How to Pay Yourself From an LLC Partnership

An LLC (Limited Liability Company) taxed as a partnership uses a unique approach to owner compensation. Unlike employees who receive W-2 wages, the Internal Revenue Service (IRS) considers partners in such an LLC as owners, not employees. This means partners “pay themselves” through specific methods with distinct financial and tax implications. Understanding these methods is important for proper financial management and compliance.

Understanding Partner Compensation Principles

Partners in an LLC taxed as a partnership hold an equity stake, and their financial relationship is defined by their capital account. This account tracks their investment, reflecting initial contributions, their share of profits and losses, and any withdrawals or distributions. It provides a continuous record of the partner’s equity.

The partnership agreement outlines how partners are compensated and how profits and losses are allocated. This agreement establishes the financial arrangements, including payment methods and frequency. It also defines each partner’s rights and responsibilities, ensuring clarity in financial dealings. This structure is important for proper accounting and tax treatment of partner transactions.

Guaranteed Payments

Guaranteed payments are a primary method for partners to receive regular compensation for services or capital provided, regardless of the partnership’s income. These payments are typically fixed amounts or percentages, ensuring a predictable income stream. For federal income tax purposes, guaranteed payments are treated as ordinary income to the partner. They are also subject to self-employment tax, covering Social Security and Medicare contributions, at the prevailing rate of 15.3% on net earnings from self-employment.

From the partnership’s perspective, guaranteed payments are a deductible business expense. This deduction reduces the partnership’s taxable income, potentially lowering its overall tax burden. Unlike a traditional salary, guaranteed payments do not increase the partner’s tax basis in the partnership. The partnership reports these payments on IRS Form 1065. Each partner receives a Schedule K-1 detailing their share of income, including guaranteed payments, which they report on their individual tax return.

Profit Distributions

Profit distributions are another method partners use to receive funds, representing a share of the partnership’s profits. Unlike guaranteed payments, distributions are generally not considered compensation for services and are typically not subject to self-employment tax. These distributions reduce a partner’s capital account, reflecting the withdrawal of equity. The partnership agreement usually determines the amount and timing of these distributions.

The tax implications for profit distributions are distinct, as they are generally tax-free up to the partner’s basis in the partnership. A partner’s basis includes capital contributions, their share of profits, and certain liabilities. If a cash distribution exceeds a partner’s basis, the excess is typically taxed as a capital gain. Tracking one’s basis is important to avoid unexpected taxable events.

Partner Expense Reimbursements

Partners often incur business expenses personally. Expense reimbursements provide a mechanism for the partnership to repay these out-of-pocket costs. These reimbursements are generally not considered taxable income to the partner. For the reimbursement to be non-taxable to the partner and deductible by the partnership, it must be part of an “accountable plan.” An accountable plan requires expenses to have a business connection, be adequately substantiated with documentation like receipts, and any excess reimbursements be returned within a reasonable timeframe, typically 120 days.

Common reimbursable expenses include travel, meals, office supplies, and professional development directly related to the business. Following the principles of an accountable plan helps ensure compliance with tax regulations. This system allows the partnership to deduct the expense while the partner receives a tax-free repayment, provided all IRS requirements for documentation and substantiation are met.

Record Keeping and Tax Form Implications

Maintaining accurate records is important for LLCs taxed as partnerships, especially concerning partner compensation and distributions. Detailed documentation for guaranteed payments, profit distributions, and expense reimbursements is important for internal financial management and tax compliance. This includes clear ledgers, bank statements, and ensuring transactions align with the partnership agreement. Good record-keeping supports proper classification and reporting of financial flows.

The IRS Schedule K-1 (Form 1065, Partner’s Share of Income, Deductions, Credits, etc.) is a key document for each partner. This form details a partner’s share of the partnership’s income, deductions, credits, and other items, including any guaranteed payments. Partners use this information to prepare their individual federal income tax returns (Form 1040). The partnership files Form 1065 to report its overall income and expenses to the IRS, with each partner’s Schedule K-1 attached.

Tracking a partner’s basis is another important aspect of record keeping. The basis is adjusted annually by contributions, share of profits and losses, and distributions. Accurate basis tracking helps determine the taxability of future distributions and potential gains or losses upon the sale of a partnership interest. Information from the partnership’s financial records and the Schedule K-1 enables partners to accurately report income and manage tax obligations.