When operating as an LLC, one of the most important decisions you’ll make is how to pay yourself. The flexibility of an LLC not only makes it an attractive option for many business owners, but it also offers a variety of payment methods depending on the company’s tax classification.
This article explores the different ways you can distribute profits from your LLC to yourself, each with its own tax implications and legal considerations.
Understanding the Tax Classification of an LLC
Before deciding on a payment method, it’s important to understand the tax classifications available to an LLC. An LLC’s tax status affects how payments to owners are handled, affecting everything from payroll taxes to income reporting on personal tax returns.
Default Tax Classification
By default, an LLC is either:
- Disregarded entity. Single-member LLCs are automatically considered disregarded entities, which means the business is treated as a sole proprietorship for tax purposes. The owner reports business income and expenses on his or her tax return.
- Partnership. Multi-member LLCs are treated as partnerships. The business itself does not pay taxes. Instead, profits and losses pass through to the members, who report them on their tax returns.
In both scenarios, members typically pay themselves through “owner’s distributions,” which are direct withdrawals of the business’s profits. These are not treated as wages, so no payroll taxes are withheld. Instead, the owners pay self-employment tax on their share of the profits.
Corporate Status Selection
An LLC can also elect to be treated as a corporation for tax purposes, specifically as an S or C corporation, by filing IRS Form 8832. Here’s how each affects owner payments:
- S corporation. Profits pass through to the owners’ tax returns, but owners who work as employees must receive a reasonable salary that is subject to payroll taxes. Any additional profits can be taken as distributions, which are usually taxed at a lower rate than income.
- C corporation. A C corporation is taxed as a separate entity. After paying corporate tax on profits, dividends can be distributed to owners, which may be subject to double taxation (once at the corporate level and again as dividend income on the individual return).
The election to be treated as a corporation can provide tax benefits, such as lower self-employment taxes, but also comes with stricter requirements for payroll and dividend distributions. Whether this election makes financial and administrative sense depends on the specific circumstances of the LLC and its members.
Methods to Pay Yourself from an LLC
Owner’s Draws
An owner’s withdrawal is a direct withdrawal of funds from the business by the owner for personal use. This method is typically used by LLCs that are taxed as sole proprietorships or partnerships.
To take an owner’s draw, you simply write a check to yourself from the business account or transfer money electronically.
Draws are not subject to payroll tax withholding; however, you must pay self-employment taxes on the amount drawn. It’s important to keep track of all withdrawals because they directly affect the owner’s capital account and tax returns.
Because these draws reduce the company’s equity, it’s important to manage them carefully so they don’t affect the company’s financial health and ability to operate.
Salary Payments
For LLCs that elect to be taxed as S or C corporations, paying yourself a salary is a viable option. This method treats the owner as an employee of the business.
To pay a salary, the LLC must set up a payroll system to withhold income tax, Social Security, and Medicare. This formal payroll structure must comply with federal and state employment laws.
The IRS requires that the salary be “reasonable” compared to what similar businesses pay for comparable services. This is particularly scrutinized in S corporations to prevent owners from avoiding payroll taxes by minimizing their salary.
Salaries are deductible as a business expense, potentially reducing the company’s taxable income. However, they also require the business and the owner-employee to contribute to payroll taxes.
Salary payments provide a clear, regimented way to manage personal income from the LLC, especially under the corporate tax treatment. This method can provide tax benefits in the form of business expense deductions but requires careful documentation and compliance with payroll rules.
Common Mistakes and How to Avoid Them
When managing finances as an LLC owner, certain pitfalls can jeopardize both your personal and business financial health. Recognizing and avoiding these mistakes is critical.
- One of the most common mistakes is not maintaining separate accounts for personal and business finances. This can lead to tax complications and problems with the IRS. To avoid this, always use separate bank accounts and credit cards for your business.
- Failure to keep detailed records of all financial transactions can lead to problems at tax time and if the business is audited. Implementing a reliable accounting system and keeping meticulous records are essential practices.
- If your LLC is taxed as an S or C corporation and you pay yourself a salary, it’s critical to comply with all payroll reporting and withholding requirements. Failure to do so can result in penalties.
- For those who take owner’s withdrawals, remember that they are not subject to automatic tax withholding. You must make estimated tax payments quarterly to avoid underpayment penalties.
Avoiding these common mistakes requires diligent management and a proactive approach to business and financial practices.
Incorporating tax projection into your annual financial planning can also significantly aid in managing these obligations more effectively.
Legal and Documentation Requirements
Understanding the legal and documentation requirements is critical to maintaining the integrity and compliance of your LLC.
- Operating agreement. While not always required by law, an operating agreement is critical. It outlines the financial and functional decisions of the business, including rules, regulations, and provisions. The agreement becomes especially important in multi-member LLCs to dictate the distribution of profits and management responsibilities.
- Employment agreements. If you pay yourself a salary, formal employment agreements are necessary to define roles, responsibilities, and compensation. This documentation will help establish clear terms and avoid disputes.
- Tax documentation. Maintaining accurate and up-to-date tax records is mandatory. This includes filings such as IRS Form 1065 for partnerships, Schedule C for a disregarded entity, or corporate tax returns for LLCs taxed as corporations. Proper documentation ensures compliance and simplifies the annual filing process.
- Payroll documentation. For LLCs that handle payroll, maintaining comprehensive payroll records is essential. This includes not only employee pay stubs and tax withholdings but also records of any employer contributions to health insurance or retirement plans.
Adhering to these legal and documentation standards is essential for smooth operations and compliance, helping to protect the business and its owners from legal complications and financial mishaps.
Bottom Line
Choosing the right method to pay yourself as an LLC owner is a decision that affects both your personal and business finances. Whether through owner drawings or payroll, each option carries its own set of responsibilities and implications for tax planning and financial management.
By understanding these implications, avoiding common mistakes, and complying with legal and documentation requirements, you can effectively manage your compensation in a way that supports the growth of your business and your financial goals.
Working with professionals such as accountants and attorneys can provide the guidance you need to navigate these complex decisions and ensure that you are not only complying with current laws but also strategically planning for the future of your business and personal finances.
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