What Are LLC Guaranteed Payments?
Guaranteed payments are payments made to owners of an LLC (limited liability company) or partnership that are not part of the owner's income. The IRS says these payments are "determined without regard to the partner's income."
Before we look at guaranteed payments, we need to look at owners of LLC's (called "members") and partners in a partnership. The IRS doesn't recognize LLC's as tax entities. So, LLC's with multiple members are considered by the IRS as partnerships for tax purposes (unless they elect to be taxed as corporations or S corporations. That's why the IRS discusses these payments to LLC members under the category of partnerships.
LLC's and partnerships are typically paid from the income of the business, but they may want to give themselves a base income in years when the business income is low, or there is a loss. They can set up this base as a guaranteed payment, through the agreement between the owners (a partnership agreement or LLC operating agreement.
How Partners and LLC Members Are Paid
Partners in a partnership and LLC members can be paid in several ways. Two common types of payments are distributive share and guaranteed payments:
Distributive Share: They can receive a share of the income of the business, based on the agreement between the owners. For example, if Tom and Teresa each own 50 percent of an LLC, each will be paid 50 percent of the profits. If the profit (net income) for a year is $80,000, each owner could be paid $40,000.
Because the partnership or LLC itself doesn't pay income tax on the net income of the business, the owners must pay that tax. Taxes must be paid on the business net income even if no actual money is distributed to the owners.
Guaranteed Payments: Some minimum payment may be guaranteed to each owner, no matter how much profit the business makes. In the case above, each owner might be guaranteed $25,0000.
How Guaranteed Payments Are Taxed
A partnership or LLC doesn't pay taxes on business income. Instead, these businesses are considered pass-through entities, meaning that the income passes through to the owners. The IRS considers guaranteed payments as ordinary income to the owners. This guaranteed payment is considered a deductible expense to the business. If the owner's share of net income is greater than the guaranteed amount, there is no guaranteed amount for that year.
Is a Guaranteed Payment a Salary?
From the standpoint of payroll taxes, guaranteed payments are not salary. But from the standpoint of tax-deductible expenses to the company, LLC guaranteed payments are treated in the same way as salary.
Partners and LLC members are not paid a salary in their positions as owners. A partner or LLC member may be paid a salary as an employee, but this payment has nothing to do with payments to the owner as an owner through the ownership agreements. If an LLC owner is paid a salary as an employee, the IRS requires that federal income taxes and FICA taxes (Social Security and Medicare) be withheld from the employee's pay.
If a partner or LLC member receives a guaranteed payment, the IRS doesn't require that withholding is taken from the guaranteed payment. But the company may treat these payments as tax-deductible business expenses, in the same way as salaries and wages to employees are treated.
Guaranteed Payments: An Example
Alex is a member of an LLC. The LLC operating agreement states that he has a 40 percent share of the LLC profits each year and that he has a minimum guaranteed payment amount of $25,000.
This year, the LLC net income is $50,000 so Alex's share is $20,000 (40 percent of $50,000). Since he has a guaranteed minimum of $25,000, $5,000 is considered as his guaranteed minimum and the other $20,000 is his distributive share. Remember, Alex must pay tax on his share of the profits even if he doesn't receive all—or any—of that money. The LLC could take a tax deduction for the $5,000 considered as guaranteed payment.
If the net income of the partnership was $70,000, Alex's share would be $28,000 and no guaranteed payments would be made. There is no guaranteed minimum for that year, so the partnership can't take a tax deduction for this payment.
How Guaranteed Payments Are Included in Tax Returns
If the partnership or LLC has made guaranteed payments during a year, these payments are included on the partnership tax return (Form 1065) on Line 10, as business expenses.
The partner or LLC member receives a Schedule K-1 with information on the amount of the guaranteed payment and any distributive share for the year. Information from the Schedule K-1 is entered on the owner's income tax return on Schedule E and it's added in with the person's other income to determine taxes.
Disclaimer: This discussion is a general, simplified example of how guaranteed payments work. It is not intended to be tax or legal advice. The topic is complicated, and each business is different. Read more about guaranteed payments in IRS Publication 541-Partnerships and consult your tax and legal professionals before you create agreements or pay business owners.