While the excitement and professional fulfillment of starting a business offer much gratification, most entrepreneurs also strive for the financial fruits (i.e., money) of their labors, too.
The way that small business owners get paid depends on the business entity type they’ve set up for their company. A business’s legal structure also affects how business owners’ income is taxed.
Generally, people who operate their small businesses as sole proprietorships or partnerships, which aren’t formally registered business entities, can take money out of the business bank account to pay themselves.
But what about owners of limited liability companies (LLCs) and S Corporations?
Let’s take a moment to discuss how LLC owners (“members”) and S Corporation owners (“shareholders”) get compensated.
Unlike those who operate small businesses as sole proprietorships or partnerships, owners of LLPs … [+]
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Getting paid as an owner of an LLC
Generally, an LLC’s owners cannot be considered employees of their company nor can they receive compensation in the form of wages and salaries.* Instead, a single-member LLC’s owner is treated as a sole proprietor for tax purposes, and owners of a multi-member LLC are treated as partners in a general partnership. To get paid by the business, LLC members take money out of their share of the company’s profits.
Here’s an overview of how that usually works:
The owner of a single-member LLC withdraws money by taking an “owner’s draw”—writing themselves a business check or (if their bank allows it) transferring money from the LLC bank account to the owner’s personal bank account.
Each LLC member has a capital account (a log of that member’s membership share of the LLC and their financial activities). When members need money, they take a draw from the LLC, which is accounted for in the capital account. Draws are usually made via a business check written out to the member.
There may be other ways for LLC members to get paid for certain services that they provide to their company and it’s critical to talk with a tax and accounting expert to understand your options.
Income taxes and the LLC
An attractive feature of the LLC business entity is the company does not pay taxes. Instead, the profits and losses of the LLC flow through to its members, who must report them on their personal income tax returns. When setting up an LLC, members decide if all owners will divide the company’s profits evenly, or based on their ownership percentage, or according to some other formula that all agree on. Then, each member gets taxed on their distribution of profits.
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For example, let’s say an LLC has two members, with one owning 60% of the company while the other owns 40%. The members have agreed that the distribution of profits should be equal to the members’ ownership percentages. In this scenario, the first member must report 60% of the LLC’s profits and losses on their personal tax return, and the other member must report 40% of the LLC’s profits or losses on their personal tax return.
AN IMPORTANT REMINDER: Owner’s draws from an LLC are NOT paychecks. No federal or state income taxes nor Social Security and Medicare taxes are withheld from those payments. Under most circumstances, LLC members must make estimated tax payments every quarter to cover taxes due on their share of the LLC’s profits. The profits are taxed the same (whether they are taken as personal draws or remain in the business’s bank account).
*Note: If an LLC elects to be taxed as a corporation, the rule about members’ eligibility to be employees of the company is null. In that case, the company pays taxes directly to the IRS. Members can be employees and therefore report their wages, salaries, and dividends on their personal tax returns.
Getting paid as the owner of an S Corporation
An S Corporation is either an LLC or C Corporation that has elected for special tax treatment with the IRS. An S Corporation’s income, losses, deductions, and credits pass through to its shareholders’ personal federal income tax returns. Shareholders then report the business’s income and losses on their personal tax returns and are taxed at their individual income tax rates.
Although LLCs and S Corps have pass-through tax treatment in common, there’s a critical difference: An S Corporation’s shareholders who do substantial work for the S Corp are considered employees. Therefore, the business must put them on its payroll and compensate them through wages or salaries—from which income taxes, Social Security and Medicare taxes (FICA), unemployment taxes (FUTA), and possibly other taxes are withheld.
An S Corp’s remaining profits are paid out in distributions to the company’s shareholders, who then report those distributions on their personal income tax returns. Unlike wages and salaries, distributions are not subject to FICA and FUTA taxes. Note that if distributions to any shareholder exceed that shareholder’s stake in the business, that excess amount will be taxed as a long-term capital gain.
It’s not uncommon for S Corporation owners to run into trouble because they’ve paid themselves a suspiciously small salary and then take most of their compensation in the form of distributions to minimize the amount of FUTA and FICA payroll taxes they have to pay. Both the IRS and Social Security Administration are vigilant in tracking down people who try to game the system this way. The government expects that S Corp owners will pay themselves a “reasonable salary,” which depends on the industry and the scope of the shareholders’ duties.
If you’re considering operating as an S Corp, I suggest you do some research to determine what reasonable compensation will be for the work you’ll perform for your company. If the IRS believes you are substantially underpaid for the services you provide, it may require that you make adjustments to your tax returns, or it might even revoke your S Corporation status.
You can still take advantage of the self-employment tax-free distributions of an S Corp, as long as you pay yourself a reasonable salary.
While the information I’ve shared in this article will help you understand the basics of how you can get paid as an LLC member or S Corporation shareholder, it is not a substitute for professional financial, tax, or legal advice. Ask a licensed accountant (and/or tax advisor) and attorney for guidance as you establish how your LLC or S Corp will compensate you for your investments of time, money, blood, sweat, and tears.