Passive vs. Active LLC Members: Who's Paid What?
Get the low-down on the legalities of paying active and passive investors in this business structure.
Let's say that you and your husband form a limited liability company (LLC) with your husband's friend Joe to run a flower shop. The three of you are equal partners (or "members" in LLC language) in the LLC and make equal contributions to the LLC's capital. During your first year in business, you and your husband will be doing all the work, as Joe has a full-time job. You'll also have a part-time employee, Jim, who'll work two days a week to create your floral arrangements and be paid by the hour. Because Joe won't be working in the business this year, you and your husband want to pay yourselves 100 percent of the LLC's profits as salaries. Can you do this?
Let's take the easy part first. LLCs, like any other business, can have employees, so whatever you pay Jim will be a business expense of the LLC and will be fully deductible to the LLC. Just be sure you pay all federal and state employment taxes (such as FICA and FUTA) on Jim's wages.
Now for the amounts you and your husband will take out of the business. Generally, state LLC laws prohibit members from being compensated at all, or having their expenses reimbursed, unless the members agree otherwise. So your LLC operating agreement should include a provision that 100 percent of the LLC's profits during the first year of operation will be payable as compensation to you and your husband. Make sure Joe signs off on that provision.
Now for the tax stuff. LLC members owning more than 5 percent of the business aren't considered "employees" for tax purposes and so do not receive deductible wages. What they get instead is a percentage (called the "distributive share") of the LLC's profits and losses, which is specified in the operating agreement. Because the exact amount of any member's distributive share can't be determined until the end of the year, LLC members usually take a "draw"--an advance against their anticipated distributive shares--out of the LLC checking account each pay period, and then frantically sort everything out in the last few weeks of the year.
So you and your husband will each have a distributive share of one-third, or 33.33 percent. By including a provision in your LLC operating agreement allowing you to take 100 percent of the profits during the first year, however, you increase your distributive shares to 50 percent each. You will each have to report 50 percent of the LLC's profits as income on your personal tax returns (Form 1040) and pay both income and self-employment taxes on the full amount. You won't have to pay federal or state employment taxes (FICA or FUTA) on the amounts you draw out of the LLC, but you won't be able to claim unemployment benefits if the LLC fails because you're not "employees."
Alternatively, according to CPA and tax expert Peg O'Donnell, "you could just elect voluntary withholding and have taxes taken out each time you make a withdrawal." You'll be doing this for Jim anyway, so why not?
Now what about your husband's friend, Joe? As long as 100 percent of your LLC's profits during the first year are fully distributed to you and your husband, Joe shouldn't have to pay income or self-employment taxes. If less than all the LLC's profits are distributed, however, he'll have to pay taxes on one-third (33.33 percent) of the undistributed profits. This is called "phantom income" and is one of the burdens of being a passive investor in any LLC. To be safe, you should put a provision (called a "gross-up clause") in your LLC operating agreement requiring the LLC to reimburse the tax liability of any member who incurs "phantom income" resulting from his membership in the LLC. That will take some money out of your pockets come tax time next year, but it'll keep Joe happy until he's ready to roll up his sleeves and get to work.
Cliff Ennico is host of the PBS television series MoneyHunt and a leading expert on managing growing companies. His advice for small businesses regularly appears on the "Protecting Your Business" channel on the Small Business Television Network at www.sbtv.com. E-mail him at email@example.com.
Cliff Ennico is a syndicated columnist and author of several books on small business, including Small Business Survival Guide and The eBay Business Answer Book. This column is no substitute for legal, tax or financial advice, which can be furnished only by a qualified professional licensed in your state.