Partnership Income for EITC

[ShoeBox Taxes]

I guess this is more of a general tax question.

I have a client whose only income is on a partnership K-1. The partnership did not pay the partners through payroll. It's a family partnership: mom, dad, and son, and they all live in the same house, which is also where the business is. The partnership pays all the home expenses (and yes, I know not all of those expenses are deductible, that's a totally different question for the partnership return) so the son doesn't really have any expenses. So he doesn't need an "income" per se. He just works at the family business, which pays all his bills. Mom and dad have retirement income and social security. 

The son is the client I'm asking about. The partnership absolutely did not pay him, even giving him any draws. But he does get to claim 50% of the partnership profit as active, qualified income. However, when I select that as active, qualified business, it doesn't seem to kick in the EIC. Am I doing something wrong, or is partnership income not considered "earned income" for the purpose of EIC?

I've read several different sources of IRS instructions on EIC and I don't see anything that says anything about partnership income except salary received from a partnership. Nothing about K-1 income. Does anyone know if my hunch is correct, and that the son would not be eligible for EIC?

[TaxGuyBill]

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@ShoeBox Taxes wrote:

He just works at the family business

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If he is working for the business, it is subject to SE tax.  Box 14 of the K-1 should show the income subject to SE tax, and that is what should trigger it as "earned" income.

[qbteachmt]

"except salary received from a partnership."

"The partnership did not pay the partners through payroll."

Partners don't get paid through Payroll, unless they elected to be treated as a Corporation.

If he was not a partner in the formation documents, he would be an employee and would be paid through payroll. Two different ways a person contributes to and benefits from the business operation.

"The partnership pays all the home expenses"

It's sad that people have no idea how to determine how the business is performing, because they do not manage the money correctly. I wonder if they are prepared for what that tax filing is going to show.

"He just works at the family business, which pays all his bills."

It seems time for him to learn to be in business, then. I've seen this is called "Adulting."

"The partnership absolutely did not pay him, even giving him any draws."

Yes; that's exactly what that gets treated as. Personal expenses paid from the business = draws. That would be part of the 1065 and his K-1.

"So he doesn't need an "income" per se"

He let mommy and daddy manage it, through the business.

[ShoeBox Taxes]

He is a partner in the partnership documents.

They were a Sole Prop before, doing business use of home, and didn't have a separate bank account. I was doing their taxes, and figured the correct amounts based on square footage. I kept telling them they needed to set up separate accounts, and pay their business expenses from a different account, but they actually kept really good records, so it wasn't hard to split everything out correctly. 

Last year, they asked how they could make it so their son could take over the business, and I said it sounded like they needed to incorporate. I told them I wasn't a lawyer, and that they should probably talk to a lawyer or someone who knew more about that than I did. So they did. I told them to make sure they started a new business account under the new business, and make sure they set things up so that the business wasn't paying home expenses. 

The lawyer who set them up did it as a partnership, and they claim he said they could continue using business funds to pay home expenses. The "partnership docs" that this lawyer drew up were terrible. They don't have a % assignment in them. They don't have what each partner is bringing in. Nothing. Fortunately they only paid the guy $5k, which isn't much, but still, for that kind of money he should have given them actual partnership documents. (It's a one-page document that lists the names of the 3 partners, their addresses, and states that they will be in business as the name of the business in perpetuity, with all 3 signatures and dates of signing.) Hell, I know nothing about this, and even I could have done better than that!!!

I set up the home as being rental income to mom and dad, in the amount of the cost of property tax and utilities (mortgage is paid in full) and the % of depreciation, with the expenses being just the %.

Anyway, thanks for the help. Sounds like I should book the son's room and board as "partner draws" in the books, and issue that as income. Thanks!

[qbteachmt]

Are they even registered with their State? Did they get FEIN?

"I set up the home as being rental income to mom and dad"

You can't rent your own house to yourself and pay yourself rent.

"in the amount of the cost of property tax and utilities (mortgage is paid in full) and the % of depreciation, with the expenses being just the %."

Are you explaining the business use only? And is that exclusive, and not "this corner of the kitchen and the shelves in the garage?"

"Sounds like I should book the son's room and board as "partner draws" in the books, and issue that as income."

Did the parents take these amounts from the business in lieu of "room and board" from the son?

There seems to be a whole lot wrong here.

[ShoeBox Taxes]

Yes, they are registered as a multi-member entity with the state, and they have an FEIN. 

And yes, the space is exclusive-use. It's a construction company, and the space is the shop. It's a separate space, and completely unlivable for anything but a shop. (I've been there.)

The family still doesn't have a separate business account (which I still wag my finger at them about, but they have impeccable records, so I can easily see what is what).

