What Are Guaranteed Payments to Partners?
Guaranteed payments to partners are payments meant to compensate a partner for services rendered or use of capital. Essentially, they are the equivalent of a salary for partners or limited liability company (LLC) members. These kinds of payments eliminate the risk of a partner making personal contributions of time or property and then never getting compensated if the partnership does not prove to be successful.
The word "guaranteed" refers to the fact that these kinds of payments — known as first-priority distributions — are made without regard to the partnership's profitability. In fact, such payments constitute a net loss for the partnership. In addition, these payments can create special and unexpected tax implications if they are not handled correctly. Income from a guaranteed payment to a partner may be subject to self-employment tax, though that depends on the terms of payment.
[Important: Guaranteed payments protect partners who put in time or money so that they will be compensated even if the partnership is a failure].
Understanding Guaranteed Payments to Partners
The concept of guaranteed payments to partners may seem pretty simple, but the details can make them complicated. Payments that have not been structured properly can lead to unexpected and expensive issues for both the partner receiving payment and for the other partners.
For example, a partnership could lose the ability to deduct a payment. Additionally, an ill-timed payment could increase the tax burden for a recipient, for whom the payment is treated as ordinary income.
Consider the timing issues under a scenario that has the partner using the calendar year while the partnership's fiscal year ends September 30, 2018. If a partner were to receive a guaranteed payment after September 30, they would include the income in the following year. In effect, the payment by the partnership would be recorded as having been made in September 2019. More special tax considerations related to guaranteed payments to partners are highlighted in The CPA Journal's advice on Avoiding costly mistakes on guaranteed payments to partners.
Guaranteed Payments to Partners and Tax Law
Guaranteed payments to partners are outlined in Section 707(c) of the Internal Revenue Code (IRC), which defines such payments as those made by a partnership to an individual partner for services or for providing capital, and which are determined without regard to the income of the partnership. When such payments meet this definition, they are considered made to a non-partner for tax purposes for both the partnership (payer) and the recipient (payee). More pertinently, such a payment to a partner is treated as ordinary income. And for the partnership, such payment is deductible under IRC Sec. 162 (ordinary or necessary business expenses) or capitalized under IRC Sec. 263.
There are also special considerations that must be taken into account with guaranteed payments to partners and real estate as local governments sometimes levy a tax on unincorporated businesses.
For example, New York City has the New York Unincorporated Business Tax (UBT), which applies to partnerships as well as sole proprietorships. While the tax burden can be significant, exempt from it is net income from renting or ownership of the real estate. Therefore, real estate partnerships should consider the tax implications of any guaranteed payment to a partner.
- Guaranteed payments to partners are compensation to members of a partnership in return to time invested, serviced provided, or capital made available.
- The payments are essentially a salary for partners that is independent of whether or not the partnership is successful.
- Guaranteed payments to partners can have various tax implications that must be carefully considered so that beneficiaries can avoid fines or significant tax burdens.