Management Company Series: How to Pay Partners – Guaranteed Payments vs. Distributions

When establishing a new management company, one of the critical decisions you will face is how to compensate partners for their services: through guaranteed payments or distributions. Both methods are commonly used, but they have distinct tax implications.

Guaranteed payments are made by a partnership to its partners, irrespective of the business’s profitability. These payments ensure that partners receive a minimum amount for specific services rendered or for the use of capital. Essentially, guaranteed payments function like salaries for partners and are considered an expense for the company. They are treated as a partner’s distributive share of ordinary income and are subject to self-employment tax. In management companies, guaranteed payments are often used when there is a need to allocate economics differently from the partnership agreement.

Distributions, in contrast, are payments made to partners from the business’s profits. These payments are typically distributed to all partners based on their share of the profits. The Partnership Operating Agreement usually outlines the distribution section, and the timing and frequency of distributions are determined by managing partners, taking into account current cash flow and future cash forecasts.

Cash distributions are not deductible at the entity level. For tax purposes, distributions are considered a return on investment. Provided that partners have sufficient tax basis in their capital accounts, the distributions reduce their capital accounts and are not taxable on their individual returns.

Health insurance premiums paid by a partnership on behalf of a partner for services as a partner are generally treated as guaranteed payments. The partnership can deduct these 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, the partnership cannot deduct the premiums.

Guaranteed payments can be advantageous for partners who provide services to the business, as they ensure compensation even if the business does not make a profit. Distributions, on the other hand, are not subject to self-employment tax. The choice between guaranteed payments and distributions depends on the specific circumstances of your business.

There are additional considerations with either method, such as fiscal year-end entities with calendar year-end partners, state and local income tax deductibility, and distributions in excess of basis. It is always advisable to consult with a tax advisor before implementing your payment plan.

Authors: Sally Sun, CPA | [email protected] and Amanda McKenna, CPA, Partner and Team Leader, Financial Services Tax | [email protected]