Got paid?
As a business owner, there are two main ways to pay yourself and your partners: The draw method and the guaranteed payments method.
Draw Method: With this approach, you have the flexibility to withdraw money from your business earnings as needed. This gives you the freedom to adjust your compensation based on business performance.
Guaranteed Payments Method: This approach is a fixed, regular income (similar to a salary), giving you more stability in your personal finances.
So, when it comes down to which method to use, it’s not an either-or thing. If you’re a sole proprietorship, partnership, or multi-member LLC, you’re definitely using draws. The question is: when do I add guaranteed payments into the mix?
The answer depends on your business’s structure, if you have owner-operators and outside investments from family, friends, or angel investors, and how involved you are in the day-to-day operations of your business.
What if I have a sole-member LLC or corporation?
For a sole-member LLC, there is little difference between guaranteed payments and draws. You can stop reading unless you’re planning to make some changes.
For a corporation, owners and shareholders are paid with salaries and dividends or distributions because:
- It’s a fair way to share profits based on ownership, and
- It also has tax advantages.
You typically won’t want to use draws or guaranteed payments because these methods don’t fit well with your legal structure and tax implications.
What is a Draw?
An owner’s draw – or draw for short – is the amount of money that owners or partners take out of the business’s profits for their personal use.
If you’ve got a sole proprietorship or a single member LLC, draws may be more flexible and informal. Since you’re the only owner, you can take out money without a set schedule.
In a multi-member LLC or a partnership, your partnership or operating agreement will typically lay out the rules for taking owner’s draws.
But regardless of your entity type, most entrepreneurs receive an owner’s draw as a percentage of the business’s profits, based on how much of the business they own.
In other words, you’re getting paid based on two factors:
- Your business’s earnings
- Your ownership stake
It’s smart to calculate your owner’s draw that way. You get rewarded when your business does well, and you keep your compensation reasonable.
However, it’s still critical to understand how much your business can afford to pay you. You may not be able to receive the same percentage of profits forever.
Why? Well, your business’s cash needs can change over time. And paying yourself too much can hurt your business’s cash flow and make it harder for your business to survive. That’s why consistent budgeting and forecasting are so important.
Consider working with an accounting professional to review your profit and loss statements, balance sheets, and cash flow projections to see how much you can afford to pay yourself while still reinvesting money back in for business growth.
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What is a Guaranteed Payment?
A guaranteed payment is the fixed amount that owners or partners agree to receive, no matter how the business performs.
In other words, it’s a set salary, ensuring you’re compensated for your time and effort!
Guaranteed payments can be a useful form of compensation when there are multiple members or partners in a business, and they are each working a different amount in the business. For example, if one partner is working significantly more in the business, they might receive guaranteed payments while the other does not. Both partners could still receive draws, though, based on their ownership percentages.
Since guaranteed payments are a set salary – one that doesn’t take into account how well your business is doing – you’ll want to be mindful here, too.
If your business is struggling, these payments could strain your company’s finances. The key is to balance fair compensation with what your business can afford.
We recommend meeting with your accountant at least once per year to reassess your guaranteed payments based on your business’s performance.
You might want to review your guaranteed payments more often depending on:
- The nature of your business
- Cash flow fluctuations
- Business expansion
- Major contracts
- Market changes
- Tax law changes
When Should I Start Making Guaranteed Payments?
Now, this is the ultimate question. As your business grows or becomes more complex, you might opt for guaranteed payments to ensure a set salary as well as a clear agreement among partners.
In general, most people start making guaranteed payments when:
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- The startup is growing,
- The managing member needs a steady income to live on, and/or
- There is outside investment money coming in.
As you go through the decision-making process, here are some additional considerations:
- Choosing guaranteed payments to pay yourself means you’ll have a steady salary, but you’ll also be responsible for all income and payroll taxes associated with those payments.
- Guaranteed payments are made without regard to business profits. These payments count as employee income, and the business can often deduct them.
- It’s not a one-size-fits-all decision. You should consider your business’s ownership structure, financial health, and goals.
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How to Pay Yourself and Your Partners Based on Ownership Structure
Guaranteed payments and draws are not a one-size-fits-all approach. You need to consider your business’s ownership structure!
Sole Proprietorships
As the sole owner of your business, you’ll most likely stick with paying yourself through draws. Why? Well, there’s no need to reconcile different contributions between partners, members, investors – it’s just you!
If your business’s income fluctuates, take bigger draws in good months and smaller draws when times are lean.
Partnerships
Guaranteed payments are common additions in partnerships.
Think back to the example we gave earlier: one of two partners might opt to receive guaranteed payments if they’re doing more work in the business. This levels the playing field and allows both partners to get paid with draws, while one partner is given guaranteed payments to supplement their draws.
If you’re in a partnership, think about how your business makes money and what you and your partners need. It may be beneficial to talk with a financial expert to make the best choice for you and your business.
After all, this decision will shape how you and your partners interact financially within the business! The right choice can foster a healthy partnership and contribute to the success of the venture.
Limited Liability Companies (LLCs)
In a multi-member LLC, the structure becomes more complex because members usually have different roles, contributions, and ownership percentages, so you’ll almost always see some sort of combination of guaranteed payments and draws.
In LLCs, guaranteed payments are often used if you are actively working in the business and want a fixed share of income. For example, in a three-member LLC, where all members are involved in day-to-day operations, guaranteed payments can be a fair way to compensate for individual efforts.
