If you’ve ever wondered, “How do I pay myself from my LLC?” then this post is for you. We go through the different structured, taxation, and payment methods and procedures.
Understanding the LLC Structure
What is an LLC?
A Limited Liability Company (LLC) offers the limited liability protection of a corporation. At the same time, it maintains the pass-through taxation of a sole proprietorship or partnership. Rather than the business entity being taxed, profits and losses flow through to the individual owners’ personal tax returns.
An LLC is governed by an operating agreement that defines the rights, responsibilities, and ownership interests of the members. LLCs are formed by filing articles of organization with the state government.
LLC owners (called members) are not personally liable for the company’s debts or liabilities. This means that their personal assets are protected.
LLC Tax Classifications
Single-member LLC
A single-member LLC is typically taxed as a sole proprietorship by default. There is only one member or owner of the LLC, and profits and losses are reported on the owner’s personal tax return.
Multi-member LLC
A multi-member LLC is owned by multiple individuals and typically taxed as a partnership. Profits and losses are reported on the members’ individual tax returns.
Taxed as Corporation
An LLC that elects to be taxed as an S Corporation avoids double taxation. In addition, members are not subject to self-employment taxes on their share of profits.
The criteria for taxation as a corporation include having no more than 100 shareholders, all of whom are individuals or estates. The LLC must also first file IRS Form 2553 to elect S Corporation status.
C Corporations can deduct certain business expenses that may not be deductible for pass-through entities. They also enjoy perpetual existence and can issue shares of stock to raise capital.
Note, however, that corporations are taxed on their profits, and then shareholders are taxed again on dividends received. C Corporations also have more complex administrative and legal requirements.
Payment Methods for LLC Owners
1. Owner’s Draw
How do I pay myself from my LLC through an owner’s draw?
Owner’s draw means the LLC member withdraws funds from the business for personal use. It’s a way for members to distribute profits or excess funds.
Since an owner’s draw is not a salary, it is not subject to payroll taxes like FICA and federal income tax. It is also not a dividend because LLCs are not taxed as corporations. Rather, the amount is personal income that the member reports on their personal tax return.
Calculating and Recording
- Calculate the LLC’s net profit for the payment period agreed upon in the operating agreement.
- Calculate each LLC member’s share and set the draw amount in line with the profit share to avoid tax implications.
- Record a journal entry debiting the Owner’s Draw account for the amount withdrawn. Then, credit the Cash account for the same amount.
Owner’s Draw Pros and Cons
Owner’s draws make withdrawing profits flexible, based on the LLC’s financial performance and the owner’s needs. Owner’s draws can potentially increase the owner’s tax liability if not done in line with share portions.
Multi-member LLC owners may be subject to self-employment taxes on their share of profits, including owner’s draws. These amounts are not treated as business expenses. This limits the potential for deductions.
Note that making too many owner’s draws can deplete the LLC’s cash reserves. This can potentially impact the LLC’s ability to operate and grow.
2. Salary (for S Corp or C Corp Tax Status)
How do I pay myself from my LLC as a salary?
If the LLC offers employee benefits, getting a salary means that an owner can be classified as an employee. If you want to establish employee status for unemployment benefits, workers’ compensation, or other purposes, paying yourself a salary can be helpful.
Receiving a salary also means deductible business expenses related to employment. This includes tax-deductible contributions to a retirement plan like a SEP IRA or Solo 401(k). Paying yourself a salary can also help ensure compliance with certain legal and regulatory requirements.
If the LLC loans you money, paying yourself a salary can help you repay the loan in a tax-efficient manner.
Reasonable Compensation Rules for S Corps
Reasonable compensation is the amount of salary or wages paid to shareholders who are also employees. The IRS looks closely at these payments to make sure they are fair market value for the services rendered. This is regardless of ownership interest, but considers factors like industry standards, education, experience, responsibilities, and the size of the corporation.
The IRS may treat excessive compensation as a dividend, which is not tax deductible for S Corporations.
Setting Up Payroll and Taxes
- Get an Employer Identification Number (EIN) from the IRS.
- Register for applicable state and local taxes.
- Recommended: Choose a payroll provider to automate calculations and filings.
- Collect necessary employee information.
Tax Implications of Paying Yourself from an LLC
Self-Employment Taxes
LLC owners, unlike corporation employees, are responsible for paying both the employer and employee portions of the self-employment tax. In addition to federal self-employment taxes, you may also need to pay state and local self-employment taxes.
Tax Withholding for Salaries
- Federal income tax is withheld based on the employee’s W-4 form and IRS tax tables.
- Social Security tax is a percentage of the employee’s salary, up to a certain wage base.
- Medicare tax is a percentage of the employee’s salary, with an additional, smaller, percentage for higher-income earners.
- State and local taxes usually vary by location, but typically include income tax and unemployment tax.
Quarterly Estimated Tax Payments
If your estimated tax liability for the year is above $1,000, you need to make quarterly estimated tax payments to avoid penalties. If you pay yourself a salary, you also need to file quarterly payroll tax returns and annual W-2 forms.
Steps to Pay Yourself from Your LLC
1. Review Your LLC’s Tax Classification
Confirm if your LLC is taxed as a sole proprietorship, partnership, or corporation. Each has its own advantages and disadvantages, and differences in taxation.
2. Decide on Payment Method (Draw vs. Salary)
Consider the tax consequences of each payment method based on your personal tax situation. Think about the LLC’s expenses, growth plans, and need for employee benefits, too. Then, evaluate your personal financial goals and preferences for income and retirement planning.
