Most LLC owners will pay themselves via an owner’s draw. We have a guide on all of your available options to receive payments from your LLC.
How To Compensate Yourself From Your LLC
The way an owner of an LLC (limited liability company) collects compensation is determined by several factors such as contracts around sweat equity and profit-sharing, how many members there are, and how the company is taxed.
This article will present the best approaches for you to consider. To start, you need to decide which type of LLC your company falls under Single Member LLC (SMLLC), or Multi Member LLC (MMLLC).
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Collecting Compensation From A Single-Member LLC
If you own a single-member LLC, you can collect compensation by:
– Distributing funds through your individual tax return by default
– Distributing funds under an S corporation
Typically, most owners of an LLC will collect compensation as distribution via their individual tax returns.
If your business makes enough income to pay you a reasonable salary and no less than $10,000 in distributions annually, you can file taxes as an S Corp.
Paying Yourself by Default Pass-Through Taxation
In pass-through taxation, the IRS taxes your single-member LLC business in the default manner where your company’s profits pass through your individual tax returns. In filing, you can indicate the distribution that will go to yourself. This draw is your compensation.
This default method of taxation ensures that your single-member LLC will only get taxed by the IRS one time. It prevents the IRS from taxing your company profits twice.
The Effects of Pass-Through Taxation on a Single-Member LLC
Let’s suppose that your single-member LLC was able to make a net income of $6,000 last year. As the owner, you file a personal tax return to report these profits.
As compensation for yourself, you decide that you are entitled to take $1,000 in distributions. Because you have already reported your company’s $6,000 on your own tax return, the $1,000 that you take as distribution will not be subject to further income taxes.
The only tax you pay on the $1,000 is the FICA tax for self-employment.
There is one point that you must remember: How much you take as compensation from your LLC can affect your company’s standing as an LLC. You must maintain sufficient capital in your company’s bank account in order for your business to continue to operate behind the corporate veil of an LLC. If funds fall below a certain level, it can have negative implications. Learn more about this subject by referring to our guide entitled Maintain Your LLC’s Corporate Veil.
When Is Pass-Through Taxation the Ideal Approach To Follow?
Filing taxes under the status of an S Corp or C Corp is beneficial to businesses that are earning a healthy profit every year. For most of the other small businesses less profitable, using the pass-through taxation method to compensate themselves with a distribution makes more sense.
Small business owners tend to reinvest profits into their companies for growth. So, there is little carry-over of profits to the following tax year.
Small businesses in the following situations will do better if they file taxes under the default LLC status:
– The business owner focuses on company growth and reinvests the profits back into the company
– Paying for payroll and accounting services needed by an S Corp or C Corp would negate the tax benefits
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Using the S Corp Status to Compensate Yourself
If you own an LLC and you want to file taxes as an S Corp, you will get a salary as an employee of your company.
– Your salary must be reasonable
– Your company must have $10,000 in distribution at the minimum for the S Corp status to make financial sense
The distribution is separate from your salary. The money from your distributions would not be subject to FICA taxes for self-employment. The FICA tax will only be assessed on your salary. This is one benefit of filing as an S Corp.
A “reasonable salary” is the amount you would pay another person if you were to hire someone to do the same job that you do.
An Example of S Corp Taxation
Suppose you own and run a business as an S Corp LLC by yourself. You are the only owner, employee and shareholder of your business. Last year, your company earned $100,000 in profits.
You decided to pay yourself $80,000 in salary because that is the industry average for an employee with your experience. So, you compensate yourself with the following:
– A salary of $80,000, reported on a W-2
– A distribution of $10,000
When you file your taxes, you will file one for yourself and one for your LLC.
You will see $80,000 on your W-2 as salary which you report on your individual tax return. Your payroll service or accountant will deduct FICA taxes from your salary. You will also report the $10,000 in distribution as an income which will also be taxable.
For the tax return filed by your S Corp, you will report the business income and profits or losses. Your company will pay its part of the FICA and FUTA taxes on your salary.
When Does Filing Under an S Corp Tax Status Become More Advantageous?
From the standpoint of tax efficiency, if a company made enough profits to pay out at least $10,000 in distributions and a “reasonable salary” to its owner, then it is more beneficial for the SMLLC to file under the S Corp status.
Since distributions are not subject to FICA taxes, the owner of the S Corp will save about 16% in taxes. Of course, doing accounting and payroll for an S Corp is more complicated, and the tax savings have to be measured against the additional expenses for these services.
Using the C Corp Status to Compensate Yourself
Similar to an S Corp, an owner of a C Corp gets a “reasonable salary” for working in the company.
