How Do Partnership Partners Get Paid?

In a general partnership, the partners are paid by withdrawing money from the business earnings or distribution of the business profits. All partners are subject to the limit of their ownership interest in the company. But how do partners in an LLC, Inc., and LP get paid?

What are examples of earned income?

Alison owns a kitchenware and home furnishing shop called Ali’s Culinary Treats in Pasadena, California. As the sole business owner, she is proud of her shop’s profits, and every year business seems to get a little bit better. However, when Alison checks over her sales and profits at the end of each fiscal year, she has many questions. As a small business owner, Alison has employees and bills to pay, and at the end of the year, she often wonders exactly how she is paid for her hard work. How do sole proprietors get paid, Alison wonders?

Alison’s friend Neil has also just started an exciting new partnership with his friend Brian. Neil and Brian’s business is called NKB Fishing Supplies, and both men are general partners, meaning they share not only the company’s profits but also its debts and liabilities. Neil and Brian grew up fishing in San Diego, California, and they are both actively involved in the business. While the two fishermen and entrepreneurs are as excited about starting their new business as they are about casting a line, they also have many questions. One of Neil’s main questions is: how are partners in a general partnership paid? What should he expect when it comes time to see his first paycheck?

Neil’s sister Gwen has just received her Master’s Degree in Business from Harvard and is headed back to Los Angeles for an exciting opportunity. Gwen has invested significantly in a new company called Stardust, which creates popular apps for people who love stargazing. As a shareholder in the company, Gwen now owns shares in Stardust. As one of 60 owners of Stardust stock, Gwen helps manage the company and consults on business plans and new project growth. Gwen is excited about being a first-time shareholder and optimistic about her involvement with Stardust, but she also has a question: How will she be paid as a shareholder?

Gwen’s boyfriend, Ben, has always been a coffee addict. After. After traveling to Costa Rica and Panama searching for the perfect beans, he returns to Cardiff, California, to open up a coffee shop called Boards & Beans. Ben’s coffee shop is an LLC, meaning he and his fellow brewers have limited liability protection and flow-through taxation. In other words, Ben and his fellow partners are not liable for the debts of Boards & Beans because the company is a separate entity. Ben is ready and willing to give all his time and effort to the new caffeine-laced venture, but he wonders how LLC owners get paid. How do owners of corporations get paid?

Business owners like Alison, Neil, Gwen, and Ben vary in age, experience level, and range of interests. However, many business owners have the same concerns: they want to be able to cover their bills, set themselves and their families up for the future, and also have a chance to enjoy the beauty of their lives once in a while.

No one can take a break or go on a vacation without personal income. Plus, we all have to be able to track and estimate our earnings, regardless of our different occupations, so that we can work hard and get the chance to take a break from time to time. Therefore, many of us spend far too much time wondering: how exactly do we get paid?

Whether individuals are shareholders, sole proprietors, general partners, or owners of a corporation, one question remains: how do we get compensated?

This article will outline how the specific type of business an individual runs dictates how they receive payment. Many clients have asked about this particular question, so let’s dive in.

How Does the Type of Business Impact How Individuals Are Paid?

It is no secret that a business’s structure dictates how everyone is paid, from owners to employees. Therefore, when forming a partnership or joining a new company, individuals should pay attention to how the business is organized. Business structure is one of the biggest clues regarding how, when, and how much they will be paid.

Many people are concerned with the amount they will be paid—the numbers they see each month on their paychecks. Unfortunately, earning amounts depend on the company’s finances, meaning that small business owners and entrepreneurs receive lower compensation rates, especially when starting.

In addition to the importance of company structure and financial position, tax requirements strongly influence payment amounts for everyone, from employees to CEOs. Therefore, this article will also examine how state and federal taxes impact how business partners, and those in other positions, are paid.

When entrepreneurs understand the reasons behind compensation rates before they choose a business structure and launch their ventures, they are much more prepared to run a successful company.

How Are Sole Proprietors Paid?

Typically, new entrepreneurs with ideas for smaller ventures opt for sole proprietorships. A single individual has complete control over the business within a sole proprietorship. This individual is both owner and operator, and therefore:

Receives the total amount of business profits
Receives the total amount of responsibility for business liabilities and taxes

Many entrepreneurs are curious about how they will be compensated if they start a sole proprietorship. Those interested in starting this type of simple company should know there are advantages and disadvantages to sole proprietors’ paychecks.

Some of the pros and cons attributed to sole proprietorships have to do with the company’s performance. For example, if Greg’s new bar and restaurant, Tilly’s, is on a roll and business is soaring, Greg will take home a significant portion of the company’s overall income. However, if Greg’s restaurant venture falls on hard times and supply costs go up while business plummets, Greg must shoulder all of the burdens.

