How to pay yourself from an LLC - guide for business owners
For owners of LLCs, determining the most efficient way to pay themselves is a critical aspect of financial management that directly impacts personal income and tax obligations.
The flexibility of an LLC offers numerous benefits, but it also introduces a variety of compensation options, each with its own effects.
This article aims to serve as a comprehensive guide for LLC owners, providing detailed insights into the methods of paying yourself from an LLC, understanding the related tax consequences, and adopting best practices for financial health and compliance.
Deciphering LLC classifications and their impact on owners compensation
An LLC is a popular option for business owners who desire management flexibility and protection from personal liability. This business model combines the protective shield of a corporation with the tax advantages and operational versatility of a partnership.
However, the way an LLC is taxed - and consequently how its owners can pay themselves - varies significantly depending on the tax classification chosen.
LLC tax classifications
- Disregarded entity. By default, a single-member LLC is treated as a disregarded entity for tax purposes. This means that the LLC itself does not pay taxes. Instead, all profits and losses are reported on the owner's personal tax return, like a sole proprietorship.
- Partnership. Multi-member LLCs are automatically classified as partnerships by the IRS. Like disregarded entities, partnerships are pass-through entities, meaning that the business itself does not pay income taxes. Instead, profits are passed through to the members, who then report their share of the profits on their personal tax returns.
- S corporation. LLCs can elect to be taxed as an S corporation. This election can provide tax benefits, such as saving on self-employment taxes. However, it requires the business to pay the owner a "reasonable salary" subject to employment taxes, with any additional profits paid as distributions that are not subject to self-employment taxes.
- C corporation. Although less common for LLCs, electing to be treated as a C corp introduces the concept of double taxation, where the corporation pays corporate income tax, and dividends paid to owners are taxed again at the individual level. However, this classification allows business owners to be treated as employees and receive a salary in addition to dividends.
Each of these classifications carries distinct tax implications for how an LLC owner can and should pay themselves, affecting everything from the simplicity of tax filing to the amount of taxes owed.
How to pay yourself from an LLC
Understanding the nuances of self-employment from an LLC is critical for both financial planning and tax compliance.
The method you choose not only affects your personal income but also how you report taxes. Here's a breakdown of the primary methods for paying yourself from an LLC, tailored to the structure of your business.
Single-member LLCs
Owner's draw. An owner's draw refers to the process of withdrawing funds from the LLC's profits for personal use. This method is simple: You simply transfer money from the business account to your personal account, reflecting your share of the business profits.
Tax implications and reporting requirements. Because a single-member LLC is considered a disregarded entity for tax purposes, the amount withdrawn will be reported on your personal tax return.
Specifically, you'll report your business income and expenses on Schedule C, which is attached to your personal tax return (Form 1040). The profit calculated on Schedule C is subject to income tax and self-employment tax, which covers Social Security and Medicare.
Multi-member LLCs
In a multi-member LLC, members typically receive distributions of profits based on their ownership percentage or according to the terms outlined in the LLC's operating agreement. These distributions are similar to an owner's share but are divided among the members.
Each member reports his or her share of the profits on his or her personal tax return, regardless of whether the profits were distributed or retained in the business.
The LLC itself reports the total profits and the allocation to each member on Form 1065, and each member receives a Schedule K-1 showing his or her share of the profits, which is then reported on his or her personal tax return.
As with a single-member LLC, income is subject to income tax and possibly self-employment tax, depending on the nature of the income and the member's active participation in the business.
Electing corporate taxation
The election to be taxed as an S or C corporation allows LLC members to be paid a salary as business employees. This salary must be "reasonable" based on the work performed, industry standards, and other factors.
Being on the payroll means that income tax and Social Security and Medicare (FICA) taxes are withheld from your salary, simplifying tax payments and potentially reducing self-employment taxes.
After paying a reasonable salary, any additional profits can be distributed to members as dividends (in the case of a C corp) or as additional distributions (for an S corps).
These are not subject to self-employment taxes, which can result in tax savings. However, C corp dividends are taxed twice: once at the corporate level and again at the individual level when distributed as dividends.
Also read. How to file business taxes for an LLC
Bottom line
Navigating the financial and tax aspects of paying yourself from an LLC requires a nuanced understanding of various tax classifications, payment methods, and their implications.
Whether you're a single-member LLC considering an owner's draw or a multi-member LLC exploring distributions and salaries, the choices you make have significant tax implications.
Given the complexity of the tax laws and the unique circumstances of each LLC, consulting with a tax professional or CPA is invaluable.
Your business structure is the key to tax savings.
Get a tax planning consultation.
FAQ
The frequency of payments to yourself from an LLC can vary depending on your business's cash flow, your personal financial needs, and tax considerations.
Some LLC owners choose to pay themselves monthly, while others opt for quarterly distributions. The key is to ensure that the business maintains sufficient cash reserves to operate effectively.
For LLCs taxed as S corporations, determining a reasonable salary involves considering the salaries paid to others in similar positions in your industry, the size and profitability of your business, and the amount of work you contribute to the business.
The salary must reflect fair compensation for the work performed, as the IRS scrutinizes unreasonable salaries to ensure tax compliance.
Disclaimer: This article is for informational purposes only and does not constitute legal or tax advice. Always consult with a tax professional regarding your specific case.
Susan Turcotte, a seasoned CPA with over 45 years of accounting experience, holds a Bachelor's in Accounting and a Master's in Taxation from Bryant College. See more
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