We figured out what % of the property was the shop years ago, and have been using that % for "Business Use of Home" while they were a sole prop. That % was used for property tax, utilities, and depreciation (the house was paid off years ago, so there's no mortgage interest). The business still uses that space.

So explain to me how to account for the business use of their home, if not by booking a rent expense on the partnership return, and as rent income on the personal return? If I don't do that, they basically avoid paying taxes on the benefit of living in a company-owned house, which I'm pretty sure is tax fraud.

[ShoeBox Taxes]

Also, no, they didn't take physical money from the business, give it to the son as a payment, and then take it back and put it back into the account to receive rent from him. The son lives in the house which is paid for by the business. They also pay for the food that the whole family eats. You had said before that money taken for personal expenses are draws, which makes sense, but now you're saying I'm not allowed to do that unless actual cash passes hands? That doesn't make sense.

Are you saying that if a business owner writes a business check (or swipes a business card) for a personal expense and calls it an "owner's draw," he's breaking the law, and that he must instead write the check to himself, cash it, and use the cash to buy the thing? I grant up front I'm not as smart as you at these things, but I'm pretty sure you're wrong on this one.

[qbteachmt]

"If I don't do that, they basically avoid paying taxes on the benefit of living in a company-owned house, which I'm pretty sure is tax fraud."

I'm sorry, but now I'm confused. Do you have a home privately owned, and these people are charging their own business entity rent for the use. Or, do you have a residential property owned by their business (titled to it) and they live in it as renting from their business (the landlord). Or, they are reporting this value as unreimbursed partner expense. Or as Office in Home.

[qbteachmt]

"they didn't take physical money from the business, give it to the son as a payment, and then take it back and put it back into the account to receive rent from him."

It's the same thing, though. If I give you money, and make you give it back as Rent; or, I tell you that we determined that same amount is not yours, because it is covering the rent..is equivalent. All we did is skip the banking.

"The son lives in the house which is paid for by the business."

And anything that should be paid using personal funds, would be treated as paid "on behalf of" him, even though the "business" paid. As you pointed out, they are commingling funds, as it is. That was not as big a deal for SP, but now they are not tracking business that isn't fully theirs and treating that son as an indentured servant.

"They also pay for the food that the whole family eats. You had said before that money taken for personal expenses are draws, which makes sense, but now you're saying I'm not allowed to do that unless actual cash passes hands? That doesn't make sense."

I stated it is treated the same as a draw. If the son doesn't take $100, but Mom pays his car insurance using $100 from the business account, it's the same as if you gave him the $100 (draw) and then he paid the insurance himself. Except, that is the way it's supposed to work.

"Are you saying that if a business owner writes a business check (or swipes a business card) for a personal expense and calls it an "owner's draw," he's breaking the law"

Nope. Never stated that. But this is commingling.

"and that he must instead write the check to himself, cash it, and use the cash to buy the thing?"

It's the same thing. You are confusing Direct and Indirect; they are both "on behalf of" personal.

"I grant up front I'm not as smart as you at these things, but I'm pretty sure you're wrong on this one."

And I never even stated what you now accuse me of.

[ShoeBox Taxes]

We are both confused.

They don't have a business account. They have only one account, into which they deposit all income (business income, a few pensions, and their social security), and from which they pay all expenses (business and personal).

Their home, which is fully paid off, but still has property tax and utilities, is the legal business address for their business. For over 10 years, they've been a sole prop. It's easy to account for business use of home in a sole prop. The % of exclusive-use is figured and charged to the business, and the remainder flows through to Schedule A (property tax), or is non-deductible. Easy peasy lemon squeezy.

They had been paying him on a Form 1099-MISC, but did not do that this year, since he was a partner, and the lawyer told them his % of the business would be his pay. (Which I thought was the case, as well, but I haven't been able to get it to count as Earned Income for the EITC, which is why I posted this originally). So that's one question. And I think we've figured that out. His % of the home expenses are "guaranteed partner payments," even though they weren't in cash I list them as partner draws out, and then they get reported on the K-1s correctly. I hope.

But now there's another issue: How do I account for the business use of the % of the home -- including property tax, utilities, and depreciation. I had booked it as "rental expense" on the partnership return, in the exact amount of their % of those things, and then rental income to the couple, so they would pay tax on it. Is there a different way to deal with that? If so, what? 

If I don't do this, the business has a much higher income, because it basically functions rent-free. The couple also doesn't have business-related depreciation to recapture (if and when they sell the house). Not sure if that's an issue? Or is this what the IRS expects? 

[qbteachmt]

I recommend you research Accountable Plans.

