Owners (also known as members) of limited liability companies are compensated in an unique way when compared to the compensation model for ordinary employees and shareholders of corporations. This post digs into how to properly compensate yourself as the owner of an LLC (whether the LLC is single-member or multi-member).
Members of an LLC (without an S-Corp election) are provided with a draw from company profits and are not typically offered a structured form of compensation.
Members of an LLC may elect to receive guaranteed payments which is, in essence, a salary, that is 100% subject to self-employment tax but provides the company with a tax deduction.
S-Corp shareholders (or LLCs that make S-Corp elections) are required to receive reasonable compensation.
S-Corp shareholders may also be given profit distributions, so long as said distributions are not intended to avoid tax liability (since profit distributions are not subject to FICA).
A 'draw' is not a 'salary'
It is popular for business owners to say that they pay themselves a salary out of their LLC. While the term used in casual conversation isn’t going to get you into any trouble (unless you’re talking to an accountant or lawyer who wants to make themselves look good), the legal term used for member’s receiving compensation from their LLC is called a draw.
A draw is a payment to a member based on their proportionate share of the company’s profits.
What is your proportionate share?
Well this could either be spelled out in your company’s operating agreement, or based off of the member schedule that accounts for all members’ equity in the business. So, if I own 50% of The Reel Law Firm LLC I would be given 50% of the profits generated by the firm. A cool little nuance that is relevant to LLC's which don't elect to be taxed as an S-Corp is that they can actually pay out member draws that are not directly proportionate to the ownership interest of the members. This goes out the window with an S-Corp election, though. More on that below.
Guaranteed Payments: The alternative option for payment through an LLC
An alternative to the member draw would be what is called a guaranteed payment. In practical terms this is very similar to a traditional compensation structure where someone receives a salary, with one important caveat. With a salary the business will take part-responsibility for the taxes associated with compensation, while a guaranteed payment still passes tax liability down to the member—who is subject to self-employment tax.
When a member is entitled to guaranteed payments it is without consideration of the profits and losses to the company and is actually factored in above-the-line as a deduction to the net revenue (or profits) of the business.
A perk attached to guaranteed payments is that the business can tally the guaranteed payments provided as an expense of the company which can be passed-through to the members as a deduction.
For example: ABC Company has 4 equal members and owes a $50,000 guaranteed payment to one of the members, John. ABC Co. can tally $50,000 as an above-the-line expense from the profits the company earns that year. This expense can pass-through evenly to the members as a deduction of their overall tax liability on the profits passed-through from the company to them.
Note: LLCs are pass-through entities, which ultimately means that the tax liability assessed to the revenues generated by the company flow to the members based on their proportionate share of the company.
So, in the example above, all 4 members of the company would get to tally $12,500 of the $50,000 as a deduction to the profits generated and thus taxed to them. Let’s say now that the business generates a profit of $100,000 (after they’ve taken out the $50k owed to John).
Since the 4 members are equal members, each is assessed a tax bill to the tune of $25,000 (their proportionate share of the $100,000 profit). Without the guaranteed payment the $50,000 would, of course, not be considered an expense and the profits would increase to $150,000. This ultimately results in a proportionate profit draw of $37,500 to each member ($150,000 / 4 = $37,500), and every cent would be subject to self-employment taxation.
S-Corp Compensation (A different way of operating your LLC)
When an LLC elects to be taxed as a subchapter S-Corporation the owners benefit from a change in the tax liability as the profits passed down to them will be exempt from FICA tax. This is achieved by way of the owners becoming W-2 employees of the company they own. Cool, right? While making an S-Corp election certainly has its benefits, but it also has its drawbacks.
S-Corp owners who are substantially involved in the operations of the business are required to receive reasonable compensation from the company. This goes for single-member and multi-member LLCs that elect S-Corp taxation.
What is reasonable compensation?
The term itself isn’t exactly clear cut, but the IRS was kind enough to put out a fact sheet that spells out some of the factors considered when determining whether the compensation is reasonable.
These factors include:
Training and experience
Duties and responsibilities
Time and effort devoted to business
Payments to non-shareholder employees
Timing and manner of paying bonuses to key personnel
What comparable businesses pay for similar services
Formulaic calculation to determine compensation
These factors don’t really help us paint a picture as to what truly constitutes reasonable compensation, but the fact remains, you cannot avoid the tax man by paying yourself straight profit distributions and no ordinary income.
So, to summarize—as an LLC that has not made a subchapter S election members are provided with a draw or with guaranteed payment. If the LLC has made the subchapter S election, then the shareholders must be provided with reasonable compensation that is taxable as ordinary income. S-corp owners are also permitted to take profit distributions which are not subject to FICA thus providing some tax advantages to the individual shareholders.
We offer a complete spectrum of legal services for businesses and can help you make the wisest choices on how to implement compensation structures for yourself as a member, proactively deal with the issues that arise as your business grows and everything in between. We also offer a LIFT Start-Up Session™ or a LIFT Audit for an ongoing business, which includes a review of all the legal, financial, and tax systems you need for your business. Call us today to schedule.