How To Pay Yourself a Salary vs. Distributions From Your LLC

Determining how to pay yourself can be both exasperating and fulfilling when you are running your business. Unlike the corporate realm where paychecks are delivered on a monthly basis, entrepreneurs have to face the annoying reality of figuring out a balanced pay so that the IRS does not come knocking on their doorstep.

The ways in which you pay yourself can change depending on the structure of your LLC. A single-member LLC will be taxed as a sole proprietorship whereas a multi-member LLC will get taxed as either a partnership or a corporation.

Single-Member LLC

This type of structure enjoys the best of both worlds. You get to fly solo with your business idea without the onus of unlimited liability. As the owner of an LLC, you have the flexibility to choose the tax structure that best suits your business. Depending on the tax classification you select, there are specific implications and requirements to consider.

Paying yourself as an S corporation

As an S corp owner, you are considered an employee of your organization, which means that you have to pay yourself a reasonable salary. Additionally, to make sure the S corp classification is beneficial, it is recommended that you pay yourself at least $10,000 in distribution.

The advantage of choosing the S corp tax classification is that you can avoid paying FICA self-employment taxes on your distributions. Instead, S corp owners only pay income taxes on the distributions they receive. However, you would have to pay both FICA self-employment taxes and income tax on your salary.

Salary

When you operate as a single-member LLC taxed as an S corporation, you have the option to pay yourself a salary. This means you can treat yourself as an employee of your own business and receive a regular paycheck.

As the sole owner and employee, you are responsible for paying both the employee and employer portions of Medicare and Social Security taxes, commonly referred to as payroll taxes or self-employment taxes. These deductions are then remitted to the appropriate tax authorities.

Additionally, as the employer, you are also responsible for the employer portion of Medicare and Social Security taxes. However, as the sole owner, you don't need to match these deductions for yourself. Instead, you will be required to pay both the employee and employer portions of these taxes when filing your individual tax return.

Paying yourself as pass-through taxation, default LLC

When your single-member LLC (SMLLC) is subject to the default tax treatment by the IRS, you have the option to pay yourself a distribution, which is also referred to as a draw. This distribution passes through to your individual tax return. This tax approach is known as pass-through taxation.

Pass-through taxation means that the profit generated by your LLC flows through to your personal tax return. It is the default tax treatment for LLCs as recognized by the IRS. One of the key benefits of pass-through taxation is that it helps single-member LLCs avoid "double taxation." Double taxation refers to the scenario where the business's profits are taxed both at the entity level and again when distributed to the owner(s)

Owner’s draw

This involves drawing money directly from the business. You can either write a check to your personal account, withdraw the cash, or transfer the money online. Owner's draws are not subject to payroll taxes since they are considered a distribution of profit. However, it's important to keep track of these withdrawals for accurate record-keeping and tax purposes.

How to make an owner's draw
  1. Since it is important to establish a clear separation between your personal finances and the LLC’s finances, make sure you have a separate bank account. If you don’t have one already, open a bank account for your LLC.
  2. Before making the draw, assess the financial health of your LLC. It is critical to ensure that the withdrawal is reasonable and won't adversely affect the operations or financial stability of your business.
  3. Transfer the funds into your account.
  4. Create a record in your LLC's financial records, noting the date of the draw, the amount withdrawn, and the purpose of the distribution.
  5. Reflect the draw in your LLC’s financial statement.

Since you do not pay taxes on the owner’s draw, here’s how you can handle the tax implications.

  1. File a Schedule C

As a sole proprietor, you report your business income and expenses on Schedule C, which is part of your personal tax return (Form 1040).

Net profit/loss = Business’ income - Business’ expense

  1. Self-employment tax

This tax is based on the net profit of your LLC and is reported on Schedule SE (a part of your personal tax return).

  1. Pay taxes

The IRS expects you to pay taxes on your LLC's profits throughout the year, rather than in one lump sum at the end. You can use Form 1040-ES to estimate and make these quarterly payments.

Multi-Member LLC

A multi-member LLC is flexible in terms of management and decision-making. The members can decide how they want to distribute profits, allocate responsibilities, and make critical business decisions. It's important to have clear communication and a well-drafted operating agreement to outline each member's rights and obligations.

The IRS looks at multi-member LLCs as partnerships. Each member is responsible for paying taxes on their share of the LLC's profits, typically determined by their ownership percentage.

  1. Distribution

Similar to owner’s draw, members' distribution refers to paying the members of your LLC, directly from the profits. The percentage of profit is determined by the percentage of the stake of each member. These distributions are not subject to payroll taxes but should be carefully documented for accurate record-keeping and tax purposes.

As a member of a multi-member LLC, the taxes you pay depend on the LLC's profits and your share of those profits. Dealing with taxes for members' distribution is pretty easy.

