Summary answer—Yes: an LLC may account for regular payments to a member for services and paid ahead of payments to members as distributions of profits as guaranteed payments, essentially a salary substitute. And like a salary, guaranteed payments are deductible by the LLC as business expenses, and represent regular income to the member recipient.
We have been asked on several occasions by businesses organizing as an LLC some variation of the following question:
If one or more of the members is paid a salary, does the salary count toward the distribution to the members at year-end, or are the salaries considered an expense which reduces the net profit to be distributed?
Generally, where a regular “salary” is paid to a member for services, the LLC accounts for the payment as a “guaranteed payment.” This is a salary substitute—a payment to compensate a member for his services before other members receive distributions out of profit. And, like a salary and unlike a profit distribution, the amounts paid as guaranteed payments are a deductible expense to the LLC – and thus reduce net profits.
LLCs, like partnerships, are flow-through entities for tax purposes. The owners are called members rather than partners. So like a partnership, an LLC, assuming it has not elected to be taxed as a corporation, does not pay federal income tax on its net income. Instead, the income attributable to each member is subject to taxation under that member’s tax return. And, generally, if the member is providing 500 hours or more of services to the LLC, he or she is treated as self-employed and must pay the self-employment tax (the employer and employee FICA percentage) and make quarterly estimated income tax filings.
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An LLC should generally account for services rendered by a member as “guaranteed payments.” A guaranteed payment is a specific term in the Internal Revenue Code defined as payments to a partner in his or her partner capacity for services (or, in some cases, use of capital) that is calculated and without regard to the income of the partnership. The courts have determined that a partner (here member) is acting in his or her capacity as a partner when he performs services that are ongoing and integral to the business of the partnership.
What this means is that any regularly scheduled payment to a member of an LLC for services which is paid not as a profits distribution but as a promised (guaranteed) “salary” instead, is properly accounted for as a guaranteed payment. These are amounts regularly paid to a member for her services to the LLC before other members receive distributions out of profits.
As to the LLC, guaranteed payments are deductible by the LLC as business expenses. As such they reduce the net profit of the LLC allocated to members as members. As to the member receiving the guaranteed payment, however, the payment is treated as ordinary income.
As ordinary income to a member, the guaranteed payment is not subject to income tax withholding or FICA tax withholding by the LLC upon payment which would be the case if a salary were paid to a non-member. Instead, guaranteed payments are declared as regular income under the recipient member’s individual quarterly estimated tax returns.
Similarly, health insurance premiums paid by the LLC on behalf of a member as partial compensation of for her services are also treated as guaranteed payments. Guaranteed payments can have other implications relative to the recipient member’s capital account, particularly if the LLC is losing money. Those implications are beyond the scope of this primer. Do seek help from your tax advisor concerning such ramifications.
Authored by Andrew (Drew) Piunti, firstname.lastname@example.org, ©2015