It’s important to note that this added flexibility in the LLC structure can create complexity in managing payments, taxes, and agreements among members. And of course, it usually requires more careful planning and legal or financial guidance to make sure that everything is fair and in compliance with the law.
Head over to our blog on ownership structures for more on how each type is taxed and which option is best for your startup.
4 Examples to Help You Understand Your Options
Example 1:
You founded an LLC. You get 80% of any earnings, while an outside investor gets 20%. (These are the draws.)
You opt to receive $75K in guaranteed payments for your efforts. By year-end, the business profits total $50K. So, after deducting your guaranteed payment, the business faces a $25,000 loss.
See the breakdown for you and your investor below:
In this first example, the founder was able to make money ($55,000) while the investor lost money ($5,000). 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.
This structure allows the owner operator to put food on the table while building the company.
What would it look like, though, if they just had a draw? Something like Example 2.
Example 2:
You founded an LLC. You get 80% of any earnings, while an outside investor gets 20%. (These are the draws.) You do not receive any guaranteed payments. By year-end, the business profits total $50K.
See the breakdown for you and your investor below:
In the example above, you and your investor are only using draws to split profits, so it’s solely based on ownership percentages.
Example 3:
Now let’s consider a boot-strapper example – one where no investors are involved.
You co-founded an LLC. You (Founder 1) and your co-founder (Founder 2) each get 50% of any earnings. (These are the draws.)
You have healthcare through your spouse, but your co-founder pays for healthcare insurance through the LLC at $1,800/month. Instead, you receive a guaranteed payment of $1,800/month.
Your company’s net income is $50K after guaranteed payments.
In this example, you and your co-founder are compensated equally by adding in guaranteed payments.
Example 4:
Another use case for guaranteed payments is 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. Let’s look at this in Example 4.
You co-founded an LLC. You (Founder 1) and your co-founder (Founder 2) each get 50% of any earnings. (These are the draws.)
You’re a VP and receive $100K in guaranteed payments. Your co-founder is the CEO and receives $150K in guaranteed payments.
Your company’s net income is $250K after guaranteed payments.
In this example, you and your co-founder are compensated with guaranteed payments to reflect the difference in roles and responsibilities at your company.
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Frequently Asked Questions
Can guaranteed payments create a loss?
Theoretically, yes, guaranteed payments can create a net loss. This is because guaranteed payments are considered a tax deductible expense.
Sometimes this happens when your business is first starting up or is operating in lean years.
If you’re not generating enough revenue, you might have to spend your business’s own capital to pay out guaranteed payments so that members can continue to earn a living.
How do self-employment taxes affect guaranteed payments and draws?
In the case of guaranteed payments, these are considered self-employment income for partners in a partnership or members of an LLC taxed as a partnership.
This means the recipient must pay self-employment taxes, including contributions to Social Security and Medicare. The amount is usually a fixed figure, paid out regardless of business profits or losses.
Draws, conversely, are not directly subject to self-employment tax. Instead, they influence the owner’s share of the business profits or losses. These profits or losses are then reported on the owner’s individual income tax return, where the self-employment tax applies.
Can an LLC have guaranteed payments?
Yes. 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.
What are guaranteed payments to partners?
Guaranteed payments to partners are payments made by a partnership to one of its partners that guarantee a certain minimum compensation regardless of the partnership’s income or profits.
These payments are usually used to compensate each partner for services they have provided or to provide financial security for a partner who has invested in the business but does not actively participate in managing it.
Guaranteed payments are considered taxable income and must be reported on the taxpayer’s annual income tax return.
Guaranteed payments vs. distributions – what's the difference?
Guaranteed payments are fixed payments to partners, regardless of the business’s profit or loss – hence the word “guaranteed.” In terms of taxes, these payments are treated as self-employment income for the partner and deductible by the partnership.
On the flip side, distributions are directly related to profits. These distributions of profits vary, depending on how much money the business makes. The way these are taxed can be different and usually depends on the overall profits of the business.
Distributions vs. draws – what's the difference?
Distributions and draws are similar in that they both represent money taken out of a business by the owner, but there are some key differences:
Draws is a term often used in sole proprietorships and partnerships, and some LLCs. Draws are amounts that the owner takes out of the business for personal use. They’re flexible and can be taken at will, without a fixed schedule or amount.
Draws aren’t considered taxable income to the business but affect the owner’s capital account. Instead, they reduce your equity in the business and affect your share of the business’s profits, which you report on your individual tax return.
Distributions is a term often used in corporations and LLCs. Distributions are payments made to the owners or shareholders from the company’s profits. They may be more structured and are often tied to ownership percentages.
Taxation of distributions can vary depending on the business structure and the nature of the distribution.
So while draws and distributions serve similar purposes, the terms are used in different contexts, and there may be differences in how they are handled and taxed, depending on the type of business entity.
What's the difference between distributive shares and distributions?
Distributive shares define how profits and losses are allocated for tax purposes, while distributions are the physical payments made.
A distribution occurs when a partnership or LLC decides to pay out its net profits to the partners or LLC members. Distributions may happen every so often, such as once a year after analyzing your business’s financial situation and decided how much profits you can distribute to its owner members.
Sometimes, though, partners or LLC members cannot wait for the distribution, so they might be able to take a draw against their future distributions instead.
In addition, a partner may receive distributions that are more or less than their distributive share; however, the tax obligation is based on the distributive share, not the distribution itself.
