We help many clients with entity formation. In many cases, the entity of choice is a limited liability company in part because of the great flexibility a limited liability company offers. Inevitably, the conversation turns to how the client, as an owner of the limited liability company, can be compensated for performing services to the company. During the course of the conversation, the term guaranteed payment will most likely be raised. A guaranteed payment is a specific term in the Internal Revenue Code, which is defined as payments to a partner (in a partnership) or a member (in a limited liability company) in his or her partner or member capacity for services rendered to the partnership or limited liability without regard to the income of the entity.
Unless a special election is made to be taxed differently (such as an S corporation election), partnerships and limited liability companies (referred to as an “entity” or the “entities”) with two or more partners or members (referred to as an “owner” or the “owners”) are taxed on a pass-through basis meaning that income is passed through to the entity’s owners for tax purposes on their individual tax returns. Each owner then pays taxes on his or her “distributive share” of income.
Distributions from the entity are payments made to an entity’s owners based on each owner’s percentage ownership interest in the entity. If the entity does not make a profit, the entity will not have funds available to make a distribution to its owners. If an entity’s owner is managing the day-to-day operations of the entity on a full time basis, that owner is likely going to desire to receive a stable stream of income (akin to a salary). This is where a guaranteed payment comes into play.
Guaranteed payments are payments that an entity makes to an owner for managing the day-to-day operations of the entity and are made regardless of whether the entity makes a profit. In the case of guaranteed payments, in situations where the entity does not make any distributions from profits to the other owners, the owner who is managing the day-to-day operations still receives a guaranteed payment and is compensated for the work he is she is performing on a daily basis for the entity. In this way, the guaranteed payment for a partnership or an LLC is the functional equivalent of a salary to a shareholder-employee in an S or a C corporation.
Like a salary expense, the guaranteed payment is treated as an expense to the entity and may pass-through as a deduction to the entity’s owners. Owners who receive guaranteed payments are subject to self-employment tax. The entity will not withhold taxes on guaranteed payments, and the owner who receives a guaranteed payment will need to file an income tax return to report the guaranteed payments.