If you are starting a business, then you have faced this question: guaranteed payments or draws? If you have owner-operators and outside money (e.g., friends and family or angel investments), read on. You have some thinking to do. (Let me save you sole-member LLC’s some time. You can stop reading here unless you’re planning for some changes or are really curious. For you, there is little difference between guaranteed payments and draws. You can go back to managing your business.)
When to Start Making Guaranteed Payments
In general, most people start making a guaranteed payment when:
- The startup is moving forward, and
- The managing member needs a steady income to live on, and/or
- There is outside investment money coming in.
In this example of guaranteed payments, the founder was able to make money while the investors lost money. Why? The guaranteed payment acts like a salary in that it becomes an expense of the company which factors into the performance of the company.
The guaranteed payment compensates people for their time, while the Draw typically compensates people for their ownership percentage. The LLC agreement is important here – likely, the named Manager of the LLC determines the guaranteed payment amount, and the LLC agreement defines the draw split. This structure allows the owner operator to put food on the table while building the company.
What would it look like if they had just had a draw with no guaranteed payment? Something like this.
Now let’s consider a boot-strapper example (one where no investors are involved). Guaranteed payments can also be used as a mechanism to settle up costs between two business partners when something is out of whack with the ownership split. Let’s say there is 50/50 ownership. Founder 1 has healthcare through their spouse’s company, but Founder 2 pays for healthcare insurance (we’ll say $1800/month) through the LLC. This can be made up through guaranteed payments.
Another use case for guaranteed payments would be if 50/50 owners decide to pay by role rather than by ownership split. So if Founder 1 has a VP title, but Founder 2 is the CEO, and they want the paychecks to reflect the difference in roles/responsibilities, they could use guaranteed payments to pay Founder 2 more.
Using these examples, you can play with different scenarios (e.g., what if you had a loss, etc.) As you go through the decision-making process, some additional considerations:
- Is taking tax losses beneficial or acceptable?
- Do you want the founder to get compensated before the partnership is profitable?
Guaranteed payments are made irrespective of partnership profits. These payments are taxable to the founders as compensation, and deductible by the LLC. That structure makes founders responsible for all income/payroll taxes associated with the guaranteed payments, meaning that you could pay taxes even if the partnership loses money.
Bottom line, it is never a bad idea to run your plans by your tax advisor before you implement a payment structure.
If you’re interested in a free tax consultation, the experts at Acuity would be happy to help.
Guaranteed Payments FAQs
Can an LLC have guaranteed payments?
Yes, an LLC can make guaranteed payments to its members. Essentially, a guaranteed payment is a way for the LLC to compensate a member for their services rendered to the LLC. However, this only makes sense for LLCs that have two or more members.
How are LLC guaranteed payments taxed?
LLC guaranteed payments are earned income and are subject to income tax and self-employment tax. That means the LLC member is going to pay 15.3% self-employment tax on their guaranteed payments, in addition to the ordinary federal and state income tax rates.
Guaranteed payments can also be subject to the additional Medicare tax of 0.9%. On the flip side, owner operators may be able to put some of the LLC guaranteed payments into tax-deferred retirement plans, such as a SEP IRA or 401(k).
Can guaranteed payments create a loss?
Theoretically, yes, guaranteed payments can create a net loss for the LLC. This is because guaranteed payments are considered a tax-deductible expense to the LLC.
Sometimes this happens when an LLC is first starting up or is operating in lean years. If the LLC does not have enough revenue, it might have to spend its own capital to pay out guaranteed payments so that LLC members can continue to earn a living.
What is a guaranteed payment? Is a guaranteed payment a partner draw? Are guaranteed payments the same as distributions?
A guaranteed payment is compensation paid by the LLC to its members for services rendered. LLC members can earn money from the LLC in two ways:
- By providing services in exchange for a guaranteed payment, and/or
- By sharing in the net profits of the LLC.
Guaranteed payments are not the same as draws or distributions. The difference is this – the LLC can decide to pay out its net profits to the LLC members, and this is called a distribution.
Distributions might happen only so often, such as once a year after the LLC has analyzed its financial situation and decided how much profits the LLC can prudently distribute to its owner members. Sometimes LLC members cannot wait for the distribution to happen, so the members might be able to take a draw against their future distributions.
At the end of the year, the LLC reviews all the draws to determine if any of the draws are really guaranteed payments as well as determine exactly how much additional money to pay out in distributions of profit.