Guaranteed Payments and the Multi-Owner LLC

Insurance & Asset Protection

A small business owner has a number of withdrawal methods available when seeking to minimize the amount of vulnerable assets within the entity by withdrawing funds from the business.

The small business owner should be familiar with the tax code concept of "guaranteed payments" and how it applies to the multi-owner limited liability company (LLC). Whether payments for salary, loans and leases constitute guaranteed payments will affect the tax basis of each owner, and exactly how the information return of the LLC will report the payments.

Specifically, payments to an owner, on account of his ownership interest, reduce the owner's tax basis in the LLC. In contrast, payments to an owner for guaranteed payments do not cause a reduction in tax basis, because these payments are made to an owner other than in his capacity as an owner (i.e., as an employee, lender or lessor).

A lower tax basis will mean higher taxable gain when the equity interest is later sold. Thus, usually, it is better to structure salary, loan and lease payments as guaranteed payments.

In addition, guaranteed payments are deducted, along with other expenses, on the LLC's information return filed with the IRS. When payments are not guaranteed payments, they are not deducted on the information return and, instead, are disclosed as part of the allocation of net income to each owner. The owners receive the same amounts in either case, but the reporting is different.

Generally, guaranteed payments are payments made to the owners other than in their capacity as owners and without reference to the LLC's earnings. Thus, usually, payments for salary, loans and leases should qualify as guaranteed payments.

However, when a salary is stated simply as a percentage of profits, this may appear to be just a way of dividing income. Thus, in this case, the salary may not qualify as a guaranteed payment. For example, if an agreement provided that one owner in a two-owner LLC was to receive a "salary" of 50 percent of the LLC's earnings, with the other 50 percent allocated to the other owner, this "salary" would be unlikely to constitute a guaranteed payment.

John and his partner each own half of an LLC. John receives a salary of $100,000 from his LLC. The LLC's income, before deducting this payment, is $400,000.

Let's say John's $100,000 salary is a guaranteed payment. On its information return filed with the IRS, the LLC reports income of $300,000 ($400,000 less the $100,000), of which $150,000 is allocated to each owner.

Thus, John has income from the LLC of $250,000 ($100,000 plus $150,000), while his partner's share is $150,000. John would separately report the salary of $100,000 as wage income and the $150,000 as his share of the LLC's income. He would pay self-employment tax on the total received, $250,000, as generally all of an owner's share of the LLC's earnings, whether an allocated share of income or a guaranteed payment, is subject to self-employment tax. (Payments for loans and leases may avoid the self-employment tax).

John must reduce the tax basis of his equity interest in the LLC only by the amount of his share of the distributed earnings, or $150,000, rather than the $250,000 he received, because the $100,000 is salary and not a distribution on account of an ownership interest.

If the salary were not classified as a guaranteed payment, John and his partner still would still receive the same $250,000 and $150,000, respectively. However, now each partner would reduce the tax basis of his equity interest by the full amount received, because all of the payments would be on account of their ownership interests. Thus, John would reduce his tax basis by $250,000, rather than $150,000.

In addition, now the $100,000 would not be reported as a deduction for salary on the LLC's information return. Instead, the information return would show income of $400,000, with $250,000 allocated to John, and the remaining $150,000 allocated to his partner.