible to the entity (partnership or LLC filing a 1065) right on the front page of the entity return.

Incorrect tax returns

Based on what was provided it seems like there may be an error on the tax return including:

  • The entities are similar in name but not identical (different TIDs).
  • Both years were for service but it is only identified that way in one year.

Given that one of the years shows passive income (meaning the owner is not active in the business) but also identifies the guaranteed payments as for service (meaning the individual did something to earn the compensation), I am leaning toward a mistake. That said, an owner can get paid to work there but not be involved in decision-making. If your feeling is that this is murky, I agree.

Layered ownership?

Assuming there are no errors on the tax returns, perhaps there is another layer between the customer and the mentioned business.  It could be that one of the partners is another company and this borrower has a K-1 from that company. That does not seem to fit your facts, but something has to explain it.

Is it possible they were a partner but are no longer?

If you have no K-1s for either 2018 or 2019, this would not be the answer. But if there was a 2019 K-1 with ‘final’ selected at the top, that would explain why they are no longer showing partnership income.

Where is the proof?

A W-2 provides proof of actual income in the form of wages. When there are amounts on a Schedule E Page 2, the k-1 provides the proof that there were actual distributions. It seems in your situation that you do not have proof, yet. 

You will have to ask

The more I look at this, the more I believe you simply need to ask the borrower:

  • Are you an owner of XYZ LLC?
  • Do you have a K-1 for that entity?
  • If not, how did the tax preparer get the information reported on Schedule E?
  • What type of services do you perform for the company?

With the answers to those questions, you will be in a better position to decide what is recurring cash flow available from the entity. And if these amounts are significant for this borrower, you do need to know if the company can continue to pay them.

More on 1065’s and Guaranteed Payments

At Lenders Online Training, 3 of the 30 modules on Tax Return Analysis cover the 1065 including

  • Overview
  • Company Cashflow
  • K-1s and Owner Cashflow 

Improve your confidence and skills in handling the pass-through entities and their owners. Click HERE to check it out. 

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Linda Keith, CPA

Linda Keith CPA is an expert in credit risk readiness and credit analysis. She trains banks and credit unions throughout the United States, both in-house and in open-enrollment sessions, on Tax Return and Financial Statement Analysis.
She is in the trenches with lenders, analysts and underwriters helping them say "yes" to good loans.
Creator of the Tax Return Analysis Virtual Classroom at www.LendersOnlineTraining.com, she speaks at banking associations on risk management, lending and director finance topics.