Lenders and underwriters in my training workshops on Cashflow Analysis of Tax Returns often stumble a bit on that word ‘guaranteed’. After all, we all know what that means, right?
Well, it is dangerous to assume that words on tax returns or in financial statements mean the same thing the do in common usage. Read on and at the bottom of this post I’ll tell you what ‘guaranteed’ means in IRSSpeak.
Where do you find guaranteed payments?
Guaranteed Payments show up on:
- Form 1065 Page One
- Form 1065 Schedule K
- Form 1065 Schedule K-1 (for each owner who receives them)
- Form 1040 Schedule E (although it is buried in the taxable amount listed for the partnership or LLC)
What are guaranteed payments?
Owners of partnership (partners) and LLCs (members) do not get paid wages. Their ‘pay’ is in the form of capital distributions which are based on % ownership…most of the time.
But what if my % ownership does not reflect the value of my contribution in terms of time, expertise or some other critical factor? Should I really split our ‘profits’ 50/50 just because I am a 50% owner, when I am the one who puts in the time or brings the expertise to the table to land the business?
Guaranteed payments are the way we can make distributions to the owners that are not related to the agreed-upon profit and loss split.
How guaranteed payments work
Here are some examples:
- I own 25% of my LLC. The other owner owns 75%. We have an agreement that whichever one of us brings in a new client receives a ‘finder fee’ of 1% of first-year revenues from that client. Those payments will be made as guaranteed payments.
- I own 50% of my partnership. I work full time in the business and the other 50% owner does not work for the business. We have an agreement that I get paid $20 per hour for each hour worked. Then we split the profits 50/50.
- I own 75% of my partnership. I recruit a second partner who has an incredible reputation in the business. He does not work in the business but is an avid blogger and speaks at industry conferences. We have an agreement that he gets a $1,000 bonus for every referral that turns into a client.
What do you as a lender/underwriter do with guaranteed payments?
- Form 1065 Page One: Nothing if you have already included them in taxable income either by starting with the bottom line of the return, with net income from Schedule M-1 or by subtracting total expenses on page one. Or include guaranteed payments just as you include other expenses if you are entering each type of expense on your spreadsheet.
- Form 1065 Schedule K: Nothing
- Form 1065 Schedule K-1 (for each owner who receives them): Include the Guaranteed Payments (Line 4 or 5 depending on which year return you are reviewing) in personal, historical cashflow
- Form 1040 Schedule E (although it is buried in the taxable amount listed for the partnership or LLC: Do not use this number. It is a placeholder for the number you actually need, which is either historical personal cashflow or cashflow available from the company.
If you are not in the habit of checking for guaranteed payments on a 1065 K-1 when you are calculating actual historical cashflow you run the risk of missing a significant, recurring source of cashflow.
IRS definition of ‘guaranteed’:
When it comes to guaranteed payments, this refers to the fact that these payments are guaranteed by an agreement between the partners that is unrelated to the agreement for the profit/loss split.
Just don’t look at Schedule K-1, Guaranteed Payments…breathe a sigh of relief…and say to yourself: “Well, at least they are guaranteed income from this company.”