How to Properly Pay Yourself From an LLC

Limited Liability Companies (LLCs) offer business owners flexibility and liability protection, separating personal assets from business debts. A common question for LLC owners involves how to properly pay themselves, which can seem complex due to various tax considerations. The method an LLC owner uses to withdraw funds from their business is directly linked to the entity’s tax classification with the Internal Revenue Service (IRS). Understanding these classifications and their associated payment rules is crucial for compliance and effective financial management.

LLC Tax Classifications

The IRS provides different tax classifications for Limited Liability Companies, significantly influencing how owners receive compensation. By default, the tax treatment of an LLC depends on the number of its members. For instance, a single-member LLC is typically treated as a “disregarded entity” by the IRS, meaning it is taxed as a sole proprietorship. This implies that the business’s income and expenses are reported directly on the owner’s personal tax return.

Conversely, an LLC with multiple members is automatically classified as a partnership for federal income tax purposes. In both default scenarios, the LLC operates under “pass-through” taxation, where profits and losses flow through to the owners’ personal tax returns, avoiding corporate-level taxation.

Beyond these default classifications, an LLC can elect to be taxed as either an S Corporation or a C Corporation. This election is made by filing specific forms with the IRS, such as Form 2553 for S Corporation status or Form 8832 for C Corporation status. Choosing an elective classification changes how the business’s profits are taxed and, consequently, how owners can legally pay themselves from the company.

Paying Yourself as a Pass-Through Entity

For LLCs taxed as sole proprietorships or partnerships, owners typically pay themselves through an “owner’s draw.” An owner’s draw represents a withdrawal of profits from the business and is not considered a salary or wage. Therefore, these draws are not subject to payroll taxes at the time of withdrawal.

However, owners of pass-through entities are responsible for self-employment taxes on their share of the business’s net earnings. This includes contributions to Social Security and Medicare. The self-employment tax rate is 15.3%, comprising 12.4% for Social Security (up to an annual earnings limit) and 2.9% for Medicare on all net earnings.

Since taxes are not withheld from owner’s draws, these owners typically need to make estimated tax payments quarterly using Form 1040-ES to cover their income tax and self-employment tax liabilities. To manage finances effectively, it is important for owners to maintain separate business and personal bank accounts. Clear accounting records are also necessary to distinguish between business income and owner’s draws.

Paying Yourself as an S Corporation

When an LLC elects to be taxed as an S Corporation, the method of owner compensation changes significantly. The IRS requires active owner-employees to pay themselves a “reasonable salary” for the services they provide to the corporation. A reasonable salary is generally defined as compensation that would be paid by a similar business for comparable services, considering factors like the owner’s training, experience, duties, and time devoted to the business. This requirement helps prevent owners from attempting to reclassify salary as distributions to avoid payroll taxes.

The reasonable salary paid to the owner is subject to FICA taxes, which include Social Security and Medicare taxes, as well as federal income tax withholding. Both the employee and employer portions of FICA taxes must be paid. This necessitates that the S Corporation runs formal payroll, just like any other employer, and issues a W-2 form to the owner-employee.

After paying a reasonable salary, any remaining profits can be distributed to the owner as tax-free distributions, up to the owner’s basis in the company. An advantage of S Corporation status is that these distributions are generally not subject to self-employment taxes. This distinction between salary and distributions offers potential tax savings for owners. Proper accounting is essential to clearly separate salary payments from shareholder distributions.

Paying Yourself as a C Corporation

For an LLC that has elected C Corporation tax status, the payment structure for owners mirrors that of traditional corporations. Owners who work for the business are considered employees and are paid a salary. This salary is treated as a deductible business expense for the corporation, reducing its taxable income.

The salary is subject to all applicable payroll taxes, including FICA taxes and income tax withholding, and the corporation issues a W-2 form to the owner-employee. After the corporation pays salaries and covers other business expenses, any remaining profits are subject to corporate income tax.

Once corporate income taxes are paid, the C Corporation can distribute any after-tax profits to owners as dividends. These dividends are then taxed again at the individual shareholder level, a concept known as “double taxation.” Qualified dividends, which meet specific IRS criteria, are generally taxed at preferential capital gains rates depending on the shareholder’s income bracket. Non-qualified dividends are taxed at ordinary income tax rates. This dual layer of taxation is a significant consideration for C Corporations.