SHORT: Guaranteed Payments for LLC Members and Partners

Posted December 12, 2012 by Andrew Mirsky in Blog, Guaranteed Payments, LLC Compensation, LLC Draws, LLC Member Draws, LLC Salaries, LLC Taxes, LLCs, Self-employment taxes, start-ups, startups, Tax, Uncategorized 1

“Guaranteed Payments”: What are They?

Guaranteed payments are exactly that: They are payments that are “guaranteed”. By whom? Well, salary payments are technically “guaranteed” in the sense that there is a contractual obligation to pay a certain amount on a regular basis. But in the partnership context, including LLCs treated as partnerships for tax purposes, guaranteed payments are made to partners or other owners (“members” in the case of an LLC).

Guaranteed Payments: What Significance?

Partners form a partnership, go about building a product or service, and prepare to (hopefully) make money. (See Warren Buffett’s Rule No. 1 of business: “Never Lose Money. Rule No. 2: Never Forget Rule No. 1.”) To get there requires significant investment in time, goods, services and money. Along the way, people actually have to pay rent, buy health insurance, pay for gas and the electric bill, and occasionally eat. Maybe take a day off once in a while.

For partnerships and LLCs, guaranteed payments even-out the unpredictability of earning money from a small business. Put another way, guaranteed payments are profits of the business paid during the course of the business year rather than all at once at the end of the year. To be clear, though, guaranteed payments are not necessarily dependent on profits, and can be paid out the same as other business expenses to reduce profits, subject to certain IRS rules (discussed below). Rather, guaranteed payments may be determined based on forecasted profits, but are not dependent on profits: As noted in Investopedia:

Guaranteed payments to partners are made to ensure that partners are compensated for specific contributions they make to a partnership, whether in the form of goods or services. This eliminates the risk of their making personal contributions of time or property for which they are never paid if the partnership is not successful. … Guaranteed payments are considered first-priority distributions and will be paid out even if the partnership is losing money. (emphasis added)

Salary vs. Draws

A partner (or LLC member) can receive income from a partnership either through a “draw” during the year to be credited against year-end profits, or through a guaranteed payment. Guaranteed payments are essentially guarantees of payment of the draws, but regardless of expectations of profits. And in that sense, guaranteed payments are similar to salaries in a corporation. As many commentators note (see here and here), guaranteed payments (or guaranteed “draws”) are commonly given to partners acting as managers of the partnership or LLC. Which should make sense, since their management services would typically be analogous to similar salary-type services for a corporation. At the end of the fiscal year, remaining profits can be distributed to partners representing the partners’ respective shares of the business’ profits, less amounts previously distributed as draws.

As noted above, the “guaranteed” part of guaranteed payments is critical because payments are not dependent on actual profits or, in theory, availability of cash flow. So, for example, in an LLC $1 million in profits does not necessarily mean $1 million in cash, and very often profits are distributed only in part or not at all due to cash flow concerns. In such cases, a guarantee of payments regardless of the business’ end-of-year discretion to reserve, preserve or re-invest cash assures a partner some sort of predictable income stream.

Guaranteed Payments: How Do They Work?

Guaranteed payments, like salary payments to salaried employees, are deductible business expenses. Internal Revenue Code Section 707(c) provides that guaranteed payments are “deducted in the computation of partnership income.” Section 707(c) continues:

Accordingly, it is considered a payment made to one who is not a member of the partnership and is deducted in full, just as if it were an ordinary expense under IRC section 162. … To the extent determined without regard to the income of the partnership, payments to a partner for services or the use of capital shall be considered as made to one who is not a member of the partnership ….

The key is “without regard to the income of the partnership”, consistent with the idea that the payment is compensation “for services or the use of capital” in accordance with IRC Section 707(c).

One commentator offers this illustration:

Under a partnership agreement, Divya is to receive 30% of the partnership income, but not less than $8,000. The partnership has net income of $20,000. Divya’s share, without regard to the minimum guarantee, is $6,000 (30% × $20,000). The guaranteed payment that can be deducted by the partnership is $2,000 ($8,000 − $6,000). Divya’s income from the partnership is $8,000, and the remaining $12,000 of partnership income will be reported by the other partners in proportion to their shares under the partnership agreement.

Even though Divya is guaranteed an $8,000 payment, only $2,000 of that amount can be deducted by the partnership as compensation in order to reduce partnership income. The rest – $6,000 – is simply partner distribution of profits.

In order to qualify, guaranteed payments must be deductible under Internal Revenue Code Section 162 as ordinary business expenses. That is consistent with the requirement that the compensation must be “for services or the use of capital” in accordance with IRC Section 707(c).

A common example is a partnership of 2 partners, each with 50% ownership. However, one partner works full-time in the business, while the other is not involved or involved to a disproportionately lesser amount. There are several ways to address potential inequities in contributions and services, including disproportionate capital contribution requirements and unbalanced profit and loss sharing arrangements. A guaranteed payment structure can provide a salary or similar compensation plan for the managing partner prior to profit 50/50 profit sharing.

Guaranteed Payments: Benefits and Burdens.

For a partnership or LLC, guaranteed payments provide an immediate tax advantage for a company’s bottom line, since deducted as other business expenses, reducing the company’s overall tax burden. A good discussion about the tax benefits of guaranteed payments for LLCs can be found on the Houston Chronicle’s small business section here.

Note, though, that although the partnership or LLC may be relieved of some of its tax burden, that burden is passed onto the partners themselves. Arizona Central writes:

Because guaranteed payments aren’t considered wage income, they’re not subject to income tax withholding. This means partners must make estimated income tax payments each quarter on all funds received through guaranteed payments. LLC members must also pay self-employment taxes on all guaranteed payments on their individual taxes.

More Information?

The CPA Journal has a few worthwhile tips for avoiding common mistakes on guaranteed payments to partners here.
Linda Keith, CPA, writes a quick synopsis on guaranteed payments here.
Entrepreneur’s Tax Expert offers advice for handling salary payments in an LLC here.
The IRS offers a good publication, Publication 541, discussing the subject of guaranteed payments and related compensation tax issues for partnerships and LLCs.