Payments to LLC Owners

Are the payments to owners of an LLC treated as salary? The answer depends on whether the LLC is treated as a sole proprietorship (a disregarded entity). a partnership or a corporation.

If the LLC is treated as a sole proprietorship, the payments are disregarded entirely. Instead, the sole owner reports all of the revenues and all of the expenses on a Schedule C on his own Form 1040. Amounts paid to him for his services are not a deduction for the business and are not reported by him as salary.

If the LLC is treated as a partnership, all amounts paid for services to the members (partners, for tax purposes) are simply treated by the members as distributions. As discussed below, the LLC treats fixed payments (called guaranteed payments) a little differently on its own return, Form 1065, but the amounts are reflected on the member’s Form K-1 and are not reported as salary on a Form W-2. Members are not treated as employees and there should be no withholding taxes deducted from the payments.

If the LLC is treated as a corporation (either a C Corporation or an S Corporation), amounts paid to a member as salary are treated as salary for tax purposes. That means that the LLC must withhold employment taxes and must provide the member/employee with a Form W-2 at the end of the year.

Guaranteed Payments

Guaranteed payments are payments made by a partnership to a partner that are determined without regard to the partnership’s income. A partnership treats guaranteed payments for services, or for the use of capital, as if they were made to a person who is not a partner. This treatment is for purposes of determining gross income and deductible business expenses only. For other tax purposes, guaranteed payments are treated as a partner’s distributive share of ordinary income. Guaranteed payments are not subject to income tax withholding.

The partnership generally deducts guaranteed payments on Form 1065 as a business expense. The guaranteed payments are also listed on Schedules K and K-1 of the partnership return. The individual partner reports guaranteed payments on Schedule E (Form 1040) as ordinary income, along with his or her distributive share of the partnership’s other ordinary income.

Guaranteed payments made to partners for organizing the partnership or syndicating interests in the partnership are capital expenses. Generally, organizational and syndication expenses are not deductible by the partnership. However, a partnership can elect to deduct a portion of its organizational expenses and amortize the remaining expenses (see Business start-up and organizational costs in the instructions for Form 1065). Organizational expenses (if the election is not made) and syndication expenses paid to partners must be reported on the partners’ Schedule K-1 as guaranteed payments.

Minimum payment. If a partner is to 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.

Example:

Under a partnership agreement, Divya is to receive 30% of the partnership income, but not less than $8,000. The partnership has net income of $20,000. Divya’s share, without regard to the minimum guarantee, is $6,000 (30% × $20,000). The guaranteed payment that can be deducted by the partnership is $2,000 ($8,000 − $6,000). Divya’s income from the partnership is $8,000, and the remaining $12,000 of partnership income will be reported by the other partners in proportion to their shares under the partnership agreement.

If the partnership net income had been $30,000, there would have been no guaranteed payment since her share, without regard to the guarantee, would have been greater than the guarantee.

Self-employed health insurance premiums. Premiums for health insurance paid by a partnership on behalf of a partner, for services as a partner, are treated as guaranteed payments. The partnership can deduct the payments as a business expense, and the partner must include them in gross income. However, if the partnership accounts for insurance paid for a partner as a reduction in distributions to the partner, the partnership cannot deduct the premiums.

A partner who qualifies can deduct 100% of the health insurance premiums paid by the partnership on his or her behalf as an adjustment to income. The partner cannot deduct the premiums for any calendar month, or part of a month, in which the partner is eligible to participate in any subsidized health plan maintained by any employer of the partner, the partner’s spouse, the partner’s dependents, or any children under age 27 who are not dependents. For more information on the self-employed health insurance deduction, see chapter 6 in Publication 535.

Including payments in partner’s income. Guaranteed payments are included in income in the partner’s tax year in which the partnership’s tax year ends.

Example 1:

Under the terms of a partnership agreement, Erica is entitled to a fixed annual payment of $10,000 without regard to the income of the partnership. Her distributive share of the partnership income is 10%. The partnership has $50,000 of ordinary income after deducting the guaranteed payment. She must include ordinary income of $15,000 ($10,000 guaranteed payment + $5,000 ($50,000 × 10%) distributive share) on her individual income tax return for her tax year in which the partnership’s tax year ends.

Example 2:

Lamont is a calendar year taxpayer who is a partner in a partnership. The partnership uses a fiscal year that ended January 31, 2010. Lamont received guaranteed payments from the partnership from February 1, 2009, until December 31, 2009. He must include these guaranteed payments in income for 2010 and report them on his 2010 income tax return.

Payments resulting in loss. If guaranteed payments to a partner result in a partnership loss in which the partner shares, the partner must report the full amount of the guaranteed payments as ordinary income. The partner separately takes into account his or her distributive share of the partnership loss, to the extent of the adjusted basis of the partner’s partnership interest.