Owners of a Limited Liability Company (LLC) can find the process of paying themselves confusing. While an LLC offers flexibility, the correct payment method depends on legal and tax compliance. How an owner takes money from the business for personal use is determined by specific factors that must be understood to handle everything correctly.
Identify Your LLC Tax Classification
How an LLC owner gets paid is tied to the business’s tax classification with the Internal Revenue Service (IRS). For federal tax purposes, the IRS assigns a default classification. A single-member LLC is taxed by default as a “disregarded entity,” meaning it is treated as a sole proprietorship, with all profits and losses reported on the owner’s personal tax return.
If an LLC has two or more owners, or members, the default classification is a partnership. The LLC files an informational tax return, and the profits and losses are “passed through” to the members. Each member reports their share of the income on their personal tax returns.
An LLC can also change its tax classification by filing forms with the IRS to be taxed as an S Corporation or a C Corporation. This decision alters the rules for owner compensation and has tax implications. Understanding if your LLC uses its default status or has elected a corporate tax status is the first step to paying yourself correctly.
Paying Yourself from a Default Status LLC
For LLCs with a default tax status (sole proprietorships or partnerships), the primary payment method is an “owner’s draw.” A draw is a distribution of company profits, not a salary. Since the owner is not an employee, no payroll is run or taxes withheld from these payments. This is done by transferring funds from the business bank account to the owner’s personal account.
For a multi-member LLC taxed as a partnership, members take draws from their capital accounts, which track each member’s ownership stake and profit share. The rules for taking draws are outlined in the LLC’s operating agreement to prevent disputes.
Multi-member LLCs can also use “guaranteed payments.” These are payments to a partner for services or capital use and are made regardless of business profit. Unlike draws, guaranteed payments are a business expense for the LLC. This provides a steady income for a member with a management role.
Paying Yourself from an S Corp Taxed LLC
When an LLC is taxed as an S Corporation, the payment structure involves both a formal salary and profit distributions, as required by the IRS. An owner who actively works for the business is an employee and must be paid a “reasonable salary” through a payroll system. This salary is subject to payroll taxes, including withholdings for income taxes, Social Security, and Medicare.
A “reasonable salary” is scrutinized by the IRS and is defined as what similar businesses would pay for comparable services. This rule prevents owners from taking a low salary and using distributions to avoid payroll taxes. The business must also pay the employer’s portion of Social Security and Medicare taxes on this salary.
After paying the reasonable salary, remaining profits can be paid to owners as distributions. A feature of these distributions is they are not subject to payroll taxes, which is a primary motivation for electing S Corp status. The owner receives a W-2 for their salary and a Schedule K-1 for their share of distributions.
Maintain Proper Financial Records
Regardless of tax status, maintaining proper financial records is important. A fundamental practice is keeping business and personal finances separate by using a dedicated business bank account for all company transactions. Commingling funds by paying personal bills from the business account can “pierce the corporate veil,” putting personal assets at risk in a lawsuit.
Accounting software helps track transactions and categorize payments. Each payment to an owner should be clearly labeled, such as “Owner’s Draw” or “Shareholder Distribution,” to create an understandable record for tax preparation and to document proper business conduct.
The LLC’s Operating Agreement is also important for financial governance. This internal document specifies the rules for paying members. For multi-member LLCs, it details how profits are divided and the process for approving distributions.
Fulfilling Personal Tax Obligations
The owner is responsible for paying taxes on all income received from the LLC. For a default status LLC, taxes are not withheld from owner’s draws. The owner must set aside money to cover income tax and self-employment tax, which includes Social Security and Medicare.
To meet these obligations, owners are required to make quarterly estimated tax payments to the IRS. This system ensures taxes are paid on income as it is earned, similar to withholding from an employee’s paycheck.
For an S Corp-taxed LLC, income taxes are withheld from the owner’s salary but not from profit distributions. The owner may still need to make quarterly estimated tax payments to cover the tax liability on those distributions. A tax professional can help calculate the correct amounts and avoid underpayment penalties.