How to Properly Pay Yourself Out of Your LLC

A Limited Liability Company (LLC) is a popular business structure, offering personal liability protection and operational flexibility. A key aspect of this flexibility is how owners, known as members, receive compensation. This process requires a clear understanding of the tax implications, which differ from sole proprietorships or traditional corporations. This article outlines the methods for properly paying yourself from an LLC while ensuring tax compliance.

Understanding Your LLC’s Tax Classification

An LLC is a legal entity established under state law, but it is not a tax classification itself. The Internal Revenue Service (IRS) determines how an LLC is taxed based on its number of members and any elections made. This classification dictates how owners can pay themselves and the associated tax treatments.

A single-member LLC (SMLLC) is treated by the IRS as a “disregarded entity” for tax purposes. This means the LLC’s income and expenses are reported directly on the owner’s personal tax return, similar to a sole proprietorship. An LLC with two or more members defaults to a partnership tax classification. In both default scenarios, the business’s profits and losses “pass through” to the owners’ individual tax returns, avoiding corporate-level taxation.

LLCs can also elect corporate taxation, which offers different advantages. An LLC can elect to be taxed as an S-Corporation by filing Form 2553 with the IRS. Alternatively, an LLC can elect to be taxed as a C-Corporation by filing Form 8832. This election must be made within 75 days of the LLC’s formation or during the current tax year to be effective for that year.

Paying Yourself as a Pass-Through Entity

When an LLC maintains its default pass-through tax classification, owner compensation methods differ from corporate structures. Owners in these entities are not considered employees and do not receive a traditional salary with payroll withholdings. Instead, compensation is handled through specific mechanisms that directly impact the owner’s personal tax obligations.

For a single-member LLC taxed as a sole proprietorship, the owner pays themselves through an “owner’s draw.” This involves transferring funds from the business bank account to a personal account. Owner’s draws are not a deductible business expense and do not reduce the LLC’s taxable income. The owner is responsible for paying estimated income tax and self-employment taxes, which cover Social Security and Medicare, on the business’s net earnings.

For multi-member LLCs taxed as partnerships, owners can receive funds through “guaranteed payments” and “distributions.” Guaranteed payments are fixed compensation to members for services rendered or capital provided, independent of the LLC’s profits. These payments are subject to self-employment taxes and are reported as ordinary income on the member’s personal tax return. The LLC can deduct guaranteed payments as a business expense, which reduces its net profit.

Distributions represent a member’s share of the LLC’s profits. Unlike guaranteed payments, distributions are contingent on the business generating net income and are not subject to self-employment tax. Distributions reduce the owner’s equity in the business.

Paying Yourself as an Elected Corporation

When an LLC elects to be taxed as a corporation, owner compensation methods align with traditional corporate structures. This election brings different tax implications and compliance requirements, particularly regarding payroll and dividends.

For an LLC electing S-Corporation status, the IRS requires owners who provide services to the business to pay themselves a “reasonable salary.” This salary is paid via a W-2 form, similar to any other employee, and is subject to federal income tax withholding, Social Security, and Medicare taxes. Both the employee (owner) and the employer (S-Corporation) contribute to these payroll taxes. The concept of “reasonable salary” is important; it must be comparable to what other businesses would pay for similar services to avoid IRS scrutiny.

After a reasonable salary is paid, any remaining profits can be distributed to owners as non-wage distributions. These distributions are not subject to self-employment tax, offering a potential tax advantage compared to pass-through entities where all profits are subject to self-employment tax. The IRS monitors S-Corporations to ensure owners do not minimize salaries to avoid payroll taxes by reclassifying compensation as distributions.

For an LLC electing C-Corporation status, owners are paid a salary via a W-2, which is subject to standard payroll taxes. The C-Corporation can deduct these salaries as a business expense, reducing its taxable income. C-Corporations can also pay dividends to shareholders from their after-tax profits. These dividends are subject to “double taxation,” meaning the corporation pays tax on its profits, and then shareholders pay tax again on the dividends received on their personal tax returns. Dividends are not deductible for the corporation.

Essential Documentation and Reporting

Proper documentation and reporting are important for all LLC payment methods to ensure compliance with IRS regulations. The specific forms and records required depend on the LLC’s tax classification and how owners are compensated. Maintaining accurate records is essential to avoid penalties and facilitate smooth tax filings.

For single-member LLCs using owner’s draws, detailed records of all withdrawals should be maintained, even though they are not reported on a separate tax form. The LLC’s net profit or loss is reported on Schedule C (Form 1040), filed with the owner’s personal income tax return. Owners are responsible for making estimated tax payments quarterly to cover their income tax and self-employment tax obligations. No Form 1099 is issued for owner’s draws.

For multi-member LLCs taxed as partnerships, the business files Form 1065. Each member receives a Schedule K-1 (Form 1065), which details their share of the LLC’s income, deductions, credits, guaranteed payments, and distributions. Guaranteed payments are specifically reported on Schedule K-1, Box 4. Members then use this information to report their share of the business’s income on their personal tax return.

For LLCs taxed as S-Corporations or C-Corporations, paying owners a salary requires adherence to payroll procedures. The LLC must issue Form W-2 to each owner receiving a salary. Federal income taxes, Social Security, and Medicare taxes are withheld from these wages. The LLC is also responsible for filing quarterly payroll tax forms, such as Form 941, and annually, Form 940 for federal unemployment taxes. For C-Corporations paying dividends, Form 1099-DIV must be issued to shareholders who receive over $10 in dividends, with a copy also sent to the IRS.