Sole proprietors must should the weight of all the financial decisions and responsibilities. Instead of sharing achievements and drawbacks with other partners, for example, sole proprietors enjoy the gains of the business and cope with the setbacks by themselves. Specifically, this means that while company profits can enhance a monthly paycheck, things like overhead costs and debts can do the opposite. For example, entrepreneurs who choose sole proprietorships should be aware that they are responsible for raising capital for the business and dealing with company liabilities.

What Does it Mean to Be a Self-Employed Entrepreneur?

When an entrepreneur decides to start a sole proprietorship, they should also be aware that they are not employees. Rather, they are self-employed.

This employment distinction changes how individuals are taxed since they take home all the profits and the numerous benefits.

For example, sole proprietors normally enjoy the advantage of tax write-offs for expenses such as:

Living expenses if working from home; internet, gas, etc.
Transportation if commuting

Also, sole proprietors receive individual tax credits within their returns, known as a self-employment tax returns.

These advantages keep money flowing through the company accounts and give entrepreneurs a choice: they can withdraw more money or invest the extra funds back into the company to strengthen it.

While these advantages sound attractive, entrepreneurs should know that profits sometimes take a while to add up when starting a small solo venture. Therefore, it is essential to practice safe budgeting before opening the doors to any sole proprietorship. Normally, savvy entrepreneurs include accurate budget predictions in their business plans.

Also, in the “cons” department, sole proprietors must deal with a lack of liability protection. This concept of unlimited liability means that if sole proprietors have debts or must deal with a lawsuit, their assets will be vulnerable. These assets could include:

Savings
Credit ratings
Real estate
Vehicles

How Are Partners Paid?

Before we delve into how partnership compensation works, let’s establish the differences between sole proprietorships and partnerships. Whereas sole proprietorships only have one business owner, partnerships feature two or more owners invested in the business. Additionally, the partnership agreement establishes the lawful provisions that govern the partnership and the duties of each partner.

Unlike a limited liability corporation, partnerships are not set up as separate legal entities. Therefore, general partners remain liable for the company’s debts.

The key to understanding how partnership partners are paid is to examine the partnership agreement the partners signed. All partnership agreements spell out that the business pays the partners and tells each partner what to expect.

Sole proprietorships are comparable to partnerships in some ways. For example, the partners’ compensation rates reflect the company’s profits. However, in the case of partnerships, the partnership agreement still dictates the partners’ income numbers.

In addition to the partnership agreement, the rate of partner investment figures into their compensation rates. Partners contribute money, labor, and other costs to companies, and these investments inform how much they get paid each quarter. The profits the business makes are also distributed according to the partnership agreement.

Many think partnership agreements must be written and signed, but they can exist as implied documents or be spoken and agreed upon verbally. However, we recommend that all partnership documents be written, signed, printed, and filed away for safe future reference. Or, partners can save the documents to their hard drives or cloud storage systems.

Since partnership agreements are vital to estimating the partners’ pay rates, it is beneficial for people to know that partnership agreements are easy to create and there is no registration process required compared to articles of incorporation. Notably, some partnership agreements require the partners to also write a business plan, but all companies should begin with a business plan in any case.

For example, Geoff, Bob, and Tessa have decided to create a new ice cream cone business called Scoops N Conez in Anaheim, California. Bob handles the business plan, careful to accept input from the others. Finally, Geoff drafts a partnership agreement, and all three entrepreneurs and ice-cream enthusiasts approve the plan.

After the first quarter, Bob, the baker of the group, has numerous questions about his paycheck. Sales have been strong, and he knows how much profit Scoops has made—why is his paycheck so small? Bob, an emotional individual, begins to question the honesty and intentions of Geoff and Tessa and finally demands to see their paychecks.

However, when all three partners share their paychecks, Bob is relieved to find that their compensation rates are equal, as was agreed on in the partnership agreement. Tessa, the financial expert of the group, explains that the costs of starting the business—bills, startup costs, rent charges, equipment, and more—have set all of their paychecks back a bit. Tessa shows Bob that though the three partners have agreed on different duties, their compensation rates, stock options, and buy-out terms are the same. Geoff, the main “people person” of the group and voice of the business, also reassures Bob that if the business remains strong, profits—and paychecks—will increase as their new venture finds its footing. Happy to hear all of this, Bob returns to work with a smile and an eye on the future.

How Are Shareholders in Corporations Paid?

While general partnerships and sole proprietorships are similar in compensation, corporations are vastly different. Many entrepreneurs prefer investing in or owning corporations because they provide owners with liability protection.

When we hear of business owners deciding to incorporate their companies, it is usually so they can take advantage of liability protection. How does this work? Corporations can file and pay their income taxes because the law treats them as separate entities from shareholders and owners.

Many wonder how this unique structure influences how owners and shareholders are paid. Corporations are directly funded by shareholders and investors and sometimes can secure bigger loans from other donors. Instead of partnership agreements, articles of incorporation govern corporations, providing them with structure. The main difference between partnership agreements and articles of incorporation is that articles of incorporation are legally required. Partnership agreements are strongly recommended by attorneys and veterans of the business world, but they are not mandatory.

