How to Properly Pay Yourself From an LLC

A Limited Liability Company (LLC) offers business owners a flexible structure, combining liability protection with operational simplicity and tax advantages. How an owner is paid depends on the LLC’s tax classification.

Default LLC Taxation and Owner’s Draws

When an LLC does not elect a specific tax status with the IRS, it is taxed by default. A single-member LLC is a disregarded entity, reporting income and expenses on the owner’s personal tax return, like a sole proprietorship. A multi-member LLC defaults to being taxed as a partnership, with each owner’s share of profits and losses passing through to their individual tax return. Owners report business income or loss on their personal Form 1040, as the LLC itself does not pay federal income tax.

Owners of a default LLC pay themselves through an “owner’s draw.” This direct transfer from the business bank account to the owner’s personal account is not a salary or wage, nor subject to payroll taxes or income tax withholding at transfer. The amount varies, determined by the business’s cash flow and the owner’s personal financial needs.

While owner’s draws are not subject to payroll taxes at withdrawal, the owner pays self-employment taxes on the LLC’s net earnings. Self-employment tax covers Social Security and Medicare contributions, normally split between employer and employee. The self-employment tax rate is 15.3% on net earnings up to the Social Security wage base, and 2.9% for Medicare on all net earnings.

For a single-member LLC, net profit or loss is reported on Schedule C. Multi-member LLCs taxed as partnerships report income and expenses on Form 1065, with each partner receiving a Schedule K-1. Self-employment tax is calculated on Schedule SE, based on net earnings reported on Schedule C or K-1. Owners must make quarterly estimated tax payments using Form 1040-ES to cover income and self-employment tax obligations.

Maintaining clear records of owner’s draws is important for accurate financial reporting and tax preparation. Draws reduce the owner’s equity but do not affect the LLC’s taxable income. Tracking accounts for the owner’s basis in the LLC is relevant for future transactions like selling the business interest.

S Corporation Election and Owner Compensation

An LLC can elect to be taxed as an S Corporation, often chosen to reduce self-employment tax liabilities. This election changes how the IRS views the entity, moving from default pass-through treatment to a structure differentiating between salary and distributions for working owners. The election is made by filing Form 2553 with the IRS.

Under S Corporation status, an owner actively working in the business must be paid a “reasonable salary.” The IRS requires this salary to reflect what a similar professional in the same industry and geographic area would earn for comparable services. This salary is subject to federal income tax withholding and payroll taxes (Social Security and Medicare). Payroll taxes are split, with half paid by the S Corporation as employer and the other half withheld from the owner’s salary as employee (e.g., 6.2% for Social Security and 1.45% for Medicare each).

Beyond the reasonable salary, additional profits distributed to the owner are “distributions.” These distributions are not subject to self-employment taxes. They are tax-free up to the owner’s adjusted basis in the company, representing their investment. This two-part compensation structure allows many S Corporations to take profits without the full self-employment tax burden of a default LLC.

The salary portion requires the S Corporation to operate a payroll system, involving regular processing, issuing Form W-2 to the owner, and remitting payroll taxes to the IRS. Distributions are reported to the owner on Schedule K-1 and are not subject to withholding.

The IRS scrutinizes the “reasonable salary” requirement to prevent owners from minimizing payroll tax obligations by taking an excessively low salary and high distributions. Failure to pay a reasonable salary can result in reclassification of distributions as salary, leading to back taxes, penalties, and interest. Determining a reasonable salary involves considering factors like owner’s duties, experience, qualifications, time devoted to the business, and compensation paid by comparable businesses for similar services.

C Corporation Election and Owner Compensation

An LLC can also elect to be taxed as a C Corporation, though less common for small businesses due to its unique tax implications. Unlike pass-through entities, a C Corporation is a separate legal and tax-paying entity, paying corporate income tax on its profits before any distributions to owners. This election is made by filing Form 8832 with the IRS.

Owners working for a C Corporation can receive a salary for their services, which is a deductible business expense reducing the corporation’s taxable income. For the owner, this salary is subject to federal income tax withholding and payroll taxes (Social Security and Medicare), similar to any traditional employee. The corporation is responsible for payroll, issuing Form W-2, and remitting payroll taxes.

Beyond salary, a C Corporation can distribute profits to its owners as dividends. These dividends are paid from the corporation’s after-tax profits, creating “double taxation”: the corporation pays income tax on its profits, and then shareholders pay individual income tax on the dividends received. Dividend income is reported to shareholders on Form 1099-DIV. This double taxation often steers small business owners away from the C Corporation.

Managing Funds and Financial Records

Regardless of tax classification, maintaining clear separation between business and personal finances is fundamental for any LLC owner. Establishing a dedicated business bank account and using separate business credit cards helps preserve the LLC’s limited liability protection. Commingling funds can jeopardize the liability shield, potentially exposing personal assets to business liabilities.

Accurate bookkeeping is important for all financial transactions, including owner compensation. Utilizing accounting software like QuickBooks or Xero, or even spreadsheets, allows for precise tracking of income, expenses, owner’s draws, salaries, and distributions. Detailed record-keeping supports proper tax reporting and provides a clear picture of the business’s financial health.

Owners of pass-through entities, such as default LLCs or S Corporations, are responsible for their own income tax and self-employment tax obligations. This necessitates making quarterly estimated tax payments to the IRS. Failing to pay enough tax through withholding or estimated payments can result in underpayment penalties.

Seeking guidance from qualified tax professionals, such as Certified Public Accountants (CPAs) or tax attorneys, is a prudent step for any LLC owner. These professionals can provide personalized advice on tax-efficient compensation, ensure compliance with federal and state tax laws, and assist with complex financial situations.