The type of LLC formed and the tax election made by the company determine how members pay themselves for their work and how businesses and owners are treated at tax time. Learn what this means for your LLC.
How LLCs Are Taxed
An LLC is an attractive business structure, especially for small businesses, because it combines certain benefits of a corporation with those of a partnership. Similar to a corporation, LLC owners (also called members) are protected from personal liability, which means their personal assets will not be at risk should the business encounter bankruptcy or lawsuits. The IRS will treat a business differently depending on the type of LLC and the number of members:
Single-member LLC: These businesses have only one member, and for tax purposes, they are treated similarly to a sole proprietorship. According to the IRS, there is no separation between the business income and the owner’s income; this is known as a disregarded entity.Multi-member LLC: Classified as LLCs with more than one owner (or member), these are taxed as partnerships. The partnership itself (or the LLC) does not pay corporate taxes directly to the IRS. Instead, the individual members pay taxes based on their share of ownership.Corporate LLC: These LLCs elect, via notification to the IRS, to be taxed as a corporation or an S corporation.
Your LLC Structure Determines How You Pay Yourself
As a business owner, paying yourself is not as simple as collecting a W-2, even if you see yourself as a consistent employee of your business. Instead, partners collect income in different ways depending on how the LLC functions.
Single-Member LLC
For tax purposes, single-member LLCs function similarly to sole proprietorships. Both are considered pass-through businesses wherein the income of the partnership “passes through” to be taxed under the owner’s individual income tax. In this case, the business entity is disregarded as separate from the owner, meaning they are one and the same. Therefore, owners of single-entity LLCs or sole proprietorships may pay themselves using a method called an owner draw.
Multi-Member LLC
Multi-member LLCs are also considered pass-through entities. Partners are taxed on the business’s income commensurate with each partner’s ownership percentage. Some partners receive owner draws, which are considered prepayments for a distribution of profits at the end of the year or of a quarter, but others prefer a more steady income, similar to a salary. These are called guaranteed payments, and they are made without regard to the partnership’s income, meaning that they are paid out even if it results in a loss for the business. Unlike owner draws, guaranteed payments are treated as a business expense and have an impact on a business’s net income. In some partnerships, members may pay themselves either with owner draws, guaranteed payments, or a combination of the two.
Corporate LLC
LLCs that have elected to be treated as C corporations or S corporations are slightly more complicated and less common, especially for smaller businesses. These types of tax classifications, however, mean that owners of the business cannot take owner draws and must be treated as employees. These owner-employees must receive reasonable compensation and be issued payments via a payroll system that withholds federal employment taxes, just as the case would be for any other employee. After that salary, owner-employees may take distributions and dividends out of the company’s yearly profits, which are considered taxable income.
Guidelines for Paying Yourself
New business owners often pay themselves too little in the interest of leaving money in the company to help it grow. While this is noble and a potentially useful strategy, it is important to note that each partner is taxed on their portion of the business income, regardless of whether they draw their full share each year. So while it may seem obvious, as a business owner you must remember to pay yourself. Additionally, you’ll want to keep in mind some basic guidelines when formulating your payment structure, whether you’re a member of a partnership or owner of a single-member LLC (or sole proprietorship):
If you have partners, establish a guaranteed payment amount and/or dividend payment schedule early on using your partnership agreement or articles of incorporation. Consider your personal expenses and ensure that your owner draws can cover your basic cost of living. Work with an accountant to set aside funds to accommodate quarterly estimated tax payments via Form 1040 ES. Ensure that there is a paper trail for all payments. Owner draws and guaranteed payments should come in the form of a check or a bank transfer and be recorded clearly in your company books. This will protect you in the event of an audit by the IRS.
How You Pay Your Taxes
When it comes time to pay your taxes, there are different considerations depending on your type of LLC. Working with a qualified tax preparer can help ease the process, especially as your business becomes more complex. Single-member LLCs: Single-member LLCs and sole proprietorships are considered disregarded entities, so the company’s profits, losses, deductions, and other pertinent financial information are reported directly on Schedule C of the owner’s tax return. Multi-member LLCs or partnerships: Partnerships do not file separate tax returns. Instead, they must file the informational return Form 1065 and Schedule K-1s, which detail the distributions and guaranteed payments collected by each member throughout the year. Members then report their income from their K-1s on Schedule E of their tax return and report self-employment tax on Schedule SE. Corporate LLCs: If the LLC is a C corporation, normal corporate tax rules apply and the business must file the Form 1120 corporation income tax return. If the LLC has elected to be treated as an S corporation, then the company must file Form 1120S and each owner must report their share of corporate income, just as in a multi-member partnership.
