As Limited Liability Companies (“LLCs”) have become more popular and prevalent, many clients have begun asking about guaranteed payments (“GPs”); specifically, what are they and why do they matter? But, perhaps the more important question is, how do they affect my tax liability? In this article, we’ll introduce GPs and hopefully dispel some of the mystique behind this rather generic type of payment.
First, what this article is and what it is not. This article will provide the reader with an introduction to GPs, where to find them, how they are reported, and how they are taxed. This article is not a dissertation on LLC or partnership accounting and the myriad complexities therein. [If you’re interested in learning more about partnership accounting, McGraw-Hill has a free site here that provides a very nice treatise on partnership accounting. Or, if you have insomnia, pick up a book at Amazon or your nearest University bookstore on partnership accounting and taxation.] Second, it’s important to remember, for purposes of discussion in this article on GPs, that LLCs are accounted for in the same manner as partnerships. That is, LLC members and partners in a partnership are taxed based on their distributive share of the profits of the LLC or partnership. So, while this article addresses GPs within the LLC context, much of the content of this article will apply to partnerships as well. With those important notes out of the way, here we go. So to clarify, while an LLC may elect alternative treatment for tax purposes, this discussion concerning GPs, takes the form of an LLC reporting as a partnership.
An LLC affords its owners or members, limited liability, without many of the risks and aggravations of maintaining a corporation. Like shareholders of a C-corporation, all LLC owners are protected from personal liability for business debts and claims. This means that if the business itself can't pay a creditor, the creditor, in most cases, cannot legally attack an LLC member's personal assets (NOTE: Do not be fooled; there are always exceptions to this liability protection). Consequently, because only LLC assets are used to pay off business debts, LLC owners are only at risk for the capital they've invested in the LLC. Thus, the term “limited liability." In addition, unlike C-corporations but similar to S-corporations, LLCs are not taxed at the entity level (but they do file an information return on Form 1065). Rather, the profits of the LLC are passed through to each member via distributions and taxed on the member’s individual income tax return.
Distributions from an LLC
Because LLCs are treated, for purposes of this discussion of GPs, as partnerships (remember, partnership accounting from above) for federal tax purposes, LLCs follow the same basic compensation and cash flow schemes as partnerships. This includes the distributions of profits to LLC members.
Types of Distributions
LLCs make two basic types of payments to members: distributions and guaranteed payments. Distributions (also known as ‘draws’) can be made at any point in time and represent an advance on expected profits to be allocated to the member at the end of the year. Distributions are not a deductible expense of the LLC; rather, they are simply a reduction in the member’s capital account (which was previously increased by the member’s share of net profits). Guaranteed payments, on the other hand, can be used as a substitute for salary, and are guaranteed regardless the profits or losses of the business. These are payments to compensate a member for his services before other members receive distributions out of profits. And, unlike distributions, GPs are considered a deductible expense of the LLC.
Using a very basic example, under the LLC Operating Agreement, Joe has been guaranteed to receive 25% of the LLC net income (his ownership interest in the LLC), but not less than $10,000. In 2013, the LLC has net income of $30,000. Joe’s share of the profits, without regard to the minimum guarantee, is $7,500 (25% × $30,000). However, since Joe is ‘guaranteed’ $10,000, he receives his $7,500 profit distribution and a guaranteed payment of $2,500 ($10,000 − $7,500). Joe’s income from the partnership is $10,000, with $7,500 reported on Line 1 of Joe’s Form K-1 and the $2,500 guaranteed payment reported on Line 4 of Joe’s Form K-1. Conversely, had the LLC’s net income been $50,000, no guaranteed payment would have been paid to Joe since his share, without regard to the guarantee, would have been more than the guarantee ($50,000 x 25% = $12,500). [Yes, I know, in this example, I did not deduct the GP prior to calculating the distributive profits, but as I said, this was a very basic example designed to give the reader the flavor of GPs.]
As explained, GPs are often used as the LLC equivalent of salary to certain members, and, as a result, GPs have tax attributes that must be understood. At the LLC level, since GPs are the de facto equivalent of wages, GPs are deductible as an expense in determining the net profit of the business. At the member level, assuming the LLC member is an individual, the IRS treats GPs like wages and requires members to pay self-employment taxes and make estimated tax payments. (Self-employment taxes are both the employer and employee portions of FICA and Medicare, currently totaling 15.3% of the GPs received.) So, short of paying the ‘employer’ side of FICA/Medicare, and making estimated tax payments, you can pretty much think of the taxation of GPs in a similar fashion you would wages reported on Form W-2.
GPs are reported in a variety of locations in the array of tax forms, so the practitioner reporting GPs or the recipient receiving GPs should have an understanding of where to find them. GPs will appear on the following forms:
- Line 10 on Page 1 of Form 1065 (the tax form used by LLCs and partnerships)
- Line 4 on Schedule K to Form 1065 (currently located on page 4 of Form 1065)
- Line 4 on Page 1 of Schedule K-1 to Form 1065 (for each owner who receives them)
- Schedule E to Form 1040 (although it is not separately listed from the taxable amount listed for the LLC)
With the ever-increasing popularity of LLCs, understanding what GPs are, how they affect an LLC return, how they affect an individual return, and how to account for them is vital for tax preparers. If you’re interested in further information on LLC/partnership accounting and taxation, I’ve listed a few sites below with additional information:
Form 1065 - http://www.irs.gov/pub/irs-pdf/f1065.pdf
Form K-1 - http://www.irs.gov/pub/irs-pdf/f1065sk1.pdf
IRS web page on Partnerships - http://www.irs.gov/Businesses/Small-Businesses-&-Self-Employed/Partnerships
IRS Publication 541 - http://www.irs.gov/publications/p541/index.html
BNA’s “Accounting by Partnerships” - http://www.bna.com/Accounting-Partnerships-Research-p7427/ (you’d better be serious here; BNA charges $400 for this publication)