You did it! You started your business, and it’s making money. Now it’s time to keep some for yourself for all your work. A common question from small business owners with an LLC is how do I correctly pay myself. The answer primarily depends on the tax election of the LLC.
Upon setting up an LLC, you either accepted the default tax status (sole proprietorship as a Single-Member LLC or partnership as a Multi-Member LLC) or elected specific tax treatment through the IRS (Internal Revenue Service).
It’s easy to confuse the liability protection of an LLC when we start talking about tax elections. Regardless of how the LLC is taxed, the member(s) still have the limited liability protection an LLC should the entity be sued. Regardless of the tax election, the LLC still provides the liability protection of the owner’s personal assets.
Below, we go over the ways to pay yourself from an LLC based on tax elections.
LLC taxed as a Sole Proprietorship
A Single-Member LLC is taxed like a Sole Proprietorship by default from the IRS. The member (sole owner) of a Limited Liability Company taxed as a Sole Proprietorship does not take a salary and instead takes a “draw” of the LLC’s profits, which are revenue minus expenses.
A draw is money taken out of the business’s accounts as a distribution for the owner to use personally. To take a draw, simply write a check from the LLC’s bank account and deposit it in your personal bank account. This draw can be taken in any amount and at any time, assuming the LLC can afford to pay.
Even though taxes are not immediately taken out from the draw, Self-Employment and Income taxes will need to be paid.
Self-Employment Taxes – Once a quarter, estimated tax payments for FICA (Federal Insurance Contributions Act) taxes and withholding taxes will submitted on Form 1040-ES to the IRS. FICA taxes (known as Self-Employment Taxes) are a combination of Social Security and Medicare. Self-Employment tax is 15.3% of the profits (not just the amount of the draw).
Income Taxes – Net profits from an LLC taxed as a Sole Proprietorship are not subject to income taxes since the LLC is considered a disregarded entity. A disregarded entity is a business entity that is separate from the owners (providing liability protection) but is not separate from the owner(s) for tax purposes. The income from the business is transferred to the owner and is called pass-through taxation. Profits and losses will show up on the owner’s Schedule C.
LLC taxed as a Partnership
An LLC with more than one member (Multi-Member LLC) is taxed as a Partnership by default from the IRS. Just like the Single-Member LLC, each of the partners of a Multi-Member LLC can take a draw. Each quarter they will pay estimated self-employment taxes by filing IRS Form 1040-ES.
The partnership is also a disregarded entity, and an informational return is filed with the IRS on Form 1065. At the end of the year, each Partner receives a Schedule K-1 and adds the income to their personal income tax return.
LLC taxed as a Corporation
The LLC can also elect to be taxed as either a C Corporation or S Corporation by filing IRS Form 8832: Entity Classification Election. As an LLC being taxed as a Corporation, the member(s) working in the business receives a wage from a paycheck from the business with taxes taken out.
There are potential benefits to electing Corporation tax status. Any remaining profits that are left after the member receives a “reasonable salary” or “reasonable compensation” can be distributed as dividends. Dividends are not subject to the 15.3% self-employment tax, which could result in significant savings. The IRS definition of reasonable compensation varies by the type of work being done and the amount of time spent in the business, but it is important to keep in mind before paying dividends. In addition to taking a reasonable wage, the owner can also take an owner’s draw, also called an owner distribution, which is a portion of the business’s profits that your business distributes to you as your payment.
Regardless of which Corporation status is chosen, a member working in the business now becomes an employee. Now, instead of paying Self-Employment taxes, Payroll taxes are withheld. Payroll taxes include both Social Security tax and Medicare tax. With Payroll taxes, the business pays half, and the employee pays the other half instead of the owner paying both halves as would be done when paying Self-Employment taxes.
One of the key areas to look at when being taxed as a corporation is double taxation. There are two choices of taxation of a corporation which include the C corporation and the S corporation. The C corp is popular with investors because of their straightforward tax requirements, as shareholders only have to pay taxes on what dividends they’ve received. Investors and owners will pay taxes on profit with an S corporation even if they didn’t receive a disbursement/dividend.
At the end of the year, all employees (whether a member or not) will receive a W-2 to enter on their personal tax returns.
Another way to receive compensation from an LLC is to work as an independent contractor. The member could be the independent contractor and bill the LLC for services rendered. This becomes a deductible expense for the LLC.
If you already set up your LLC and want to change how it is taxed, look into IRS Form 8832: Entity Classification Election. There are restrictions, but an LLC can change its tax election.
There is a lot to contemplate when deciding on the tax election of an LLC, so we recommend getting tax advice from a professional CPA who is skilled in this area.