Can the Owner of an LLC Pay Himself Through Payroll?

A Limited Liability Company (LLC) offers business owners a flexible structure, combining the liability protection of a corporation with the operational simplicity of a sole proprietorship or partnership. LLC owners often wonder if they can pay themselves through payroll. Understanding owner compensation methods is important for managing business finances and personal tax obligations.

Common Ways LLC Owners Take Money

By default, the Internal Revenue Service (IRS) treats a single-member LLC as a disregarded entity, similar to a sole proprietorship or a partnership. For tax purposes, the LLC itself does not pay federal income tax; instead, its profits and losses “pass through” directly to the owner’s personal tax return. Owners report their share of the business’s income on individual tax forms, such as Schedule C for single-member LLCs or Schedule K-1 for multi-member LLCs.

LLC owners under this default pass-through method are responsible for self-employment taxes, including contributions to Social Security and Medicare, totaling 15.3% of net earnings from self-employment. This tax applies to all of the owner’s share of the LLC’s profits, regardless of withdrawal. Owners typically take money out of the business through “owner’s draws” or “distributions,” which are transfers from the business to a personal account. These draws are not considered wages and are not subject to income tax withholding or payroll taxes, but the owner must account for them when calculating self-employment tax liability. Without a specific tax election, an LLC owner is not considered an “employee” and cannot pay themselves a W-2 salary.

Electing S Corporation Status for Payroll

An LLC owner can pay themselves through payroll by electing to have their LLC taxed as an S corporation. This election changes the LLC’s tax classification, treating the owner as both an employee and a shareholder. Under S corporation status, the business can pay the owner a W-2 salary, subject to payroll taxes.

To elect S corporation status, the LLC must file Form 2553, “Election by a Small Business Corporation,” with the IRS. This form informs the IRS of the election, provided the business meets eligibility requirements. The main advantage is potential tax savings on self-employment taxes.

S corporation owners must pay themselves “reasonable compensation” for services provided to the business. The IRS defines reasonable compensation as the amount ordinarily paid for similar services by similar businesses under similar circumstances. Factors the IRS considers include the owner’s training, experience, duties, responsibilities, time devoted, and what comparable businesses pay. Any remaining profits after the reasonable salary can be distributed to the owner as dividends, which are not subject to self-employment taxes. This distinction between salary and distributions is an important part of the S corporation tax strategy.

Setting Up Payroll for an LLC Owner

After an LLC elects S corporation status, the owner can begin setting up payroll. An Employer Identification Number (EIN) is required for any business that hires employees, including an S corporation owner. This federal tax ID can be obtained for free directly from the IRS, usually through an online application that provides the EIN immediately.

Beyond the federal EIN, the business must register with relevant state agencies for state-specific payroll taxes, such as state unemployment insurance (SUI) and state withholding taxes. These registration processes vary by state but are essential for compliance. Once registered, the business needs to establish a payroll schedule, determining how often the owner will be paid (e.g., weekly, bi-weekly, or monthly). The paycheck will include gross pay, with withholdings deducted to result in net pay.

Withholdings include federal income tax, the employee’s portion of Social Security and Medicare taxes (FICA), and state income tax withholdings. The business, as the employer, is also responsible for its share of FICA taxes and Federal Unemployment Tax Act (FUTA) taxes. Payroll can be processed manually, through specialized software, or by utilizing professional payroll services, often simplifying compliance. At the end of each year, the S corporation must issue a Form W-2 to the owner, detailing their gross wages and taxes withheld, just like any other employee.

Taxation and Ongoing Obligations

The tax implications for an LLC taxed as an S corporation, compared to the default pass-through method, revolve around self-employment taxes. Under the default structure, owners pay self-employment tax on all business profits. In contrast, with S corporation status, only the reasonable W-2 salary paid to the owner is subject to Social Security and Medicare taxes; distributions are not. This can lead to potential tax savings for profitable businesses.

Operating an LLC as an S corporation with payroll entails ongoing compliance. Businesses must regularly file federal payroll tax forms, such as Form 941, “Employer’s Quarterly Federal Tax Return,” due quarterly (April 30, July 31, October 31, and January 31). Form 940, “Employer’s Annual Federal Unemployment (FUTA) Tax Return,” is filed annually by January 31. Federal tax deposits for withheld income and FICA taxes must be made regularly (monthly or semi-weekly), depending on the business’s tax liability.

State payroll tax filings and deposit schedules vary by jurisdiction. Maintaining accurate payroll records, including wage statements and tax forms, is essential for demonstrating compliance. The IRS requires adherence to the “reasonable compensation” rule for S corporation owners. If the IRS determines the salary is unreasonably low, it can reclassify distributions as wages, potentially resulting in back taxes, penalties, and interest. The S corporation must also file its annual income tax return, Form 1120-S, and issue Schedule K-1s to its shareholders.