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.
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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.