Unlike employees, LLC members typically don’t receive a standard salary or hourly wage. That doesn’t mean they don’t receive payment for their work. In fact, there are several options for paying LLC members — each with its own pros, cons, and tax implications. Here are three of the most common methods:
- Draw Payments
Draw payments typically work best in a sole proprietorship, partnership, or single-member LLC. A member may take a draw payment at any time as either a withdrawal of profits or an advance payment of future profits. For tax and recordkeeping purposes, LLCs don’t consider draw payments as a business expense and don’t record them on their profit and loss (P&L) statement. They essentially act as distributions of profits recorded on the company’s balance sheet.
- Distributive Payments
Similar to draw payments, distributive payments are a distribution of profits not recorded as a business expense. LLCs typically schedule and allocate them based on the company’s operating agreement. The distribution percentage for each member usually matches their ownership stake in the company.
- Guaranteed Payments
Guaranteed payments differ considerably from distributive and draw payments. First, a company’s profitability doesn’t affect the amount or frequency of guaranteed payments. These payments ensure a member receives a guaranteed minimum amount even if the company doesn’t turn a profit. Second, LLCs consider guaranteed payments as a business expense and record them on their P&L statement. As a result, the Internal Revenue Service (IRS) taxes guaranteed payments like a regular salary.
Any member of an LLC can receive a guaranteed payment — as long as the company’s operating agreement allows them. Be sure to clearly outline all payment structures in writing to avoid any legal or tax issues.
It can take months, or even years, for a business to turn a profit. Many LLC members either cannot wait, or simply don’t want to wait, that long for compensation. Guaranteed payments compensate members for their work or investment in a company by removing any waiting or uncertainty surrounding the company’s profitability.
Guaranteed payments guarantee a minimum amount of total compensation. This means that if a member is due a guaranteed payment, but also received another form of payment like a distribution, the LLC could reduce their guaranteed payment portion. Take a look at the following examples:
An LLC’s operating agreement states one of its members has a 15 percent share of the LLC’s profits each year with a minimum guaranteed payment amount of $20,000. This year, the LLC’s net income totaled $100,000, making the member’s share of the profits $15,000 (15 percent of $100,000). Because he has a guaranteed minimum of $20,000, the member will receive $5,000 as a guaranteed payment and the other $15,000 as his distributive share.
If the LLC was more profitable and the member received a distributive share of $20,000 or more, they would not receive a guaranteed payment because their compensation already met the minimum guaranteed threshold. Conversely, the member would receive a $20,000 guaranteed payment if the LLC didn’t earn any profits.
The IRS permits LLCs to deduct guaranteed payments from the business’ total revenue, which lowers a company’s total taxable amount. Additionally, because the IRS taxes guaranteed payments differently than regular wages, LLCs don’t have to pay a Federal Insurance Contributions Act (FICA) contribution on these payments.
Like most things, guaranteed payments offer both advantages and disadvantages. Below is an overview of the main pros and cons of this payment method. Keep in mind that you may consider some items both a pro and a con, depending on if you view them from the perspective of the business as a whole or the individual member.
- Members can get paid without waiting for the company to turn a profit
- Guaranteed payments lower the business’ taxable income
- The LLC doesn’t have to pay FICA tax on the payments
- Your LLC must make payments even if it isn’t profitable
- Members may have to pay both their and the company’s share of the appropriate FICA tax
Choosing guaranteed payments to compensate members of your LLC has both advantages and disadvantages. Be sure to carefully examine all the options and their tax implications before you select a payment method for your business — keeping in mind you can pick more than one. Consider consulting with experts on this topic, such as accountants or lawyers, for additional guidance as you evaluate your options.