Salary Payments In an LLC Perplexed by what you can deduct and what you can't in a limited liability company? Our Tax Expert helps you make heads or tails of how to handle those all-important salary payments to your members.
Q: In an LLC, if one or more of themembers is paid a salary, does the salary count toward thedistribution to the members at year-end, or are the salariesconsidered an expense which reduces the net profit to bedistributed?
A: It depends. (Don't you loveit when your trusted tax advisor or attorney gives you thatanswer?) LLCs are probably the most popular form of corporatestructure going right now. They offer limited liability protectionwithout the double taxation of a regular corporation.
LLCs are generally treated like partnerships as flow-throughentities for tax purposes. Rather than partners, however, LLCs havemembers. In the context of this column, I'll use the term LLCinstead of partnership and member instead of partner. An LLC is notsubject to taxes; instead, the income attributable to each memberis subject to taxes in that member's tax return. Herein liesthe complexity of dealing with a partnership or LLC.
Generally, regular payments for services rendered by a membershould 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 partnercapacity for services or the use of capital if determined withoutregard to the income of the partnership. The courts have determinedthat a partner is acting in his or her capacity as a partner whenhe performs services that are ongoing and integral to the businessof the partnership.
What all that gobble-de-goop means is that any regularlyscheduled payment to a member of an LLC for services rendered thatis not predicated on the LLC's income, such as in the case ofsalary, should be treated as a guaranteed payment.
The good news for the LLC is that guaranteed payments aredeductible by the LLC as business expenses and the net profit ofthe LLC is reduced by that amount. The bad news for the memberreceiving the guaranteed payment is that the payment is treated asordinary income.
As ordinary income, guaranteed payments aren't subject toincome tax and FICA tax withholding as a salary would be; instead,guaranteed payments are subject to estimated income taxes andself-employment taxes. What this means is that the LLC saves onFICA taxes but the member has to carry the burden ofself-employment taxes.
Another important consideration is if premiums for healthinsurance are paid by the LLC on behalf of a member for servicesrendered, then those premiums are also treated as guaranteedpayments. Guaranteed payments have other ramifications relative tothe member's capital account in the LLC (especially if the LLCis losing money) that are beyond the scope of this column. Seekhelp from your tax advisor to sort out all the intricacies in yoursituation.
Some folks have tried to get around the guaranteed payment rulesby using distributions from an LLC instead. Distributions aregenerally made relative to prior or current year's earnings, orin liquidation of a member's interest or the LLC, whereasguaranteed payments are made irrespective of earningconsiderations. Cash distributions are generally treated as areturn of the member's capital or previously taxed income. Itgets complicated at this point. Using cash distributions to paysalary exposes you to the risk that the IRS may reclassify thedistribution as a guaranteed payment and subject the payments toself-employment taxes, penalties and interest.
LLCs allow significant flexibility and benefits for smallbusinesses. Be careful, however, to avoid misclassifying salarypayments to members as cash distributions, because reclassificationby the IRS could prove to be quite a headache.
Laura A. Collins is a CPA and freelance writer with more than18 years' experience in finance and taxation. She writes fromher home in Greensboro, North Carolina.
The opinions expressed in this column arethose of the author, not of Entrepreneur.com. All answers areintended to be general in nature, without regard to specificgeographical areas or circumstances, and should only be relied uponafter consulting an appropriate expert, such as an attorney oraccountant.