Example:

"Partnerships, accountable plans and reimbursements.

Ways to cover expense that revolves around your business.

Written by Halon Tax Support
Updated over a week ago

Can a partnership adopt an accountable plan to reimburse home office and business expenses?

Yes, a partnership can absolutely utilize an accountable plan. However, the partnership will need to adopt an accountable plan and the partnership agreement should reflect the reimbursed expense policy."

[ShoeBox Taxes]

Okay, let's pretend they had separate accounts, one for business and one for personal. Would the correct way to do it be for them to pay every utility bill, property tax bill, etc. with two checks, one from the personal account and one from the business account, at the set %? That seems a little silly. And it still doesn't account for the depreciation.

To me, it makes sense for the couple to charge the business "rent" in the amount of the % of property tax, utilities, and depreciation, and then pay tax on the income. But I'll be the first to admit that tax laws don't necessarily make sense! (Don't get me started on MACRS.)

So, we're still left with the question: how SHOULD they do this?

[TaxGuyBill]

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@ShoeBox Taxes wrote:

but I haven't been able to get it to count as Earned Income for the EITC

I had booked it as "rental expense" on the partnership return, in the exact amount of their % of those things, and then rental income to the couple, so they would pay tax on it. Is there a different way to deal with that? If so, what? 

The couple also doesn't have business-related depreciation to recapture

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Did you figure out the EIC?  You never commented about Box 14 of the K-1.

It could be rearranged as an Accountable Plan, where the taxpayer pays for the expenses then submits for a monthly reimbursement of the the office expense.

Another option is for the Partners to pay for the expenses, then take the expense as Unreimbursed Partnership Expense (UPE) (make sure there is a Partnership Agreement that dictates that).  However, if the parents are no longer working for the business, that is potentially more problematic.

The current rental situation they are depreciating the property, so they will probably have Unrecaptured Section 1250 when when they sell the house.  There could be options for the future to avoid adding to that, but they don't seem ideal.

[qbteachmt]

"To me, it makes sense for the couple to charge the business "rent" in the amount of the % of property tax, utilities, and depreciation, and then pay tax on the income."

Under the terms of An Accountable Plan, that could be nonreportable and nontaxable reimbursement, unless they set up something over and above the provision.

Example:

Business miles on the personal vehicle would be turned into the partnership to be reimbursed at IRS rates. if they decide to pay themselves Double the IRS rate, that becomes a taxable fringe benefit instead of Accountable Plan reimbursement.

[ShoeBox Taxes]

<< Under the terms of An Accountable Plan, that could be nonreportable and nontaxable reimbursement, >>

"...that could be..." 

Could be? If what? I'm less interested in what it could be and more interested in what it IS.

"...over and above the provision..."

What provision?

You mean the % they've been using for 10 years? Is that considered "a provision"?

Honestly, it still sounds to me like you're saying they won't be paying taxes on the benefit they're receiving. You denied that you're saying that, but you say that it's not reportable and nontaxable, and if that's the case, then they're avoiding taxation, which still sounds like fraud to me. Please explain how it's not fraud if they don't report it or pay taxes on it.

[TaxGuyBill]

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@ShoeBox Taxes wrote:

Honestly, it still sounds to me like you're saying they won't be paying taxes on the benefit they're receiving.

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What "benefit" are you referring to?  The office expense?  Or the fact the business is paying for personal expenses?

If you are referring to an Accountable Plan for the office expense, there isn't really a "benefit".  The taxpayer receives the Accountable Reimbursement that is tax-free and not reportable.  But it is a business expense that they paid, so there is no "benefit".

In the scenario, the taxpayer claims no income from reimbursement.  The business reports the deduction, which flows to the K-1 and office expense ends up reducing taxpayer's income.  Net result:  No reportable income but gets a deduction.

Compare that to a Sole Proprietor.  Taxpayer pays for office expense.  They don't add anything to their income because of the office expense.  They get deduction on 8829.  Net result:  No reportable income, but gets a deduction.

[ShoeBox Taxes]

<< What "benefit" are you referring to?  The office expense?  Or the fact the business is paying for personal expenses? >>

Yes. Both.

[qbteachmt]

"Could be? If what"

Could be, if it meets the Requirements. That's why it's called "Accountable." I explained one example = mileage rate as per IRS, or Not. If Not, it's taxable.

"Please explain how it's not fraud if they don't report it or pay taxes on it."

That's the point of An Accountable Plan. You should read up on it.

[qbteachmt]

"Yes. Both."

Any amounts spent on Personal is Not Business and is the same as Draw.

Read up on Accountable Plans per the IRS. That likely is one of the big pieces you overlooked.

You will love learning about it.