How to Pay Yourself From an LLC

Operating a Limited Liability Company (LLC) offers flexibility and liability protection, but understanding how to properly compensate yourself as an owner requires navigating various tax considerations. The method an LLC owner uses to receive payment depends significantly on the entity’s tax classification with the Internal Revenue Service (IRS). Properly structured compensation ensures compliance with tax laws and optimizes financial outcomes for both the business and the individual owner.

Understanding Your LLC’s Tax Classification

An LLC is a legal business structure that provides liability protection, but it does not have its own distinct tax classification by default. The IRS taxes an LLC based on the number of its owners and whether it elects to be taxed as a corporation. This tax treatment directly influences how an owner can withdraw funds or receive compensation.

For single-member LLCs, the default tax classification is as a “disregarded entity,” taxed as a sole proprietorship. The business’s income and expenses are reported directly on the owner’s personal tax return, typically using Schedule C (Form 1040). The owner is responsible for all tax obligations. Multi-member LLCs, by default, are taxed as partnerships. The LLC files an informational return, Form 1065, and provides each owner with a Schedule K-1, detailing their share of the business’s income and expenses, which is then reported on their individual tax returns.

Beyond these default classifications, an LLC can elect to be taxed as either an S corporation or a C corporation. An S corporation election, made by filing Form 2553, allows profits and losses to be passed through to the owners’ personal income without corporate income tax. This structure often requires the owner to pay themselves a “reasonable salary” subject to payroll taxes, while remaining profits can be distributed without self-employment tax. Alternatively, an LLC can elect to be taxed as a C corporation by filing Form 8832. In this case, the business is treated as a separate taxable entity, paying corporate income tax on its profits, and owners are typically compensated as employees or through dividends.

Owner’s Draw and Guaranteed Payments

For LLCs taxed as disregarded entities (single-member LLCs) or partnerships (multi-member LLCs), owner’s draws and guaranteed payments are common methods for owners to receive funds. An owner’s draw represents a withdrawal of the business’s profits for personal use. This is not considered a tax-deductible business expense for the LLC.

To manage an owner’s draw, accurate bookkeeping is essential, typically involving journal entries that reduce the owner’s equity account. The owner is responsible for paying self-employment taxes on the LLC’s net earnings, regardless of the amount of draws taken. This self-employment tax is 15.3% on net earnings.

For multi-member LLCs taxed as partnerships, guaranteed payments are another compensation method. These are fixed amounts paid to a partner for services rendered or capital provided, irrespective of the partnership’s income. Guaranteed payments are generally a tax-deductible expense for the partnership. Partners receiving guaranteed payments remain responsible for self-employment taxes on these amounts, in addition to their share of the partnership’s ordinary business income. These payments are reported on Schedule K-1 (Form 1065).

Salary and Distributions for S Corporations

When an LLC elects to be taxed as an S corporation, the compensation structure for owners changes significantly, involving both a salary and owner distributions. The IRS requires active owner-employees of an S corporation to be paid a “reasonable salary” for services performed. This salary is treated as a W-2 wage, similar to any other employee.

Determining a reasonable salary involves considering various factors, such as the owner’s duties, experience, qualifications, and the compensation paid by comparable businesses for similar services. The salary is subject to federal income tax withholding, Social Security, and Medicare taxes, with both employee and employer portions paid through payroll. An Employer Identification Number (EIN) is necessary for this process.

After the reasonable salary is paid, any remaining profits can be taken as owner distributions. These distributions are generally not subject to self-employment taxes. They are typically tax-free to the extent of the owner’s basis in the S corporation. Distributions are reported on Schedule K-1 (Form 1120-S).

Compensation Methods for C Corporations

For an LLC that has elected to be taxed as a C corporation, the methods for owner compensation align with traditional corporate structures, primarily through salary and dividends. Owners who actively work for the company are typically paid a salary, similar to any other employee. This salary is a tax-deductible expense for the C corporation.

The salary paid to an owner-employee is subject to federal income tax withholding, Social Security, and Medicare taxes, just like wages for non-owner employees. The C corporation is responsible for running payroll, remitting these taxes, and issuing a Form W-2 to the owner.

Beyond salary, C corporations can distribute profits to owners in the form of dividends. A notable aspect of C corporation taxation is “double taxation.” The corporation first pays corporate income tax on its profits, and then shareholders pay tax again on the dividends they receive, typically at capital gains rates. Dividends are paid from the corporation’s after-tax profits and are not tax-deductible expenses for the C corporation. This double taxation of dividends is a significant consideration when an LLC chooses to be taxed as a C corporation.