FICA and other income taxes are assessed on their salary. Dividends are only liable for income taxes. The difference between an S Corp is that a C Corp has to pay a corporate tax on the profits.
An Example of C Corp Taxation
You own and run a C Corp LLC, and you are the only owner, employee and shareholder. Last year, your company did very well and earned $500,000 in profits.
You gave yourself a salary of $80,000 because that is the industry average for a person with your experience and responsibilities. So, you have the following:
– Salary of $80,000, reported on your W-2
– Dividends of $10,000
For yourself, you report $80,000 as your salary on your tax return. FICA taxes will be deducted from your salary. Because you are also the only shareholder of record, the dividends of $10,000 will appear on Form 1099-DIV. You report this sum on your tax return because it is taxable income.
For the C Corp tax return, you report the business income and profits or losses. The company pays its share of FICA and FUTA taxes on your salary.
The C Corp also pays 21 per cent in corporate taxes on profits.
When Is Filing Under a C Corp Tax Status More Advantageous?
LLCs with a C Corp status have these features:
- They are good for investors and venture capitalists
- More possibilities for qualifying business expenses and tax deductions
- The cost to maintain this status is higher due to more complexity
- The corporate tax rate is 21%, and you can be taxed twice.
Investors like C Corps because taxation is simple. Only the dividends that they received are taxed. With other LLCs’ tax situations, investors may have a tax liability on profits even when they did not get any dividends.
To make it worthwhile, you have to balance potential tax savings against how much you pay for accounting and payroll service fees in addition to the 21% corporate tax rate.
Getting Compensation from a Multi-Member LLC (MMLLC)
Owners of MMLLCs have to agree on how profits will be divided and distributed among the members. After this is decided, then the owners can decide on how taxes should be filed.
When all the members come to an agreement on how the ownership of the business will be divided, then they can create a structure of payment:
– Choose the default of distributing funds through the owners’ respective individual tax returns
– File as employees of an S Corp where they will report their reasonable salaries and distributions
Sweat Equity, Profit Sharing, and Guaranteed Distributions
In the agreement for your MMLLC, there must be details on guaranteed distributions for each member and how residual profits will be divided.
A guaranteed distribution is what each member will get for the work that they do for the company, regardless if the company made any profits. The members plan and agree on the amounts for each member and document this in the MMLLC agreement.
If there are profits remaining in the MMLLC, the remainder is divided among the members based on the ownership interest of each member. By default, the distribution and share of profit go through each owning member’s individual tax returns.
The ownership interest of each member is not necessarily equal across the board. The percentage of ownership of each member in your MMLLC depends on two determinants:
– The amount invested by each member
– The sweat equity or the amount of work contributed by each member
Sweat Equity and the Percentage of Investment
Sometimes the agreement has to form a balance between a member’s sweat equity and a member’s financial investment in the company to determine each member’s percentage of ownership in the business.
Sweat equity is the value of the work done by a member of the company for which he was not paid. To put a value on it, the members have to form a sweat equity agreement. This agreement describes what tasks the member must do to earn equity, and how much equity each task is worth. Here are things to include in the sweat equity agreement:
– What Kind of Equity: What does the equity look like, and how much is being offered
– Criteria of Performance: Clearly define what tasks the member must complete earning equity
– Vesting Period: Clearly define how long the member must work for the company in order to get equity
– Stipulations on Separation: Under what circumstances can this agreement be broken, and by whom
Here is an example:
An MMLLC has two members, A and B. Person A is low on funds but has the time to start and run the business. Person B does not have the time, but he invests $2,500 into the company. These two members come to an agreement that the value of sweat equity is $7,500 for the startup and for each year of operations after that.
The operating agreement in this scenario will detail the distributions and profit-sharing based on the ratio between the sweat equity and the financial investment. Therefore, Person A, whose sweat equity is valued at $7,500, will get 75%, and Person B, who invested $2,500 in capital, will get 25%.
Getting Compensation Through a Partnership
The IRS taxes an MMLLC as a partnership by default, as pass-through taxation. Under this method, the profits of the MMLLC pass through the members’ individual tax returns. The owners can compensate themselves via a distribution. The distribution goes through the member’s individual income tax.
This method prevents double taxation. The IRS will not be able to tax your company’s profits and then tax the money again when you take a distribution.
Most of the time, a small business does not earn enough annual profits to make filing as an S Corp or C Corp worth their while. They tend to compensate themselves under the default LLC pass-through tax status
Example of an MMLLC Filing and Pass-Through Taxation
Suppose your MMLLC earned $50,000 last year. Your operating agreement states each owning member has a 25% share of the company.
