When forming a limited liability company (LLC), you may be concerned with how to pay yourself so that you can profit from the company's success. Payment options include a salary, a draw, a guaranteed payment, and profit distributions.
Paying yourself a salary
If you choose to pay yourself a salary from the LLC, you need to be hired as an employee. The LLC deducts the salary as a business expense and withholds taxes and FICA.
This is true whether your LLC is organized as a sole proprietorship, partnership, C corporation, or S corporation.
If your LLC is organized as an S corporation and you hire yourself as an employee, you must be sure that your salary is commensurate with the amounts paid to similar professionals in your field in your region.
This Internal Revenue Service (IRS) rule prevents you from maximizing your income through distributions and avoiding employment taxes for your salaried role.
Some tax professionals recommend paying yourself 60 percent in salary and 40 percent in dividends to stay clear of IRS problems unless this means your salary would be too low compared to others in your field.
If your LLC is a C corp., reasonable compensation plays the other way. The IRS wants to make sure the compensation is not unreasonably high to absorb taxable income so that the employee does not avoid taxes on what would otherwise be paid out as a dividend.
Distribution of profit
LLCs that are formed as partnerships and sole proprietorships distribute their profit to members in a distribution, with each member receiving a distribution equal to their ownership position.
For example, if you own one-half of the LLC, you receive one-half of the profits. The LLC reports distributions using the Partners' Share of Income, Deductions, Credits, Etc. (Schedule K-1), which is given to the members.
Members then report the distribution income on their own U.S. Individual Income Tax Return (Form 1040) with Supplemental Income and Loss (Schedule E) attached.
LLCs that are corporations pay dividends to stockholders. A C corp. pays taxes on its profits, then the shareholders pay taxes on their dividends.
An S corp., on the other hand, is a pass-through entity like a sole proprietorship or partnership, so the corporation does not pay corporation taxes. Shareholders in an S corp. pay tax on their dividends.
Draw as payment
Another option for getting paid is to receive a draw, which is basically an advance on the profit distribution paid out of the member's equity share of the company.
A draw is often used when a member needs regular income and doesn't want to wait for profit distributions. When profit is distributed to members, the draw is paid back in full and the member receives whatever profit is left.
So, if a member received a draw of $500 per month ($6,000 per year) and the profit distribution for that member totaled $6,500, $6,000 would be kept by the LLC as a payback on the draw and the member would receive $500. The member reports the draw on their taxes as if it were a distribution.
If you need an ongoing income from your LLC but don't want to become an employee, guaranteed payments may be the best option. A guaranteed payment is a tax-deductible expense for the LLC that is subject to estimated income tax and self-employment taxes for the member.
Guaranteed payments are made whether or not the LLC is profitable, which can ease your financial burden while you are waiting for the business to take off.
The type of payments you choose for your LLC have important tax ramifications, so they are worth careful consideration.