Where's My Paycheck? Paying Yourself Through Your LLC
The IRS rules about how an LLC’s pass-through income is taxed are still a bit murky.
This is, in part, because the self-employment tax law was developed long before LLCs
were an option. In addition, Congress has been slow in laying out definitive rules
about how to distribute income from an LLC. Still, the IRS provides options to the
owners of LLCs that can help manage how you take earnings out of your business.
When you file an LLC registration, the IRS default is to treat your company as a
sole proprietorship or partnership for tax purposes. For single-owner LLCs, that’s
pretty much it – all the profits of your LLC will pass-through and be reported on
your personal income taxes. The company does not pay federal taxes. You will pay
self-employment taxes at a rate of 15.3% on everything you earn up to the IRS’s annual
limit ($106,900 for 2009). If you register a multi-member LLC with no foreign partners,
you have the option of being treated as a partnership or as a Corporation for federal
tax purposes. The default is to be treated as a partnership, with the same self-employment
pass-through rules.
A well-planned Operating Agreement can include guaranteed payments to members of
a partnership-status LLC – essentially a salary that can be paid whether or not the
business turns a profit. Guaranteed payments become an expense of the LLC, but are
still reported as ordinary income by the member on their personal taxes, thus are
subject to self-employment taxes. Though the IRS regulations are unclear, it is believed
by most accountants that any profit distributed beyond the guaranteed payments is
also taxed as ordinary income. In addition, any benefits (health insurance) paid
for by the partnership-status LLC are considered guaranteed payments and must also
be reported as ordinary income.
Remember, too, that as an LLC taxed as a partnership, you will have to report all
of your share of business profits, even if they are not distributed, on your personal
income tax. That is, you will owe taxes on all the earnings for the year even if
you choose to leave them in the business. It is a good idea to include a provision
in the Operating Agreement to pay out distributions at least in the amount to cover
the expected personal tax liability at the end of each year.
Electing to be treated as an S-Corp (or C-Corp) by the IRS simply requires you to
file a form with the IRS when you register your LLC (or before the next tax year).
S-Corp status allows the LLC to pay its members actual salaries, with the appropriate
withholding paid through the business. The profits of the business are then distributed
according to the Operating Agreement, and are treated as surplus income for tax purposes.
The important factor here is to be sure you set a reasonable salary for your position
in the business. If you don’t, the IRS may reclassify some or all of your profit
distribution as ordinary income and go after you for the self-employment tax on that
amount.
The option to classify your LLC as a C-Corp is also available. In this case, the
business earnings will be subject to federal taxes. However, if you expect to significantly
expand your business, the C-Corp status can provide significant tax benefits without
the hassles of an actual C-Corp.
The best decision for paying yourself through your LLC depends entirely on your particular
set of circumstances. If you are a single-owner LLC, the IRS considers the business
as a disregarded entity and all earnings are reported on your own taxes. If you are
a multi-member LLC, consider your situation before deciding on a tax status, and
check with a qualified accountant if you are uncertain.
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