Guaranteed Payments LLC: Everything You Need to Know
When a company has multiple members, this is called an LLC. LLCs are treated like a partnership by the IRS for federal income tax purposes.7 min read
Guaranteed Payments: The Equivalent of a Salary for LLC Members and Partners
When a company has multiple members, this is called an LLC. LLCs are treated like a partnership by the IRS for federal income tax purposes. The treatment comes with various tax benefits that can make the LLC entity type a preferred format over the corporation for some businesses. LLCs offer limited liability protection without the double taxation of a regular corporation. As a member of an LLC, members receive payments in one of two ways. They may receive payment through a salary or any other form of planned and recurring payment.
Second, they may have payments that hinge upon the company's financial performance, such as profit-sharing plans. In particular, LLCs are set up to not pay corporate taxes. All earnings are reported on a Schedule K, which is filed with the IRS and distributes all profits to members' individual taxes.
Something called a “pass-through” taxation leaves all the LLC's taxes to be paid by members. Guaranteed payments have limited effect on the overall tax rate paid by a member: Either funds are held as earnings within the LLC and taxed by passing through to individual returns or are paid out as guaranteed payments, which are then taxed as self-employment income.
The IRS says salary payments and other payments are considered guaranteed payments, and profit-sharing payments are called distributions. Because of the nature of guaranteed payments, the LLC receives tax advantages for all guaranteed payments that it makes to members.
Because special elections are taxed differently than other types, partnerships and limited liability companies are referred to as “entities” when they have two or more partners or members. These are referred to also as the owners and are taxed on a pass-through basis for federal income taxes purposes.
Such entities are not subject to a direct federal income tax. A guaranteed payment is a term in the Internal Revenue Code that refers to payments to a partner for services or the use of capital if that payment was determined without regard for the income of the partnership. The court has stated that a partner is acting as a partner in capacity when they are performing services which are ongoing and vital to the business of that partnership.
Guaranteed payments of revenue made to owners of an LLC, can have tax benefits attached that are not applicable to other types of payments. Any payment that's scheduled regularly to a member of the LLC for any services rendered that aren't predicated on the income of the LLC, such as salary, should be treated like a guaranteed payment.
The benefit for an LLC is that guaranteed payments are deductible through the LLC as company expenses, and the net profit of an LLC is reduced by that sum. The disadvantage for the member who receives the guaranteed payment is that said payment is treated like ordinary income.
Like with ordinary income, the guaranteed payments don't have to pay income tax and the FICA tax from a salary would be paid. However, the guaranteed payments are subject to self-employment taxes and estimated income taxes. Also, if health insurance premiums are paid through the LLC on behalf of a member for rendered services, then said premiums are also treated like guaranteed payments.
Guaranteed payments have additional ramifications that are relative to the member's capital account in an LLC, especially if the LLC is losing money. An LLC is treated as a pass-through entity by default by the IRS unless the owners, known as members, elect to be treated as a corporation. A pass-through entity does not pay taxes on its profits at the business level.
The entity passes a proportionate share of profits and losses through to the members, who then record their share on personal income tax returns and pay taxes on the share at an individual rate.
- Distributions, or payments, of excess profits made to members of an LLC, are constrained by the company's status as a pass-through entity.
- Distributions are one-time payments made from profits as investment income for members as a return for investing in the company.
- The IRS treats payments differently from guaranteed payments and allows cash distributions to be made to members without incurring self-employment taxes.
- Distributions are typically provided relative to previous or current earnings for that year, or in liquidation of the LLC or a member's interest. In contrast, guaranteed payments are made irrespective of earning considerations.
- Cash distributions are typically considered as a return of the member's previously taxed income or capital.
Using cash distributions in order to pay a salary risks the company of the IRS reclassifying the distribution as a guaranteed payment and subjecting the payments to self-employment taxes, interests, and penalties. Although the IRS relieves the LLC of much of the tax burden associated with guaranteed payments, the partners take up the slack.
Partners must make estimated income tax payments each quarter on all funds received through guaranteed payments. Members should be careful not to use one-time cash distributions as a means to pay salaries, as the IRS may reclassify payments as guaranteed payments and require members to make good on all self-employment taxes associated with that type of income. LLC members must also pay self-employment taxes on all guaranteed payments on their individual taxes.