In that scenario, each person will have a taxable income of $12,500 which is reported on each person’s individual tax return. Each person only pays taxes on $12,500.
Then, from the $12,500, all of you decide to receive $6,000 as a distribution. Because you have already paid income taxes on your respective shares, the distribution will not be subject to additional income taxes. However, you do need to pay the FICA self-employment tax on the $6,000.
An important point to remember is that your LLC must have sufficient funds in order to keep behind the LLC corporate veil. Insufficient funds in the business bank account can impact your LLC status. Learn more about this crucial subject by reading the guide called Maintain Your LLC’s Corporate Veil.
When Is the Partnership Status Appropriate To Use?
Most owners of MMLLCs prefer to compensate themselves through pass-through taxation, or partnerships. If you intend to reinvest most of the company’s profits back into the business, pass-through-taxation is the most appropriate. Most small businesses earn little annual profit because they put the money back into their business for growth. So, the default tax structure for LLCs is best for a small business if:
– The owners intend to grow their company by putting profits back into the business
– The payroll and accounting fees of maintaining an S Corp or C Corp status negate the tax benefits
Getting Compensation As An S Corp
If you want your MMLLC to have an S Corp status, then each “active shareholder” will receive a salary.
– The salary must be reasonable
– The MMLLC must have a minimum of $10,000 to distribute for the S Corp status to make financial sense
An active shareholder is essentially an owner and an employee of the MMLLC S Corp. He actively participates in the company’s operations.
As an owner-employee, the member gets a reasonable salary which is subject to self-employment FICA taxes and income taxes. The distribution they get is subject only to income taxes.
An Example Of Taxation on an S Corp
Suppose your S Corp LLC has four owners, and you are one of them. Last year, your company earned $500,000. Each of you as a shareholder has 25% ownership of the company. So, each share is $125,000.
You decide that your salary should be $100,000 because that is the industry standard for someone who does what you do. Your compensation is:
– A salary of $100,000, reported on the W-2
– A distribution of $20,000
During tax time, each of you will report the amount from your W-2, which is $100,000, on your individual tax return. Your payroll administrator will deduct FICA taxes from your salary. Each of you will also report the distributions which is subject to only income taxes.
Your company, as an S Corp, must file a separate tax return. This is where you will report the business income and profits or losses. The company will pay its part of the FICA and FUTA taxes on the salaries.
When Is It Advantageous To Report Under An S Corp Status?
In general, if the MMLLC can afford to pay the owners a minimum of $10,000 as a “reasonable salary” every year, then filing under the S Corp status would be logical.
Owners of an S Corp can save around 16% in taxes because their distributions are not subject to FICA taxes. However, payroll and accounting adminstration are more complex in maintaining an S Corp status. So, you need to see if the tax savings are still more than the extra maintenance expenses.
Getting Compensation From a C Corp
Just like an S Corp, a C Corp must pay each owner a “reasonable salary” for the work they do in the company.
As stated earlier, a reasonable salary is what you are expected to pay another person for performing the same tasks that you are doing.
As the owner of the business, you pay income taxes including FICA on your salary, but the dividends you receive are only liable for income taxes. The difference from an S Corp is that a C Corp must pay a corporate tax on the profits as well.
Example of a C Corp Taxation Scenario
Your C Corp LLC has four owners, and you are one of them. Last year, your company made a profit of $500,000. You and the other three shareholders each own 25% of the company. So, each of your gets $125,000 as your share.
You decide that your salary should be $100,000 because that is the average salary for a person at your level of experience in your industry. So, your compensation is:
– A salary of $100,000, reported on a W-2
– Dividends of $20,000
When you file taxes, you file your individual tax return and report $100,000 from your W-2 as your salary. FICA taxes are deducted from your salary automatically. You dividends will show up on Form 1099-DIV which you also report because it is taxable income.
Your company with C Corp status files a separate return and reports business income and profits or losses. The company pays FICA and FUTA taxes on the salaries.
When Is It Advantageous To File Under C Corp Status?
The LLC should have the following traits if a C Corp status is preferred:
– Good for investors and venture capitalists
– More options in qualifying business expenses and tax deductions
– Higher cost in account maintenance due to more complex filing structure
– Corporate tax rate of 21%, subject to double taxation
Investors like C Corps because the tax requirements are not complicated. They just need to pay taxes on their dividends. In other types of LLCs, investors might need to pay taxes on profits even if they did not get a dividend distribution.
The administration cost of maintaining a C Corp can also be high. Therefore, you should compare your tax savings with the high maintenance fees to see if a C Corp status is worth your while.