For many restaurant owners, guaranteed payments and distributions to owners may not come up until it’s time to file the annual tax returns. If you’re a restaurant client of The Forks CPAs, you’ll hear about guaranteed payments and distributions throughout the year because the distinction impacts your finances and taxes significantly. But what exactly are guaranteed payments and distributions, and how are they different?
What are guaranteed payments?
Guaranteed payments are like salaries paid to restaurant partners. These payments are made to partners:
- In exchange for the use of capital or services provided; and
- Without regard to the income of the partnership
That means that guaranteed payments of at least minimum amounts (usually identified in the partnership agreement) must be paid, even if the restaurant incurs a loss because of those payments.
Guaranteed payments are expenses reported as labor costs on your Profit & Loss statement (P&L). A management fee paid out to managing partners in a restaurant structured as an LLC partnership is considered a guaranteed payment. Investors and other partners base their profit allocations or distributions after guaranteed payments have been paid to the managing partners. It is treated like any other labor expense.
Guaranteed payment clauses are frequently included in partnership agreements to ensure a partner receives payment for their services before investors are paid.
You can determine your guaranteed payments and/or management fee amount by reading How Much Should Restaurant Owners be Paid?.
What is a distribution?
A distribution, however, is an unguaranteed transfer of cash or property from the partnership to the partner, which reduces the partner’s ownership basis. Distributions don’t include loans made to partners, or amounts paid to partners in exchange for service or the use of property, such as guaranteed payments or rent. A distribution is a return of contributed capital or a distribution of profits. Distributions are NOT reported on the P&L, instead they are reported as a reduction to equity on your balance sheet.
Distributions must follow the distribution or profit/loss arrangement outlined in the operating/partnership agreement. In a profitable restaurant, distributions are typically determined quarterly based on cash flow and profitability for that quarter. Many operating/partnership agreements also call for tax distributions. Tax distributions are minimum distributions that the partnership must make so that partners can cover their quarterly taxes. Read more about how distributions and profit allocations are taxed here.
How to tell the difference between guaranteed payments and distributions?
Guaranteed payments are guaranteed to be paid to partners regardless of the restaurant’s financial performance. Distributions, however, may be contingent upon the restaurant turning a profit.
To emphasize this difference, IRC Sec. 707c states: Payments to a partner for services or for the use of capital are guaranteed payments to the extent that they are determined without regard to the partnership’s income. That is, as soon as the amount of any payment to a partner is contingent upon income, it is considered a distribution. Any amounts identified for payment that do not hinge on income are considered guaranteed payments.
For example, the owners of ABCD Eatery have a partnership agreement that states that Partner B will receive 20% of the partnership income but not less than $13,000. During the year, the restaurant produces a net profit of $100,000, so Partner B is entitled to $20,000.
Because the portion of income allocated to Partner B exceeds the minimum $13,000, no part of the $20,000 paid to Partner B is considered a guaranteed payment; it’s all a distribution.
However, if we change the facts so that the restaurant only produced $30,000, Partner B’s allocation of income would be $6,000. That $6,000 is considered a distribution, but Partner B is still guaranteed an additional $7,000 to reach their minimum of $13,000 for the year. The remaining $7,000 must be paid to Partner B regardless of the restaurant’s income, and is considered guaranteed payment.
How are guaranteed payments and distributions taxed?
Because guaranteed payments are payments for the use of capital or services performed for the partnership, they are considered self-employment earnings, and are subject to self-employment taxes on the partner’s tax return. Guaranteed payments do not qualify for the Qualified Business Income deduction (QBID), where distributions do, so shifting as many dollars from guaranteed payments to distributions is more favorable. See The Best Tax Classification for Your Restaurant for a full breakdown.
Guaranteed Payments and Distributions: The Bottom Line
Ensuring payments to partners are classified as guaranteed payments and distributions accurately is important because it impacts your financials and taxes and has legal implications. Your bookkeeper, accountant, lawyer, and tax preparer should be on the same page and advise you on the differences throughout the year to ensure your financials reflect your performance and that you’re compliant with taxes and your operating agreement. This is part of our default process at The Fork CPAs, so if you’re interested in getting your financials in order, please contact us.