Q: In an LLC, if one or more of the members is paid a salary, does the salary count toward the distribution to the members at year-end, or are the salaries considered an expense which reduces the net profit to be distributed?
A: It depends. (Don't you love it when your trusted tax advisor or attorney gives you that answer?) LLCs are probably the most popular form of corporate structure going right now. They offer limited liability protection without the double taxation of a regular corporation.
LLCs are generally treated like partnerships as flow-through entities for tax purposes. Rather than partners, however, LLCs have members. In the context of this column, I'll use the term LLC instead of partnership and member instead of partner. An LLC is not subject to taxes; instead, the income attributable to each member is subject to taxes in that member's tax return. Herein lies the complexity of dealing with a partnership or LLC.
Generally, regular payments for services rendered by a member should be treated as "guaranteed payments" by an LLC. Guaranteed payment is a specific term in the Internal Revenue Code, which is defined as payments to a partner in his or her partner capacity for services or the use of capital if determined without regard to the income of the partnership. The courts have determined that a partner is acting in his or her capacity as a partner when he performs services that are ongoing and integral to the business of the partnership.
What all that gobble-de-goop means is that any regularly scheduled payment to a member of an LLC for services rendered that is not predicated on the LLC's income, such as in the case of salary, should be treated as a guaranteed payment.
The good news for the LLC is that guaranteed payments are deductible by the LLC as business expenses and the net profit of the LLC is reduced by that amount. The bad news for the member receiving the guaranteed payment is that the payment is treated as ordinary income.
As ordinary income, guaranteed payments aren't subject to income tax and FICA tax withholding as a salary would be; instead, guaranteed payments are subject to estimated income taxes and self-employment taxes. What this means is that the LLC saves on FICA taxes but the member has to carry the burden of self-employment taxes.
Another important consideration is if premiums for health insurance are paid by the LLC on behalf of a member for services rendered, then those premiums are also treated as guaranteed payments. Guaranteed payments have other ramifications relative to the member's capital account in the LLC (especially if the LLC is losing money) that are beyond the scope of this column. Seek help from your tax advisor to sort out all the intricacies in your situation.
Some folks have tried to get around the guaranteed payment rules by using distributions from an LLC instead. Distributions are generally made relative to prior or current year's earnings, or in liquidation of a member's interest or the LLC, whereas guaranteed payments are made irrespective of earning considerations. Cash distributions are generally treated as a return of the member's capital or previously taxed income. It gets complicated at this point. Using cash distributions to pay salary exposes you to the risk that the IRS may reclassify the distribution as a guaranteed payment and subject the payments to self-employment taxes, penalties and interest.
LLCs allow significant flexibility and benefits for small businesses. Be careful, however, to avoid misclassifying salary payments to members as cash distributions, because reclassification by the IRS could prove to be quite a headache.
Laura A. Collins is a CPA and freelance writer with more than 18 years' experience in finance and taxation. She writes from her home in Greensboro, North Carolina.
The opinions expressed in this column are those of the author, not of Entrepreneur.com. All answers are intended to be general in nature, without regard to specific geographical areas or circumstances, and should only be relied upon after consulting an appropriate expert, such as an attorney or accountant.