We highly recommend that you consult with a tax professional to choose the most suitable payment method. They can help you look at the best setup for your specific LLC structure and circumstances and help you optimize your tax strategy.
3. Set Up Bookkeeping and Record Keeping
We recommend using specialized accounting software to record transactions and track income and expenses. Most tools also generate very useful financial reports. Alternatively, you can create spreadsheets to manually track everything, but this is time-consuming and error-prone.
Another great option is outsourced bookkeeping services where you can hire professional help for less. These agencies typically offer expert help to cover bookkeeping tasks for accurate and efficient record-keeping.
Compliance Considerations
Keep all your records for at least seven years.
Make sure you’re filing taxes on time. These include federal, state, and local tax returns, including income tax, self-employment tax, payroll tax, and sales tax.
Check that you are paying quarterly estimated taxes if estimated tax liability exceeds $1,000. If you pay yourself or employees a salary, you need to comply with payroll tax laws. These include withholding, reporting, and payment.
4. Calculate Your Payment Amount
Business Profits
- Calculate the LLC’s net profit after expenses.
- Decide on a portion of profits to retain for reinvestment in the business.
- Distribute the remainder among the owners based on the operating agreement.
Tax Liabilities
LLC owners with self-employed status must pay self-employment taxes, including Social Security and Medicare taxes. An LLC taxed as a C corporation must pay corporate income tax. Profits distributed to owners are subject to individual income tax.
Personal Needs
Think about your personal living expenses and your short-term and long-term financial goals. Savings, investments, and debt repayment are important factors. Look at your retirement savings needs as well when determining your payment amount.
5. Make Regular Payments
Monthly is a common payment frequency, especially for businesses that already have consistent cash flow. If owners do not require regular income, quarterly payments can work well, especially for businesses with seasonal fluctuations.
Annual payments are less common but can work for businesses with significant year-end profits if the owners have other sources of income.
Setting Up Regular Payments
- Decide on the frequency that best suits your business and personal needs.
- Calculate the payment amounts based on the LLC’s profits, tax liabilities, your personal financial goals, etc.
- Set up a payment schedule for consistency.
- Record payments with the dates, amounts, and reason for the payment. Accounting software or a payroll system to automate regular payments and simplify the process.
Common Mistakes to Avoid When Paying Yourself from an LLC
How do I pay myself from my LLC without mixing personal and business finances?
Keep separate accounts for personal and business finances. This gives you a clear picture of your business’s financial health and protects your personal assets from business debts and liabilities.
How do I pay myself from my LLC fairly?
Paying yourself too much or too little can result in significant negative consequences, including:
- Deductions for excessive compensation treated as dividends, increasing taxable income.
- Substantial penalties and interest for unreasonable compensation.
- Loss of S Corporation status, resulting in double taxation.
- If your income is too low to justify business expenses, you may not be able to deduct any. THe same goes for certain employee benefits.
- Lower income limits retirement plan contributions and tax benefits.
How to Handle Distributions and Dividends (for LLCs Taxed as Corporations)
Distributions vs. Dividends
Distributions are a return of capital and typically not taxed as income if the distribution does not exceed the owner’s basis in the corporation. Dividends represent a portion of the corporation’s profits that are distributed to shareholders.
Tax Treatment of Distributions
If the distribution is more than the shareholder’s basis in the corporation, the IRS taxes the excess as ordinary income. The IRS usually taxes dividends from C Corporations as ordinary income. Qualified dividends may be eligible for a lower tax rate, though.
Benefits of Consulting an Accountant or Tax Professional
When to Seek Professional Advice
Tax experts can give you accurate advice and guidance around complex calculations and deductions. A tax expert can help you submit a well-prepared tax return to avoid penalties and audits.
Ensuring Compliance with IRS Rules
More than avoiding penalties and interest charges, staying compliant helps you to maintain your business’s reputation and credibility. It also protects you from legal action and business closure.
Frequently Asked Questions
How do I pay myself from my LLC a different way?
Yes, however, switching payment methods may have tax consequences. You may also need to update your payroll system, file amended tax returns, and notify your tax professional of the change.
How does paying myself from an LLC affect my eligibility for personal loans or mortgages?
Lenders calculate your debt-to-income ratio (DTI) to determine your ability to manage debt.
If you take a salary, lenders will factor your income into your debt-to-income ratio. If you use owner’s draws, the lender may not fully consider your income.
What happens if my LLC doesn’t make enough profit to pay myself?
Consider:
- Cutting back on non-essential expenses.
- Reinvesting profits to grow the business and generate future income.
- Borrow money or look for other ways to supplement your income.
- Dissolve the LLC if the business is not viable.
How do I pay myself from my LLC as a salary and take an owner’s draw at the same time?
Yes, but consider the different tax implications and limitations of reasonable compensation.
How does the LLC’s tax election impact retirement contributions and benefits?
S Corporations can offer member employees tax-advantaged retirement plans like SEP IRAs, SIMPLE IRAs, and Solo 401(k)s. C Corporations have more flexibility, and can offer traditional 401(k)s, profit-sharing plans, pension plans, and more.
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And here’s some free resources:
- Monthly Finance Meeting Agenda
- 9 Steps to Master Your Ecommerce Bookkeeping Checklist
- The Ultimate Guide on Finding an Ecommerce Virtual Bookkeeping Service
- What Is a Profit and Loss Statement?
- How to Read & Interpret a Cash Flow Statement
- How to Read a Balance Sheet & Truly Understand It
Conclusion
If you are asking yourself, “How do I pay myself from my LLC?” this post should give you a good starting point. Make sure you look at all the factors and their collective implications.
