Guaranteed Payments Explained (2024)

In partnerships and most limited liability companies (LLCs), the business owners don’treceive salaries. Instead, they get a share of the profits. That can be problematic if thebusiness makes little or no profit — which is often the case in the early stages of anew venture. Guaranteed payments are a way to solve the problem. They reward partners fortheir services by guaranteeing them a minimum payment, whatever the company’sprofitability. Here’s a breakdown of how guaranteed payments work, how they compare toother types of income, their tax implications and how to track them with software.

What Are Guaranteed Payments?

Guaranteed payments ensure that a partner gets a guaranteed minimum amount, even if thebusiness makes little or no profit. The partners must establish the initial terms for theseguaranteed payments when they form the business, as part of their operating agreement. Theoperating agreement should set out the guaranteed payment value and the payment schedule foreach partner.

A lot of growing businesses are structured as partnerships, including many LLCs. Examplesinclude legal, accounting, consulting and other professional services firms, but there aremany others. In these businesses, the partners don’t get paid salaries — theyare rewarded by receiving a share of the profits. However, businesses don’t alwaysmake a profit, especially in the startup phase. But some of the partners may need a steadyincome, especially if they’re working full time to build up the business.

Guaranteed payments are often designed to reward partners for their contributions to thefirm’s success, such as their labor, management skills or ability to bring in newbusiness. For example, Mary plays the lead role in a consulting business partnership,managing day-to-day operations and helping to bring in new clients. The partnership’soperating agreement states that Mary should be guaranteed $50,000 per year. Mary willreceive payments of $2083.33 two times a month as outlined in her payment schedule.

Key Takeaways

• Guaranteed payments in partnerships and LLCs can provide partners with a reliable incomestream, even if the business is not profitable.
• Guaranteed payments stipulate that a partner must receive at least a minimum amount eachyear.
• Partners must establish the guaranteed payment amounts and payment schedule at the timethe company is formed, as part of their operating agreement .
• The partnership records guaranteed payments as business expenses, and partners reportthem as ordinary income on their personal tax returns.

Guaranteed Payments Explained

Guaranteed payments are typically structured to ensure that partners receive at least aminimum income amount every year. But the portion of that amount that’s designated asa guaranteed payment can depend on how much profit they receive from the partnership.Here’s an example illustrating how this works.

Paige and Perry own equal shares in their partnership. Their operating agreement specifiesthat each partner gets 50% of the net income — but not less than $40,000 per year.

At the end of the first year, the business posts a net profit of $20,000. Since each partnergets 50% of the net income, that’s $10,000 for each partner. In addition, each partnerreceives a $30,000 guaranteed payment to top up the amount to the minimum of $40,000 spelledout in the operating agreement.

In its second year, the business experiences healthy growth and net income surges to$100,000. Each partner receives a profit distribution of $50,000, or half of the total netprofit. Because each partner’s share of the profit exceeds the $40,000 minimum definedin the operating agreement, no guaranteed payments are made.

Guaranteed Payments vs. Salaries vs. Draws

Business owners and partners can receive payment in a variety of ways, depending on certainfactors, such as the structure of the business. Guaranteed payments are one method; drawsand salaries are others. It’s important to understand the differences.

• Guaranteed payments are used by businesses structured as partnerships,including LLCs. With these types of business, partners don’t take salaries, soguaranteed payments are a way to ensure that they get a steady income stream, even ifthe business doesn’t make a profit. The amounts and timing of guaranteed paymentsmust be defined in the business’s operating agreement. Guaranteed payments aretreated as business expenses bythe partnership. Payroll taxes are not withheld on guaranteed payments.
• Member Draws are used by partnerships and also by sole proprietorships.Owners simply transfer cash periodically from the business to themselves, typically whenthe business has adequate cash available. Draws are considered to be reductions in theowner’s equity in the business, not business expenses. Compared to guaranteedpayments, draws provide a more flexible way to remunerate business owners. Unlikeguaranteed payments, draws don’t have to occur according to a predeterminedschedule, and their amounts are not fixed. Payroll taxes are not withheld on draws.
• Salaries are paid by businesses that are structured as S or Ccorporations, as well as LLCs that are taxed as corporations. Business owners aretreated as employees and are paid a regular salary. Payroll taxes are withheld onsalaries.

