If you're a partner in a limited liability company (LLC), the IRS states you cannot receive a salary. Instead, partners are paid out by distributions which split the profit the business has earned over the year.
This can put partners in a tricky position without a consistent income. After all, businesses aren't typically profitable in their early years. Guaranteed payments are a fix to this.
Guaranteed payments are exactly how they sound: a minimum amount that is "guaranteed" to be paid regardless of a business's profitability. These payments are the equivalent of a salary—scheduled payments made to partners for their services or capital provided.
These payments are a type of first-priority distribution—payments made even if it results in a loss for the business. This protects the partner's income while the business is becoming profitable.
Further reading: How to Pay Yourself From an LLC
Guaranteed payments must be outlined in the operating agreement. The operating agreement is your coverall document. It should document the name of the LLC, the address, information of the partners, and purpose of the business. To make sure you don't miss a detail, start with a free template.
The operating agreement should explicitly outline the guaranteed payment amount and the payment schedule for each partner.
Arrange your guaranteed payments before setting up your LLC. You cannot set up guaranteed payments for an already formed LLC.
A guaranteed payment amount is the difference between the agreed upon guaranteed payment and the year-end distribution you receive.
For example, if a partner has arranged for guaranteed payments of $20,000 and their distribution of the profit is $15,000, the guaranteed payment amount is the difference: $5,000.
If the yearly distribution of the profit is greater than $20,000, no guaranteed payment is made because the minimum payment is already met. Simply put, a guaranteed payment can never pay you more than the agreed upon amount.
Any guaranteed payments made are treated as business expenses and are tax deductible. This means they will affect your net income number.
Partner A and partner B have equal shares in their business. At year-end, the business posted a net profit of $50,000 meaning each partner records $25,000 as their share.
In the operating agreement, partners A and B agreed on $30,000 guaranteed payments as they grew their company.
Both partners A and B receive $30,000 by year-end: $25,000 from the distributions and $5,000 in guaranteed payments.
Guaranteed payments are paid out like a salary, but have some key differences.
These payments are not subject to any payroll taxes. Instead, these earnings are reported on each partner's form 1040 for income tax and on their Schedule K-1 for self-employment tax.
Guaranteed payments are reduced if an LLC is profitable. Whereas a salary is a set amount, guaranteed payments are reduced by any distributions of the LLC's profits.
But similar to salaries, guaranteed payments count against net income and are tax deductible. They are expenses that get reported on an LLC's form 1065 tax return.
A partner can also collect both guaranteed payments and a salary. This would require holding a salaried position in the LLC, not just holding an ownership position. For example, if a partner holds a job as the social media manager, they can collect a salary for that job and guaranteed payments.
Partner A and partner B have equal shares in their business. At year-end, the business posted a net profit of $50,000 meaning each partner records $25,000 as their share.
Partner A also holds a salaried position in the business running the paid advertisements. They earn $25,000 a year from this job.
Both partners A and B receive $25,000 from distributions. Partner A receives another $25,000 in salary.
Another way partners can get paid is through draws. With draws, money can similarly be taken from the business throughout the year. They can be recurring payments or taken as needed.
However, draws are treated as a prepayment of any profit distribution. Any draws taken throughout the year get taxed the same as year-end distributions and recorded on each partner's Schedule K-1.
Unlike guaranteed payments, draws are not treated as an expense and don't impact a business's net income.
Partner A and partner B have equal shares in their business. At year-end, the business posted a net profit of $50,000 meaning each partner records $25,000 as their share.
Partner A takes no draws throughout the year. But partner B has been taking $1,000 draws every month, totaling $12,000.
Partner A receives the full distributive share amount of $25,000 at year-end. Partner B, having taken $12,000 of their share throughout the year, receives a distributive share of only $13,000.
Guaranteed payments are taxable income. They are treated as ordinary income and self-employment income for tax purposes. For partners receiving guaranteed payments, the payments will be recorded on their Schedule K-1 and included as income on Schedule E of their form 1040. So partners pay income tax and self-employment tax on any guaranteed payments.
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