A Limited Liability Company is a legal entity created for conducting commercial transactions. The owners of such entities are called members who invest their capital and labor into developing the company. This naturally merits appropriate compensation.
The company’s owners are paid based on the LLC ’s tax system, as well as the number of members. Let’s look at how this process applies to entity types based on their management.
How LLC Ownership Works
An LLC can have multiple members but can also be owned by a single person. Companies operated by a sole member are classified as single-member LLCs, while companies with 2 members or more are called multi-member LLCs.
In order to become a member, whether during the initial launch or after the fact, the candidate must, above all, make a capital contribution. Any profits earned by the company will be shared between all contributors according to the rules of distribution outlined in the operating agreement.
The ownership group may choose to distribute the profits according to the scale of each contribution, but they can choose to induct another system of compensation.
Each member’s percentage interest, often measured in membership units, is outlined in their individual capital account. The amount of compensation paid to each member changes depending on the company’s profits and expenses. It also changes in cases when members withdraw funds for personal use which can be done even prior to the end of the fiscal year.
Typically arranged through payment checks, this procedure is often referred to as distribution or a draw. These withdrawals do not fall under the definition of normal wages since LLC members are not classified as employees. The only instance where the owners are not considered to be self-employed is when an LLC follows a corporate taxation system.
How an LLC is Taxed
One of the main advantages of LLC formation is the ability to choose the company’s taxation system. Unlike other business structures, LLC can elect to be taxed as:
- Sole proprietorship;
Single-member LLCs created and operated by a sole owner are classified as pass-throughs by default. Like sole proprietorships, these entities are exempt from federal income tax. Instead, all profits and expenses are reported on the personal tax returns of the members.
Multi-member LLCs are also pass-throughs, although their tax classification is close to that of a partnership or corporation. Unless elected otherwise, the IRS classifies companies with several members as partnerships. In this case, the company itself is exempt from income taxes, leaving this responsibility to the owners.
However, LLC members have the opportunity to elect a corporate tax system, identical to that of C or S corporations. Although C-corporations allow for a number of tax deductions, they are also notoriously double-taxed. With S-corporations, you can avoid the double tax, though expect other limitations to take its place.
How to Pay Yourself in an LLC
As the owner of a single-member LLC, you are entitled to compensation. But what is the correct way of paying yourself without violating any IRS regulations?
Given that a single-member LLC is treated as a sole proprietorship in terms of taxation, all company profits go to the sole owner who reports them to the IRS at the end of the fiscal year.
However, any fledgling company must be sustained financially, so it wouldn’t be prudent to withdraw all profits for personal use. A more considerate course of action would be dividing the funds in order to pour some of them into the development of your company.
For a partial withdrawal from the capital account, the sole member must do the owner’s draw by:
- Issuing a check in your name;
- Transferring the sum stated in the check from LLC’s account to your personal account;
- Recording the transaction in your ledger as an owner’s draw.
In this case, the withdrawal amount can be anything since the owner of a single-member LLC pays tax on all profits, not just a share. Even if you choose to reinvest all of the profits without taking any portion for yourself, you will still need to pay the tax on all of it. Additionally, you may be required to pay the 15,3% self-employment tax consisting of the social security and Medicare taxes.
As for multi-member LLCs, the payout procedure is defined by the company’s tax system, specifically if it’s taxed as a partnership or corporation.
Let’s start with payments for the default partnership tax system. Just like with a single-member LLC, an owner in a multi-member company may use an owner’s draw.
Multi-Member LLCs taxed as partnerships are not subject to federal income tax. However, they must file Form 1065 to inform the IRS about the profits, with each member reporting on the profits allocated to them on Schedule K-1. Based on this, the IRS calculates each member’s income tax and self-employment taxes.
Members in multi-member LLC may receive guaranteed payments. These are different from draw payments in that they are classified as tax-deductible expenses reported on Form 1065. Such payments aren’t suitable for every business since they affect the LLC’s net profit. Make sure that your business is financially stable first, otherwise, its growth will be stunted by these regular payments.
Then, there are multi-member LLCs that follow corporate tax systems. For these entities, the payments don’t follow the process of the owner’s draw.
When your company is taxed as a corporation, you are entitled to dividends, i.e. regular payments calculated based on your ownership percentage. These units are usually allocated in the formation documents and the Operating Agreement.
Owners can also pay themselves salaries if they are technically employed by the LLC. Keep in mind that this salary is subject to income and payroll taxes. The salary size must be considered “reasonable” if you don’t want the IRS to flag you. The best way to calculate it is to consider the company’s financial capabilities and industry statistics that give you an estimate of an average wage in a specific field.
If you want to minimize your taxes, make sure that your salary and dividend yield are well-balanced. On average, you are likely to pay less in tax if your dividend yield is higher than the salary.