Salary vs. Distributions — Tax Implications Partners Miss

The K-1 arrives in March and reports income substantially larger than anything the partner received. She calls the practice manager, who confirms the number is correct. She calls her accountant, who confirms the tax is due. Nothing has gone wrong in the sense of anyone doing something improper. What has gone wrong is that the practice never decided, in writing, how a partner’s economics divide between compensation and distribution, how much cash is reserved against the tax that division produces, or who speaks for the partnership when a taxing authority asks about any of it.

Two facts about pass-through entities generate most of the confusion. The first is that taxable income is allocated to owners whether or not cash is distributed, which is why a partner can owe tax in April on money the practice spent in October on an ultrasound. That gap is phantom income, and it is a cash-planning problem before it is a tax problem. The second is that how a dollar is characterized—wages, guaranteed payment, or distribution—changes what taxes attach to it, which creates a permanent incentive to characterize dollars favorably and a corresponding interest on the other side of the table.

The characterization rules depend on entity form and tax election, and the agreement’s job is to name the process rather than to supply the answer. In an S corporation, shareholder-employees who perform services must be paid reasonable compensation, which carries employment taxes; distributions do not. Understate the salary and the Internal Revenue Service may recharacterize distributions as wages, with back employment taxes, interest, and penalties following. Courts have sustained that recharacterization where the compensation was implausibly low relative to the services actually performed—David E. Watson, P.C. v. United States is the case usually cited for the proposition. In an entity taxed as a partnership, partners are generally not employees; payments for services are guaranteed payments, and a partner’s distributive share of the business’s income is generally subject to self-employment tax, with the scope of the limited-partner exclusion an area of continuing dispute. In a C corporation the pressure runs the other way, since compensation is deductible and dividends are taxed twice, so scrutiny falls on excessive rather than inadequate compensation. None of these determinations belongs to the partners. All of them belong to the practice’s certified public accountant, and the agreement should require an annual review with that accountant and a documented basis—duties, hours, comparable survey data, and the practice’s own economics—retained in the file.

Keep this analysis separate from a different test with a similar vocabulary. Fair market value and commercial reasonableness under the federal fraud-and-abuse laws are their own gates, answered with their own documentation, and a compensation figure can satisfy one analysis while raising questions under the other. Article 29 covers that architecture. Conflating the two is how a practice ends up with one memo doing two jobs and neither well.

Several allocation decisions ride alongside the characterization question and move real money without appearing in any formula. Employer payroll taxes are the clearest example: a partner earning $325,000 costs the practice more than $4,000 above a partner earning $150,000, because the Social Security match stops at the wage base while the Medicare match never does. Pool that line and the lower earners are quietly subsidizing the difference. Charge it individually and the arithmetic matches the cost. The wage base moves annually, which is one more reason the base salary figure gets set on purpose, with the accountant, rather than by a convention that once matched a threshold and outlived it.

Then build the tax reserve, which is the provision that converts a tax problem into a cash-flow routine. Define a tax distribution: a stated percentage of each partner’s allocated taxable income, distributed ahead of the quarterly estimated-payment dates, treated as an advance against later distributions and reconciled when the year closes. Say whether the rate is uniform across partners or computed individually. Say whether the tax distribution is mandatory—a floor the practice must fund before any discretionary distribution—or subject to the same reserve tests as everything else. Say what happens when the practice’s cash cannot support it, because a mandatory tax distribution colliding with a lender covenant is a problem best solved on paper in advance. And say whether state pass-through entity tax elections, where the practice’s state offers one, change the calculation, because they change who pays and when. The rate and the elections belong to the accountant. The obligation belongs in the agreement.

Give each partner an audit right over her own characterization. A partner may examine how her W-2 wages, guaranteed payments, and distributions were computed, and may see the basis on which the reasonable-compensation figure was set. This is not an invitation to relitigate a colleague’s pay. It is the ordinary corollary of the transparency principle: a partner who cannot verify the tax character of her own compensation cannot evaluate her own exposure, and cannot tell whether the practice’s position is one she wants to stand behind if it is ever examined.

Finally, name the person who speaks for the partnership, and update the title while doing it. For tax years beginning after 2017, the centralized partnership audit regime enacted in the Bipartisan Budget Act of 2015 replaced the former tax matters partner with the partnership representative, who holds sole authority to act on the partnership’s behalf in an examination and whose actions bind the partnership and every partner in it. That is a substantial grant of power, and it is sitting today in a great many agreements that still use the older title and assume the older rules. Draft it properly: who serves, how she is appointed and removed, a duty to notify all partners promptly of any notice received, limits on settling or making elections without a partner vote, indemnification for acting in good faith, and the decision framework for the push-out election and for electing out of the regime where the practice is eligible. Which elections make sense in a given year is the accountant’s call, made with counsel. That the authority is defined at all is the partners’ responsibility.

Red flags. Partners paid almost entirely through distributions with a salary nobody can justify. No annual reasonable-compensation review and no documentation supporting the figure. One partner adjusting her own salary downward to increase distributions, with no process governing the change. No tax reserve, so K-1 income lands in April against cash the practice already spent. And an agreement that still designates a tax matters partner, which means the practice has not looked at this provision in nearly a decade.

Tax authorities do not grade on intent, and they do not wait for the practice to get organized. A partnership that has not defined reasonable compensation has not avoided the question. It has left the answer to someone else.