A guaranteed payment is a specified payment that partnerships pay to their partners for service or use of capital (as if they were made to a person who is not a partner). These payments are made without any regard for the profits of the partnership.
The goal of paying guaranteed payments is to assure that a partner will earn a particular minimum amount for certain services rendered or the use of capital, thereby limiting the risk of not being compensated for services performed or capital contributions. A guaranteed payment is not the same as a distributive share, which is made with regard to the profits of the partnership.
Types of Guaranteed Payments
There are two types: guaranteed payment for services and guaranteed payment for capital.
Guaranteed Payment for Services
Guaranteed Payment for Capital
What It Is
Payments made to a partner in exchange for work performed in the partnership
Payments based on the capital contributed and not based on how much money the partnership makes
Partners often receive payment for services that are rendered without regard to the profits of the partnership
Partners often give capital to the partnership in exchange for a preferred return
Tax Treatment by Partner
Payments are subject to income and self-employment tax
Tax Treatment by Partnership
Payments reduce ordinary income prior to being allocated to partners using their income allocation ratios
Minimum Payments Resulting in Guaranteed Payments
Guaranteed payments sometimes result from partners being entitled to a minimum payment from the partnership. If you receive a minimum payment from the partnership, the guaranteed payment is the amount by which the minimum payment is more than the partner’s distributive share of the partnership income before taking into account the guaranteed payment.
- Scenario 1 (partner receives guaranteed payment): Under J&L’s partnership agreement, Jazmine receives 10% of the partnership profits but will not receive less than $6,000.
- In 2022, J&L had an income of $50,000. Jazmines’s share, without regard for the guaranteed payment, is $5,000 ($50,000 × 10%).
- Jazmine’s guaranteed payment will thus be $1,000 ($6,000 minimum payment minus $5,000 distributive share).
- Scenario 2 (partner doesn’t receive guaranteed payment): Under L&P’s partnership agreement, Patrick receives 25% of L&P’s profits but no less than $5,000.
- In 2022, L&P’s net income was $25,000. Patrick’s share, without regard to the guaranteed payment, is $6,250 ($25,000 × 25%).
- Since Patrick’s distributive share is in excess of the minimum payment, Patrick will not receive a guaranteed payment.
Guaranteed Payments’ Effect on Partnership Income Allocation
- Effect on the partner receiving payment: Guaranteed payments are issued to the receiving partner before any distributions are made by the partnership. For the receiving partner, this increases the amount of income they are allocated because they get 100% of the guaranteed payment plus their share of the remaining income.
- Effect on other partners: A guaranteed payment to one partner reduces the income allocated to other partners since the guaranteed payment reduces the income available to distribute via income allocation ratios.
Let’s say T and L are 50/50 partners in TL, LLP:
- 2022 net income: $100,000
- Guaranteed payment to T: $40,000
In our scenario, T’s guaranteed payment was issued before the partnership made a distribution of income to either T or L—so this reduced the amount available to distribute by $40,000, thereby leaving $60,000 to distribute evenly to each partner. The guaranteed payment ($40,000) to T does not reduce the net income, and TL, LLP, makes a special allocation of the amount available ($60,000) to L.
As such, here is how T and L share the $100,000 of partnership income:
- T: $40,000 guaranteed payment + 50% of remaining $60,000 = $70,000
- L: 50% of $60,000 = $30,000
Tax Treatment of Guaranteed Payments
Guaranteed payments can be taxed in different ways, based on the type of payment and the tax situation of each partner. Most of the time, guaranteed payments are treated as ordinary income for the partner who receives them and are subject to self-employment taxes:
- Partnership: Guaranteed payments are subtracted on page 1, line 10, of the Form 1065 and thus reduce the ordinary income that is reported on line 1 of the Schedule K. The guaranteed payment is then shown as a separate item of income on Schedule K, line 4. Thus, total partnership ordinary income is unchanged. Guaranteed payments transfer income from line 1 to line 4 of the Schedule K.
Moving the income from line 1 to line 4 of the Schedule K is important because line 1 is allocated to partner K-1s based on their income allocation ratios while line 4 is allocated to partner K-1s based on who received the guaranteed payment.
- Partners: Partners report guaranteed payments shown on line 4 of Schedule K-1 as income on Schedule E, Part II, Section I, or Schedule K (depending on whether it is passive or nonpassive income). The guaranteed payment will also need to be included on Schedule SE and subjected to self-employment tax.
Example: Under Aakansha’s and Asia’s partnership agreement for A&A, LLP, Aakansha is to receive $5,000 per quarter for the legal service she provides to A&A, LLP. These payments are made to her without regard to the profits of the partnership. She will report the $20,000 ($5,000 × 4) she earned on her tax return as ordinary income in Part II, line K, of Schedule E of Form 1040.
How To Set Up Guaranteed Payments
- Step 1: Determine how guaranteed payments will be determined.
- Step 2: Add a guaranteed payment clause to the partnership agreement. The partnership agreement should include details about the guaranteed payment, such as how it is calculated, how often it is paid, and for how long it will be paid.
Our guide on how to create a business partnership agreement may be of interest to you. It includes a free template that you can download and customize.
Frequently Asked Questions (FAQs)
No, guaranteed payments can only be made to partners in a partnership.
Guaranteed payments limit a partner’s risk by reducing the likelihood of partners making significant contributions to the partnership without being compensated.
No, guaranteed payments are not the same as wages. They are wage-like payments to partners in a partnership but are not subject to payroll taxes. Instead, the partner pays self-employment tax on the payments when they file their individual tax return.
Partners may get guaranteed income from a partnership regardless of the success or failure of the business. Instead, the partnership might agree to pay a partner a predetermined sum for services done or capital received, and that amount will not change based on the partnership’s financial results.