The law firm of David Bjornson, Bjornson Law, helps clients with entity formation. What is entity formation, you ask? Entity formation refers to the formation of a business or a legally recognized organizational entity existing within an economically free country designed to provide goods and/or services to consumers and businesses.
Because of the great flexibility that limited liability companies offer, many choose to go with this entity. Clients then turn to asking the question of how they can be compensated for performing services to the company. At this point, somebody is bound to bring up the topic of guaranteed payment.
This discussion will assume that a limited liability company has not elected to be treated as an association taxable as a corporation, and, therefore is treated for federal income tax purposes as a partnership, governed by Subchapter K of the Internal Revenue Code.
A guaranteed payment is a specific term found in the Internal Revenue Code (Section 707(c)), which is described as payments to a partner (in a partnership) or a member (in a limited liability company) in his or her partner or member capacity for services rendered to the partnership or limited liability without regard to the entity’s revenue.
So if an entity’s owner is managing the day-to-day operations of the entity on a full time basis, that owner is likely going to want to get a stable stream of income. This is where a guaranteed payment comes into play.
Guaranteed payments are payments that an entity makes to an owner for services, for example for running the day-to-day operations of the entity, and are made regardless of whether the entity makes a profit. So if David Bjornson owns a limited liability company, and David Bjornson runs the everyday operations of Bjornson Law, he is entitled to receive guaranteed payments from his firm.
In the case of guaranteed payments, in situations where the entity does not make any distributions from profits to the other owners, the owner who is managing the day-to-day operations still receives a guaranteed payment and is compensated for the work he or she is performing on a daily basis for the entity. In this way, the guaranteed payment for a partnership or an LLC is the functional equivalent of a salary to a shareholder-employee in an S or a C corporation.
Like a salary expense, the guaranteed payment is in effect treated as an expense to the entity, reducing the taxable income otherwise passed through to owners. It is reported on the K-1 of the owners receiving such payments and not on form W-2, as it is not payroll.
Owners who receive guaranteed payments for services are subject to self-employment tax and medicare on such earnings, just as if they were self-employment income. The entity will not withhold taxes on guaranteed payments, and the owner who receives guaranteed payments will need to make estimated payments of federal and applicable state taxes, and file an income tax return to report the guaranteed payments.
The owner could arrange for the limited liability company to make the estimated payments of tax for him or her, with such payments being treated as distributions to such owner.