Guaranteed payment to partners

What is the partner’s guaranteed payment?

Guaranteed payments to partners are made to compensate partners for services rendered or for use of funds. Essentially, they are the salaries of a partner or limited liability company (LLC) member. Such payments eliminate the risk of a partner making a personal time or property contribution, which can never be compensated if the partnership is unsuccessful.

The term “guarantee” refers to the fact that such payments (called first priority distributions) are made without regard to the profitability of the partnership. In fact, such payments constitute a net loss for the partnership. Additionally, these payments can have idiosyncratic and unexpected tax implications if not handled properly. Earnings from guaranteed payments to partners may be subject to self-employment tax, depending on the payment terms.

Guaranteed payments protect those partners who have invested time or money and are compensated even if the partnership fails.

Learn about guaranteed payments to partners

The concept of guaranteeing payment to partners may seem simple, but the details can complicate them. Improperly structured payments can cause unexpected and costly problems for the receiving partner and other partners.

For example, a partnership may lose the ability to deduct payments. Additionally, untimely payments may increase the tax burden on recipients whose payments are considered ordinary income.

Consider the timing issue if the partners use the calendar year and the partnership’s fiscal year ends on September 30, 2018. If partners receive guaranteed payments after September 30, they will include the following year’s income. In effect, the partnership’s payment will be recorded as being paid in September 2019.

More special tax considerations related to guaranteed payments to partners highlighted in recommendations CPA Magazine exist Avoid costly mistakes when guaranteeing payment to partners.

Guaranteed payments to partners and tax laws

Guaranteed payment to partners at Section 707(c) The Internal Revenue Code (IRC) defines such payments as payments made by a partnership to an individual partner for services or provision of capital, which are determined independently of the partnership’s income.

When such payments meet this definition, they are deemed to be made to non-partners for tax purposes to the partnership (payer) and recipient (payee). More aptly, such payments to partners are considered ordinary income. For partnerships, such payments are deductible under IRC Sec. 162 (ordinary or necessary business expenses) or capitalized under IRC Sec. 263.

Since local governments sometimes tax unincorporated businesses, there are also special factors that must be taken into account when securing payments to partners and real estate.

For example, New York City has a New York Unincorporated Business Tax (UBT) that applies to partnerships and sole proprietorships. While the tax burden can be substantial, the exception is net income from rent or real estate ownership. Therefore, real estate partnerships should consider the tax implications of providing any guaranteed payments to partners.

key takeaways

  • Guaranteed payments to partners are compensation to partner members in exchange for time invested, services rendered, or funds available.
  • The payment is essentially the partner’s salary and has nothing to do with the success of the partnership.
  • Assured payments to partners may have various tax implications that must be carefully considered so that beneficiaries can avoid penalties or significant tax burdens.

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