Can a Single-Member LLC Owner Be on Payroll?

A common question for entrepreneurs forming a single-member Limited Liability Company (SMLLC) revolves around how they can pay themselves. Many assume they can simply put themselves on payroll, similar to an employee of a larger corporation. The reality is more nuanced due to how the Internal Revenue Service (IRS) classifies SMLLCs for tax purposes. Understanding these classifications and options is important for financial management and tax compliance.

Default Treatment of Single-Member LLC Owners

By default, the IRS treats a single-member LLC as a “disregarded entity” for federal income tax purposes. The LLC itself is not separately taxed; its income and expenses are reported directly on the owner’s personal tax return using Schedule C. As the owner and business are considered the same for income tax purposes, the SMLLC owner is self-employed, not an employee of the LLC. Consequently, they cannot be “on payroll” in the traditional sense, receiving a W-2 wage.

Instead of wages, SMLLC owners typically compensate themselves through “owner’s draws” or “distributions.” Draws involve transferring funds from the business bank account to the owner’s personal bank account as needed. These distributions are not wages and are not subject to withholding. The owner reports the business’s net profit or loss on their personal tax return; draws are a reduction of owner’s equity, not a deductible business expense.

A significant tax implication for SMLLC owners is self-employment tax. Since they are self-employed, owners are responsible for paying both the employer and employee portions of Social Security and Medicare taxes, collectively known as FICA taxes. The self-employment tax rate is 15.3% on net earnings, covering Social Security and Medicare. This self-employment tax is calculated on the LLC’s net earnings and reported on Schedule SE.

SMLLC owners also have an obligation to pay estimated taxes quarterly. These payments cover their income tax liability and self-employment tax obligations for the year. Payments are required throughout the year to avoid underpayment penalties.

Electing S Corporation Status for a Single-Member LLC

A single-member LLC can choose to change its tax classification by electing to be taxed as an S Corporation. This election is made by filing Form 2553 with the IRS. The primary motivation for this election is tax savings on self-employment taxes. Once an SMLLC is taxed as an S-Corp, the owner can receive a “reasonable salary” subject to payroll taxes and take remaining profits as distributions, which are not subject to self-employment tax.

To qualify for S Corporation status, a business must meet specific requirements. These include being a domestic corporation, having no more than 100 shareholders, and having only one class of stock. Shareholders must be individuals, certain trusts, estates, and U.S. citizens or residents. For the election to be effective for the current tax year, Form 2553 generally must be filed by a specific deadline early in the tax year.

Beyond self-employment tax savings, S-Corp status can offer other tax advantages, such as eligibility for the Qualified Business Income (QBI) deduction, also known as Section 199A deduction. This deduction allows eligible taxpayers to deduct up to 20% of their qualified business income, subject to certain limitations based on taxable income, W-2 wages, and the unadjusted basis of qualified property.

Compensating Yourself as an S Corporation Owner

Once a single-member LLC has elected to be taxed as an S Corporation, the owner’s compensation structure changes significantly. The owner, now a shareholder-employee, must receive a “reasonable salary” for services performed. This salary is traditional wages and is subject to federal income tax withholding, plus Social Security and Medicare taxes (FICA). The IRS emphasizes that this salary must be comparable to what other businesses would pay for similar services under similar circumstances.

Determining a Reasonable Salary

Factors considered in determining a reasonable salary include:
The owner’s duties and responsibilities
Time and effort devoted to the business
Qualifications
Compensation paid for similar roles in the industry

Running payroll for an S-Corp owner involves steps. First, the S-Corp must obtain an Employer Identification Number (EIN). Next, the business needs to set up a payroll system using payroll software or a professional service.

The S-Corp is responsible for withholding federal income tax, Social Security tax (6.2%), and Medicare tax (1.45%) from the owner’s salary. The S-Corp also pays the employer’s matching portion of Social Security (6.2%) and Medicare (1.45%) taxes. These withheld and employer-paid taxes are reported quarterly to the IRS on Form 941. Additionally, the S-Corp must file Form 940 to report federal unemployment taxes. At year-end, the S-Corp must issue a Form W-2 to the owner, detailing their salary and withheld taxes.

After paying a reasonable salary, any remaining business profits can be taken as distributions (dividends) by the S-Corp owner. A key advantage is that these distributions are generally not subject to Social Security or Medicare taxes, offering substantial tax savings. The S-Corp reports its income, deductions, and distributions on Form 1120-S. The owner’s salary and distributions are then reported to them on Schedule K-1, which they use to report these amounts on their personal tax return (Form 1040).