Guaranteed payments are legitimate business expenses where a firm pays one of more of its owners for services rendered, over and above their share of profits. The accounting conventions and standards stipulate guidelines for making guaranteed payments and the resulting journal entries.
What Is a Guaranteed Payment?
Guaranteed payments are payments made by an organization to one or more of its partners or equity holders, for the services rendered by that partner or equity holder. Such payments are distinct from the profits or losses shared by partners or equity owners and make for first priority distributions, disbursed irrespective of whether the concern makes a profit or loss.
The IRS and Generally Accepted Accounting Practices (GAAP) recognizes guaranteed payments as a legitimate business expense. The basis of disbursement of these payments is an agreement among the partners or owners specifying the services provided by the partner for a stipulated guaranteed payment.
The purpose of these payments is to ensure compensation for the efforts put in by the partner or a shareholder in form of goods or services, over and above his or her capital. The efforts put in receives due compensation and remain risk free, whereas the amount invested receives returns in proportion to the profit, or suffer losses. Guaranteed payments are similar to a salary and attracts self employment tax.
A general ledger and the appropriate journal entries list the firm’s transactions in chronological order and includes columns for the date, accounting head, the description of the transaction, and two columns to record the debits or credits. Guaranteed payments are recorded as first priority debits, listed in the same order of salaries. They cannot be clubbed with salaries and find inclusion as a distinct draw.
The shareholder withdrawing cash as part of profit shows a debit to a draw account and a credit to the cash account when payment moves out. A pure expense such as rent would be a debit to the expense account and a credit to the cash account.
For recording guaranteed payments, a journal entry must create a separate account head called “Guaranteed Payment" for each partner, and credit the amount to this account. At the end of the year, close this account with all other income and expense accounts to Retained Earnings and make a journal entry to credit the member’s equity account with the member’s net income in Retained Earnings. Now debit the member's equity account for the amount of the guaranteed payment. Next, distribute what remains of the net income in the Retained Earnings to the shareholders according to their ownership share or agreement.
Opting for guarantee payments may not allow the partner to save on direct taxes as the proceeds from guaranteed payments attracts self employment tax. The IRS, however, makes each partner of a partnership firm liable for his or her distributive share of profits each year regardless of the profits actually drawn by the partner. In the partners involved in business operations decide to retain cash in the partnership firm for reinvestment, opting for guaranteed payments for whatever amount they withdraw will reduce overall profit of the concern, and by extension, reduce the distributive profit tax burden.
A proper system and recording of guaranteed payment ensures equity among shareholders and contributes to healthy corporate compliance.
- Quick MBA “Accounting." http://www.quickmba.com/accounting/fin/journal-entries/. Retrieved May 07, 2011.
- How Partnerships are Taxed. http://articles.bplans.com/growing-a-business/how-partnerships-are-taxed/136. Retrieved May 07, 2011.
- Investopedia. “Guaranteed Payment to Partners." http://www.investopedia.com/terms/g/guaranteed-payments-partners.asp. Retrieved May 07, 2011.
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