How to Compensate Yourself and Others

Answers to some of your most pressing questions about how to pay your own salary and how to compensate independent contractors

By Cliff Ennico

Opinions expressed by Entrepreneur contributors are their own.

As the limited liability company, or LLC, is fast becoming the preferred legal vehicle for small businesses nationwide, entrepreneurs are struggling with the difficult tax issues that arise when divvying up responsibilities, profits and losses. This week's e-mails focus on some recurring questions.

Q:I am forming an LLC to buy a franchise. There will be three of us owning equity in the LLC, and we will split profits and losses equally (one-third each). I will be the only one working in the business, however, and want to pay myself an annual salary, which the three of us will agree on each January for the coming year. The idea is that I will pay myself the salary each month, and then whatever's left over gets split three ways. What is the best way to set up this LLC taxwise?

A:Connecticut CPA Stephen Tiberio, responds: "If the LLC is taxed as a partnership, as this one almost certainly will be, the company can pay one or all of its members a "guaranteed payment." Guaranteed payments are deductible by the LLC but still remain a pass-through item for the individual receiving the guaranteed payment." Tiberio adds that the guaranteed payment will have to be reported on the Form K-1 the LLC gives you at the end of each year, along with your share of the remaining profits in the LLC. Each of your partners should also receive a Form K-1, reporting only their one-third share of the LLC profits.

"I would also suggest that you talk to your lawyer about setting up this LLC as a 'manager-managed' LLC. Unlike a 'member-managed LLC, which is run by the owners, a manager-managed LLC is run by the 'manager' or 'managers' designated in the operating agreement. In most states, the manager can be one of the members. By having yourself designated the 'manager' of your LLC, you ensure that your business partners will not have the ability to meddle with or second-guess your management decisions. Your partners are putting up money and want only a return on their investment, so they should not object to this structure. You may also (depending on your state law) be able to include a provision in the operating agreement prohibiting your partners from removing you as the LLC 'manager' unless you commit a crime or engage in fraudulent behavior."

Q:My wife is getting into freelance account management in the advertising industry. She will invoice the client and get paid for her services. She is also paying one or two other people who will assist her with the project. I am very unclear about the tax consequences of this. My guess is that her client will send her a Form 1099 next year for her work. Do we have to send 1099s to my wife's subcontractors? Also, how can we pass on some of the tax owed on to the people that she paid to help her out on these projects?

A:We have focused on this issue in previous columns, but it never hurts to have a refresher. According to CPA Tiberio, your wife will have to report all income received from the client as self-employment income, but the amounts your wife pays her subcontractors should be fully deductible by your wife as business expenses. Tiberio adds that your wife will be required to send Form 1099 to each of her subcontractors next January if 1) the subcontractor is not incorporated (such as a sole proprietorship or LLC) and 2) your wife pays the subcontractor more than $600 during the calendar year.

I would add that your wife should have a written agreement with each of her subcontractors, in which the subcontractor 1) acknowledges that they are an "independent contractor" of your wife and not her business partner or employee, and 2) accepts responsibility for paying all taxes on the income your wife pays him or her. Your attorney should have a simple one- or two-page form that will do the job.

Cliff Ennico

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.

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