Self-employment taxes are 13.3 percent on the first $106,800 in earnings, and 2.9 percent on all earnings beyond that. There is some flexibility, though for LLCs and there are benefits for small businesses. The owners pay taxes based on the distributive share of their income. Instead of receiving the income from the entity as a paycheck with wages, the owners are given a payout in income in the form of a capital distributions. These distributions are payments that the LLC makes to owners in respect to the ownership.
Typically, the distribution amount that an owner is entitled to is determined based on the ownership interest percentage in the relative entity to that of other owners. When an entity doesn't earn a profit, the entity typically won't make a distribution to the owners.
This could be problematic if the owner is involved heavily in any day-to-day operations and will need a continuous stream of income that they can live on or the owner's percentage ownership interest doesn't actually reflect the value that the owner brings to the entity in regard to time commitment, experience, or other expertise. These call for a guaranteed payment.
Guaranteed payments are payments that an entity makes to an owner whether the entity makes a profit or not. Unlike distributions, however, even if the entity loses money in a year and does not pay any profits out to the other owners, the owner who gets a guaranteed payment will still be compensated for the work rendered for a certain year.
The payment that's guaranteed for an LLC or a partnership is the functional equivalent of a salary to a shareholder-employee in a C or S corporation. The guaranteed payment is then treated like an expense to that entity and may pass through like a deduction to entity owners. Every payment to members as a salary are treated similarly to a business expense, which reduces any taxable sum reported on the LLC's Schedule K.
The guaranteed payment factors into the performance of the entity, so that to the extent any net income is not paid out to the owners as a guaranteed payment, the excess net income is typically divided among the owners as a distribution. Owners are subject to self-employment taxes on distributive share of income and guaranteed payments. The business won't withhold taxes on any of the payments, and the owners need to file income tax returns that are estimated.
Guaranteed payments are usually deductible by the business through Form 1065 as a business expense. Guaranteed payments are also found on Schedules K-1 and K of the partnership return. The individual partner should report guaranteed payments on Schedule E of the IRS Form 1040 as typical income, along with the distributive share of the partnership's other ordinary income.
Owners of startups who need assurance of a consistent salary-type payment, which may not be proportionate to the percentage ownership interest of the company, do not need to insist on using a C corporation or S corporation which they will do business. These owners should consider whether a partnership or LLC is the best entity type since the fact that a guaranteed payment might be used to achieve compensation goals.
Types of Distributions
LLCs provide two different kinds of payments to their members:
Draws are able to be taken at any time and are an advance on profits that are expected and would be allocated to the member at the end of the year.
Draws aren't usually guaranteed unless the member manages the company and the draw is for the member's salary. The members aren't considered employees of the company if it was organized as a corporation. Guaranteed draws are used as an alternative to a salary, and they ensure that a member who is running the everyday operations of the business is paid for the services before other members get payments out of the profits. The other kind of payment — distributions — is handed out at the end of the year and is a member's proportionate share of the business's earnings.
Treatment of Taxes
A guaranteed payment or draw is used like the LLC equivalent of salary to managing members. A guaranteed payment has specific benefits with taxes. The managing member has to pay the entire amount of the employment tax.
Benefits to Taxes
A managing member who gets part of the company's revenue as a guaranteed payment or draw will only end up paying about 7 percent taxes, or about 1/2 the sum of the employment tax rate, on the amount. The Internal Revenue Service considers the managing member as active in the daily business of the LLC and provides a deduction of 1/2 the employment taxes on the managing member's tax return. Most members of the LLC view the lower tax rate applicable to guaranteed draws treated as wages as a great benefit.
If you need help with any issues surrounding guaranteed payments for LLCs, you can post your legal need on UpCounsel's marketplace. UpCounsel accepts only the top 5 percent of lawyers to its site. Lawyers on UpCounsel come from law schools such as Harvard Law and Yale Law and average 14 years of legal experience, including work with or on behalf of companies like Google, Stripe, and Twilio.