  1. K-1 Form: This form outlines the member's distributive share of the LLC's income, deductions, and other tax items. Each member uses the information from the K-1 to report their share on their personal tax return.
  2. Estimated tax payments: Members of a multi-member LLC often need to make quarterly tax payments to cover their income tax and self-employment tax obligations. You can use Form 1040-ES to estimate and pay these quarterly taxes.

Tax laws can vary, and it is important to be familiar with the tax laws in your jurisdiction.

  1. Profit sharing

Profit sharing is a way of compensation in a multi-member LLC. If you are a partner, this allows you to draw your share of the profit, based on your ownership. This share is irrespective of your day-to-day involvement. The details of the ownership are mentioned in the operating agreement of your LLC. This agreement is a legally binding document that outlines the rights, responsibilities, and compensation structure for each partner.

It's important to note that partners are required to pay income tax on their share of the partnership's earnings, regardless of whether they draw all of it or not. For instance, if you own 50% of the business and your LLC makes a profit of $10,000, your draw comes to $5,000.

Here’s the important part; even if you take only $2,500, you will have to pay income tax on $5,000, the stake of your partnership. The reason is that the government considers your ownership stake as your fair share of the business's earnings.

Once you receive your share as a draw, you still have to pay 15.3% as self-employment tax.

  1. Salary

If you wish to be treated as an employee of your LLC, you are entitled to a salary, just like in any other company. You can also choose to hire partners as employees, as it gives the LLC a more structured way to compensate the partners.

When partners receive salaries the LLC becomes responsible for payroll. This involves calculating the partners' salaries, deducting payroll taxes, and issuing regular paychecks. It’s important to ensure that the salaries are reasonable and in compliance with the regulations of the IRS.

One aspect of payroll is the deduction of payroll taxes like Medicare taxes and Social Security taxes. Employees as well as employers are responsible for paying these. These deductions will be withheld from your paychecks. The LLC then has to match these deductions.

The withheld taxes, along with the LLC’s portion need to be submitted to the proper authorities, either quarterly or annually. This is based on the LLC’s payroll depositing schedule.

It's worth noting that salaries are considered ordinary income and are subject to federal and state income tax withholding. Partners will receive Form W-2 at the end of the year, which outlines their earnings, withholdings, and other relevant information.

By receiving a salary, you enjoy benefits like:

  • Regular paycheck
  • Potential employee benefits
  • 401(k)
  • IRA

However, as an employee of your LLC, your salary would be subject to both income tax withholding and payroll taxes.

Tax Implications for a Multi-Member LLC

When a multi-member LLC chooses to be taxed as an S corporation, the owners, also known as shareholders, become employees of the corporation. As employees, they are required to receive a reasonable salary for the work they perform for the business. This salary is subject to federal income tax withholding as well as payroll taxes, such as Social Security and Medicare taxes.

On the other hand, if a multi-member LLC chooses to be taxed as a C corporation, the owners are also considered employees. However, one key distinction with a C corporation is the concept of double taxation. The corporation itself pays taxes on its profits at the corporate tax rate. When the corporation distributes dividends to the shareholders, those dividends are also subject to individual income tax.

Even with these structures in place, the question remains…

How Much Do You Pay Yourself?

As the owner of your LLC, this can get tricky. You never know what may set off alarms for the IRS. To ensure that doesn’t happen, let’s consider this.

You own an LLC that earns $200,000 in revenue, annually. Step 1 would be to determine if that is profitable for your business. You need to start by subtracting all the expenses your LLC incurs, like rent, supplies, and salaries. You are then left with $100,000.

Considering the industry standards and the hats you wear, you decide to pay yourself $70,000. This will be subject to income tax withholding and payroll taxes, like a normal employee.

You can take the other $30,000 as distribution. This would just be subjected to self-employment taxes. Although when you are deciding to take home earnings as distributions, you need to bear in mind the financial health of your business. It would be wise to retain a portion of the profits for the business to prepare for unforeseen expenses that may arise.

If you decide to take home $30,000 as your salary and $70,000 as distribution, you may alert the IRS. This is because you are not paying payroll taxes on $70,000 and have unintentionally decided to evade tax.

Here’s a great method to decide how much to take:

  1. Look at your books, and confer with your accountant if you have to. This would help you gain an understanding of the financial standing of your business.
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  2. The minimum amount you need to earn is the added figure of your personal expenses.
  3. Once you have that, you can then look at the industry standard and pay yourself accordingly.

In conclusion, when it comes to determining how to pay yourself as an owner of an LLC, there isn't a one-size-fits-all playbook. However, by considering a few key factors and understanding the various moving parts, you can come to a well-informed decision that aligns with your financial goals and the needs of your business.