One significant advantage to organizing your business as a limited liability company (LLC) is the flexibility it provides. For example, the Internal Revenue Service (IRS) allows LLC owners to choose whether their business will be taxed as a sole proprietorship (if you are the LLC’s sole member), as a partnership (if your LLC has two or more members), or as a corporation. An LLC also provides flexibility in how the owners will pay themselves, depending upon the chosen tax classification.
There are various rules for how different business entities are allowed to pay their owners as well as IRS guidelines to consider. This article provides a general overview of how to pay yourself when you own an LLC. Specific questions about LLC-owner payments and which payment structure is best for your company can be directed to a business law attorney.
Your Business Entity Structure
Forming an LLC as opposed to a sole proprietorship or a partnership allows owners to avoid personal liability for business debts and liabilities. However, LLCs can still be taxed like a sole proprietorship or a partnership. LLC owners can also elect to be taxed as a corporation. Here is how it works:
- Are you the only member of your LLC? If so, the IRS will treat it as a sole proprietorship unless you choose for it to be treated as a corporation.
- Does your LLC have multiple members? In this case, you can decide whether it is taxed as a partnership or as a corporation. The IRS, by default, treats a multimember LLC as a partnership. Alternatively, you can opt to set up your LLC to be taxed as a C corporation or an S corporation.
Why does the tax classification of your LLC matter? One important reason is that it affects the ways you are legally allowed to pay yourself as the owner of an LLC.
Let’s look at the payment options for each structure.
Paying Yourself from a Single-Member LLC
Single-member LLC owners pay themselves an “owner’s draw.” To make an owner’s draw, you simply write yourself a check from your business account and deposit it in your personal account (or transfer money between accounts online). You can take an owner’s draw at any time, and there is no limit to the number of draws you can take. Keep in mind, though, that an owner’s draw reduces the amount of funds available for business expenses.
- Tax implications: In a sole proprietorship, you and the business are one and the same for income tax purposes. Like a sole proprietorship, a single-member LLC is an entity disregarded as separate from its owner. For income tax purposes, this means that all of the income generated by your business is reported on your personal tax return. Taking a draw does not increase business income and it is not taxed separately. For purposes of employment tax and some excise taxes, however, a single-member LLC is treated as a separate entity. You pay estimated taxes and self-employment taxes on your business profits for the year.
Paying Yourself from a Multimember LLC
Depending on whether the multimember LLC is classified as a partnership or a corporation, the owners of a multimember LLC can take an owner’s draw or they can be paid a salary.
If your multimember LLC uses the IRS’s default classification as a partnership, your only option is to take a draw. The IRS does not allow you to be both a partner and an employee in your business.
- Tax implications: Owner draws are treated somewhat differently in partnerships than they are in sole proprietorships. As in a sole proprietorship, draws in a partnership are not taxed as income. Thus, for partnerships and LLCs, each partner or LLC member owns a share of the business, as determined by the company’s partnership or LLC operating agreement, and they are taxed on their share of the partnership’s or LLC’s While you are not taxed again on any owner’s draw you make from the partnership or LLC, you do have to pay self-employment tax on a draw. Like partners, LLC members report their income on Form 1065, Schedule K-1.
If your multimember LLC is treated as a corporation for tax purposes, you can be considered an employee. As an employee, you can be paid a salary. This works the same for the LLC member as for any other employee. You set the wage you want to pay yourself and receive a paycheck every pay period. Alternatively, you can hire yourself as an independent contractor.
- Tax implications: As an employee of your LLC, your salary is subject to automatic tax withholdings each pay period, and you will need to file a W-2 tax form. A benefit of taking a salary is that employee wages qualify for a tax write-off as an operating expense. If you hire yourself as an independent contractor, your taxes are not automatically withheld. You will have to pay estimated taxes and self-employment taxes, and your company will have to file form 1099-NEC.
Other Considerations for Paying Yourself as an LLC Owner
Knowing how to pay yourself from your LLC is just the tip of the iceberg. Here are some other important points to keep in mind:
- Take care not to misclassify yourself. The same rules that apply to determining whether a worker is an employee or a contractor apply to you as well.
- If you treat yourself as an employee, the IRS expects you to collect a reasonable salary, or reasonable compensation. Unfortunately, the agency fails to go into detail about what “reasonable” means in this context, only stating that it should be “commensurate with your duties.”
- Your LLC partnership can set up partner draws as a guaranteed payment—a minimum distribution that each partner is paid, regardless of business profit.
- LLCs that are set up as an S corporation can pay owners in distributions in addition to salary. In a C corporation, owners (i.e., shareholders) can receive a salary and dividends. Distributions and dividends are taxed at different rates. C corporations are also taxed doubly, but dividends are exempt from payroll tax. An S corporation or C corporation classification could provide tax savings depending on factors such as how the business is operated and how payments are made.
- Your LLC should have an operating agreement that specifies the details of how members are compensated, how often they are compensated, how company profits are split up, and the other nuances of member compensation.
- Your income does not have to be set in stone. It can be adjusted based on how well the business is performing, how much money you want to reinvest in the business, and your fluctuating personal expenses.
LLC tax classification and owner payments are complex issues to think about. If you need help balancing what is best for you and what is best for your business while complying with IRS rules, do not hesitate to contact our office (651-738-3433) to schedule an appointment with attorney Mark Tebelius.