Can an LLC Owner Be a W-2 Employee?

A Limited Liability Company (LLC) is a business structure that provides liability protection to its owners, known as members. Whether an owner can be treated as a W-2 employee of their LLC is determined by how the business elects to be treated for federal tax purposes by the Internal Revenue Service (IRS). This tax classification, not the LLC structure itself, dictates if an owner can receive a W-2 wage.

Owner Compensation Under Default LLC Tax Rules

By default, the IRS treats an LLC based on its number of members. A single-member LLC is classified as a “disregarded entity” and taxed like a sole proprietorship, while a multi-member LLC is taxed as a partnership. Under these default classifications, an owner cannot be a W-2 employee. The legal structure of the LLC is separate from its owners for liability purposes, but for tax purposes, the owner and the business are considered the same.

Instead of a salary, owners are compensated through draws or distributions. In a single-member LLC, the owner takes an owner’s draw. For multi-member LLCs, compensation can be a mix of guaranteed payments for services and distributive shares of the company’s profits. These payments are not considered wages and do not have taxes withheld.

All net profits of the business flow through to the owners’ personal tax returns. The owners are then responsible for paying the full self-employment tax, which covers both the employee and employer portions of Social Security and Medicare taxes. This is reported on Schedule SE of the individual’s Form 1040 tax return.

Owner Compensation When an LLC Elects S Corp Status

An LLC owner can become a W-2 employee if the LLC elects to be taxed as an S Corporation. When an owner provides more than minor services to the business, the IRS requires the S Corp to pay that owner-employee “reasonable compensation” as a salary, which is reported on a Form W-2.

This election creates a two-part compensation structure for the owner. The first part is the W-2 salary, from which Social Security and Medicare taxes are withheld. The S Corp pays the employer’s share of these taxes, and the employee’s share is withheld from their paycheck.

Any remaining profits after paying the salary and other expenses can be paid to owners as shareholder distributions. The primary tax advantage of the S Corp election is that these distributions are not subject to self-employment taxes. This separation of income can result in tax savings on the portion of profit taken as a distribution.

Determining Reasonable Compensation for S Corp Owners

When an LLC elects to be taxed as an S Corp, the IRS mandates that any owner-employee must be paid a reasonable salary before receiving profit distributions. Reasonable compensation is the amount a comparable business would pay for the same or similar services. This rule prevents owners from avoiding payroll taxes by paying themselves an artificially low salary and taking most of their compensation as distributions.

To determine what is reasonable, the IRS considers several factors, including:

• The owner’s specific duties and responsibilities
• The owner’s level of training and experience
• The amount of time and effort devoted to the business
• Compensation paid to non-shareholder employees
• What comparable businesses in the same industry pay for similar services

Setting an unreasonably low salary carries significant risk. If audited, the IRS can reclassify shareholder distributions as wages, subjecting them to FICA and unemployment taxes. The business would then be liable for back taxes on these wages, in addition to penalties and interest.

Owner Compensation When an LLC Elects C Corp Status

An LLC can also elect to be taxed as a C Corporation. Any owner who actively works in the business is considered an employee and must be paid a reasonable salary for their services via a Form W-2. This salary is a deductible business expense for the corporation, which lowers its taxable income.

After the C Corp pays its owner-employees and covers other expenses, any remaining profit is taxed at the 21% federal corporate rate. If the corporation then distributes these after-tax profits to its owners, those payments are considered dividends. The owners must then pay personal income tax on the dividends they receive.

This system is known as “double taxation” because profits are taxed once at the corporate rate and a second time at the individual owner’s dividend tax rate. This is a disadvantage compared to the S Corp structure, where profits passed through as distributions are only taxed once on the owner’s personal return.

How to Change an LLCs Tax Classification

An LLC can change its tax status by filing a specific election form with the IRS. It is important to adhere to the filing deadlines to ensure the election takes effect for the desired tax year.

S Corp Election

To be taxed as an S Corporation, an LLC must meet eligibility requirements. The election is made by filing Form 2553, “Election by a Small Business Corporation,” which requires the consent of all members. Filing Form 2553 on time also serves to classify the LLC as a corporation, so a separate Form 8832 is not needed. For the election to be effective for the current tax year, the form must be filed by the 15th day of the third month of that tax year. For a new LLC, the deadline is within two months and 15 days of its formation.

C Corp Election

To be taxed as a C Corporation, an LLC must file Form 8832, “Entity Classification Election.” On this form, the LLC elects to be classified as an “association,” which is taxable as a corporation. The election cannot take effect more than 75 days before the date the form is filed or more than 12 months after it is filed. Once an entity files Form 8832, it generally cannot change its classification again for 60 months.