Guaranteed Payments to Partners and the IRS

Partnerships and most LLCs are treated as pass-through entities for tax purposes. This meansthat unlike a corporation, the business doesn’t pay income tax itself. Instead, theprofits (or losses), as well as any guaranteed payments, pass through to the owners. Theowners then report those payments on their personal tax returns and pay income taxes on themoney they receive. The partnership must also report its profit to the IRS and provide abreakdown of each partner’s share of the profit.

Guaranteed payments are recorded as business expenses by the partnership, so they reduce thebusiness’s net profit. Expense managementsoftware can help companies make sure they accurately track these businessexpenses.

Each partner includes their guaranteed payment, along with their share of the profit, ontheir personal tax return. Partners pay income tax on their guaranteed payments and profitdistribution; both items are taxed as ordinary income.

The IRS considers partners to be self-employed when they are performing services for thepartnership, so partners must additionally pay self-employment taxes on their guaranteedpayment. General partners — those who play an active role in business operations— also pay self-employment taxes on their share of the profits. Limited partners, whoaren’t involved in day-to-day operations, generally pay self-employment taxes only onany guaranteed payments they receive.

The 2018 Tax Cuts and Jobs Act has complicated the tax picture for guaranteed payments.That’s because it allows partners to deduct 20% of the partnership’s qualifiedbusiness income (QBI) from their federal tax liability. Because guaranteed payments aretreated as a category of businessexpense, they reduce the business’s QBI and the corresponding deductionamount. So, in some cases, partners could pay less income tax if a smaller portion of theirincome comes from a guaranteed payment and a larger portion comes from a profitdistribution.

Further complicating the picture, partners may be subject to a variety of state and localtaxes on their guaranteed payments and profit distributions.

Fiscal Year and Calendar Year Considerations for Guaranteed Payments

The timing of guaranteed payments can have a significant impact on partners’ income andtax liability — especially if the partnership’s doesn’t coincide with thecalendar year. That’s because a partner must report guaranteed payments in thecalendar year that includes the end of the partnership’s corresponding fiscal year.

For example, consider a partnership whose fiscal year ends in September 2023. The partnershipmakes guaranteed payments the following month, in October 2023 — early in its 2024fiscal year. Accordingly, the partnership records the expense during its 2024 fiscal year,which ends in September 2024. Partners must report the guaranteed payment on their 2024 taxreturns — even though they received the money during 2023.

Track Your Business Expenses and Stay Compliant With Software

For growing businesses, tracking income and expenses — including guaranteed payments— can quickly become extremely complex, time-consuming and error-prone. automates andsimplifies the entire accounting process faster. Businesses can customize workflows andapproval processes to meet unique requirements. Real-time dashboards and analytics toolsenable finance teams to track business performance and drill into details. And becauseNetSuite is cloud-based, you can access data from anywhere at any time, not just whenyou’re in the office. As your business grows, NetSuite’s expense managementsoftware seamlessly integrates with NetSuite financial management and other applicationswithin NetSuite’s unified ERP platform, including inventoryand order management, HR, CRM and ecommerce.

Guaranteed payments are a way to reward partners with a steady, predictable income,regardless of whether the business is making a profit. They’re particularly usefulearly in the life of a business, when the partnership isn’t yet generating muchprofit. It’s important to remember that the payments must be defined in thepartners’ original operating agreement and that they require careful tax-reportingtreatment.

Guaranteed Payments FAQs

What is the relationship between guaranteed payments and profit sharing distributions?

The balance between guaranteed payment and profit distribution varies, depending on how muchprofit the business makes. Guaranteed payments come into play if a partnership’soperating agreement specifies that a partner should receive a minimum amount each year. Ifthe partner’s profit distribution isn’t enough to reach that minimum, aguaranteed payment is made to make up the difference.

What are the benefits of guaranteed payments?

Guaranteed payments provide partners with a reliable income stream, especially during thebusiness’s startup period. Guaranteed payments also benefit the partnership in severalways. The guaranteed payments to a partner are deducted as expenses, therefore reducing theprofit and tax burden passed through to other partners. The partnership’s operatingexpenses are also more predictable.

Are guaranteed payments included in income?

For the partnership, guaranteed payments are recorded as business expenses. Partnersreceiving guaranteed payments report them as ordinary income, subject to their individualand self-employment tax rate.

What is the difference between a guaranteed payment and a distribution?

A distribution is a share of the business profits. Guaranteed payments are an amount that is“guaranteed” to be paid, regardless of the partnerships’ profitability.