Articles of incorporation outline partners’ duties but also include the income rates for shareholders, details on bonuses, and other relevant information. Although these articles are vital for corporations, partners’ payment amounts also are contingent on their companies’ financial strength.

What are the Differences Between Draw, Distribution, and Dividends?

Three fundamental structures dictate how business owners receive payment. These terms are known as:

Draw
Distribution
Dividends

Sole proprietors receive payment through a draw. General partners are paid through distribution. Finally, corporations pay their shareholders with profit dividends.

These designations may appear complicated, but they are easy to understand. Once entrepreneurs can distinguish between draw, distribution, and dividends, they can choose what type of business to set their sights on.

Who Takes a Draw from the Business?

First, sole proprietors are not technically “paid.” Meaning they do not receive a salary. Instead, sole proprietors get a draw from the business. The draw is based on how much money the individual invests and is a direct payment to the sole proprietor.

A draw is much different from a share or a dividend in terms of taxes. Partners claim the draw on the business owner’s tax returns instead of their income taxes. This occurs because:

Sole proprietorships are not lawful entities and do not file taxes
Sole proprietorships are not separate entities from the owner

Who Takes Distributions from Profits?

Similar to sole proprietors, partners do not receive a typical salary either. Instead, general partners are paid based on profit distributions.

Partnership agreements usually spell out how distributions work for partners. For example, if the agreement stipulates that the partners receive 5% of the company’s profits, that is what the partners expect to receive.

If partners did not include information on distribution shares in their partnership agreements, we strongly recommend they do, even if they must amend the agreement. This addition will help compensation be more transparent and prevent partners from questioning their payment amounts.

General partners’ payment amounts are based on their specific share of:

Company income
Company gains
Company losses
Company credits and deductions

These figures change yearly, so partners expect their paychecks to also change.

Since partnerships are not lawful entities, tax returns include partners’ distributions. Partners, therefore, are not seen as separate from the business, and their taxes reflect the year’s gains and losses.

Since partnership taxes can become complex, we recommend contacting an attorney and an accountant to ensure everything proceeds smoothly when tax season rolls around.

Which Individuals Receive Dividends?

Corporate shareholders also do not earn a salary, but their dividends take their place. Unlike distributions, the articles of incorporation define dividends as a specific slice of the company’s profits. Therefore, dividends change with time.

The articles of incorporation dictate the number of dividends that shareholders receive. Plus, if the business makes extra money that is not paid dividends, this capital returns to the business. This relatively simple system keeps shareholders paid and motivates them to help the company achieve greater heights.

Corporations are legal entities and possess similar legal duties as individuals. For example, individuals must pay their taxes each year, and so must corporations.

Therefore, taxes placed on dividends are the responsibility of the shareholder. Take this as a reminder: company shareholders must pay taxes on the dividends they receive—if they fail to, they could be in trouble with the Internal Revenue Service (IRS).

What Amount Should Partnership Partners Be Paid?

Hopefully, this article helps entrepreneurs choose what type of business to start and understand how they will be paid. If you have questions, we recommend consulting with a professional business attorney from Nakase Wade.

Why not start with a business plan if you are unsure where to go first? Whether individuals become sole proprietors or shareholders, business plans pave the way for success. For corporations, business plans are included in the articles of incorporation and often utilize ideas from multiple owners and shareholders.

What Should a Business Plan Cover?

We’ll devote another article to creating business plans, but in brief, all business plans should include:

How many workers will be paid
How to cover overhead costs (rent, utilities, supplies)
How will taxes be paid
Anticipated profits and losses

Small business owners sometimes struggle to predict how their LLC or sole proprietorship will perform. However, networking with similar business owners or conducting online research in one’s free time can help entrepreneurs gather information. Also, do not forget to include some extra capital in the business plan, just in case the business encounters unforeseen problems as it gets off the ground.

Business plans should provide a plan for the company’s cash flow and a general prediction of the business’s health. The next step may be to figure out exactly how to structure the company. That choice should be easier now that you are familiar with the different payment structures.

Why Contact the Expert Legal Team at Nakase Wade?

Starting any type of business hinges on important decisions, and our California corporate attorneys and business lawyers are here to help. With our advice and planning help, numerous small businesses have gone on to great success in California.

We understand that entrepreneurs have enough to worry about without agonizing over their paychecks. However, if you have questions about how sole proprietors are compensated or are a shareholder but are unsure about the company’s articles of incorporation and what that means for your paycheck, we can help.

Nakase Wade helps entrepreneurs achieve their goals and make the best of their business ventures. We care about our clients and want to see them continue to succeed. So contact us today, and together, let’s find out the best path to your business future.

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