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 roll 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.
Originally published Nov 23, 2015, updated October 15 2019.