Last Updated on September 24, 2021 by DMEditor
The first thing you need to determine when you want to take money out of your small business is if you have a single-member or multi-member LLC. Furthermore, if you’re an employee of your small business, the IRS expects you to give yourself adequate compensation.
In this article, we’re going to cover how to pay yourself via your LLC, as well as how to ensure that your compensation is aligned with what the IRS wants to see (which is important for when you file your tax return).
Table of Contents
- 1 LLCs: How Sole Proprietorships, Corporations and Partnerships Come Into Play
- 2 Paying Yourself From a Single-Member LLC
- 3 Paying Yourself From a Multi-Member LLC
- 4 How Much Should You Pay Yourself From an LLC?
- 5 Paying Yourself From an LLC: Covering Your Bases the Legal Way
- 6 Owner’s Draw vs. Salary: Which is Better?
- 7 Owner’s Draw
- 8 Salary
- 9 How to Increase Your Salary
- 10 FAQ
- 11 Wrapping Up
LLCs: How Sole Proprietorships, Corporations and Partnerships Come Into Play
Some LLCs can be treated as a sole proprietorship during tax time – or yours may be treated as a corporation or a partnership instead. If you’re not sure which one to set up your business as, consider speaking with a professional . Here’s how single- and multi-member LLCs impact the type of business entity it’s taxed as.
Single-Member vs. Multi-Member LLCs
If there are no other members of the LLC besides you, it’s considered a single-member business, which means it’ll be taxed as a sole proprietorship. If your LLC has additional members, it’s considered a multi-member LLC, and it can be taxed as either a corporation or a partnership.
Now, while corporations and partnerships are both multi-member LLCs, they’re taxed differently, and its members – including you – get paid differently, too.
Paying Yourself From a Single-Member LLC
In order to pay yourself from a single-member LLC, you have to make an owner’s draw.
A single-member LLC is considered a disregarded entity, which means that your income and the business’ profits are the same. On your personal tax return – which you’ll use IRS Form 1040 for – you’ll report your income and profits with Schedule C.
When you make an owner’s draw, you’re essentially saying that a portion of the LLC’s income is remaining in the company as retained earnings and that there’s another portion that you’re taking for your own use.
Making an Owner’s Draw
It’s not difficult to make an owner’s draw so that you can get paid from your single-member LLC. There are a few basic steps:
Step 1: From your business account, write a check to yourself for the amount that you want to be compensated.
Step 2: Deposit the business check into your personal bank account.
Step 3: Add a double-entry in your accounting books. The first will have “Owner’s Equity” and the amount as a debit. The second will have “Cash” and the amount as a credit.
Let’s briefly talk about that double-entry a bit more. When you take cash out of your business, two accounts are affected: Cash and Owner’s Equity. Both of these accounts should be included on your balance sheet.
Cash is the most obvious of the two: It refers to the amount of cash that your bank account is decreasing by. Owner’s Equity is the total amount that you’ve invested or drawn from the business. You credit your Cash account because that’s how much it’s decreasing by. You debit the Owner’s Equity account because you’re drawing that amount from the business.
Paying Taxes On an Owner’s Draw
The IRS charges tax (minus deductions) on your business’ earnings for the year. Your personal income will not be taxed a second time – you’ve already paid taxes on it once, as a business.
For example, let’s say your small business earned $ 50,000 last year. You’ll pay income tax on just the $ 50,000, even if you took an owner’s draw of $ 25,000. You don’t need to pay income tax on that $ 25,000 “salary” because it’s already been taxed.
What you do have to pay is self-employment tax, which is calculated based on your owner’s draw. The rate for self-employment tax is 15.3%, and it’s similar to the taxes that traditional employees have deducted from their paycheck.
That money goes toward things like Medicare and Social Security. Knowing you’ll have to pay self-employment tax is important so that you can set aside 15.3% of whatever you take as your Owner’s Draw.
Paying Yourself From a Multi-Member LLC
The way that members of a multi-member LLC are paid is based on whether the business is considered a corporation or partnership. The IRS defaults to treating all multi-member LLCs as partnerships, but that doesn’t mean you can’t have yours treated as a corporation.
Partnership Multi-Member LLC: Compensation and Taxes
Taking compensation for yourself from this type of multi-member LLC is similar to taking an Owner’s Draw from a single-member LLC. However, this type of business is considered a pass-through entity, which impacts how you’ll handle taxes.
The main difference is that you will use IRS Form 1065 to report your income to the government, but the partnership will not be taxed. That doesn’t mean that the partnership’s earnings aren’t taxed at all, of course.
Each member (also referred to as “partner”) will pay part of their income towards the income tax on the business’ earnings. How much of a share each member pays should be laid out in the partnership agreement.
You don’t have to try to calculate exactly how much to pay. At the end of the year, each member gets an IRS Schedule K-1 form, which should have the member share of the business’ income. That form will be used when preparing your personal tax return.
Each member will pay the full amount of income tax on their share, even if they don’t take all of it as a draw. For example, if you have a 25% share in the partnership but you only take 10% as a draw for your own compensation, you’ll still pay income tax on the 25% share.
Like with a single-member LLC, you don’t pay tax on your draw; you only pay tax once, on the total share you own. And also like a single-member LLC, you will need to pay the 15.3% self-employment tax on your draw.
With a multi-member LLC, you can also arrange guaranteed payments, which means you’re paid a minimum amount of compensation even if the business has a loss. We’ll get into that a bit more after we talk about salaries.
Corporation Multi-Member LLC: Compensation and Taxes
When an LLC is set up as a C or S corporation , a member, called a shareholder, cannot take a draw. Instead, they must be hired as an employee and paid a salary. Once the salary is paid, the member can take a percentage of the business’ income as dividends. How much an employee is allowed to take in dividends will be clarified in the articles of incorporation.
Since you’re technically an employee of a corporation, income and payroll taxes are self-deducted from your earnings. AC corporation is double-taxed, which means that the IRS charges income tax from the corporation and also collects personal income tax from the salary and dividends earned by each member.
Dividends are not charged payroll tax. If you receive a generous portion of your income from dividends, they won’t be taxed as much. However, the IRS still requires business owners to earn reasonable compensation, so your corporation can’t pay you entirely in dividends as a way to avoid paying payroll tax.
Guaranteed Payments vs. Salaries
At first, it may sound like guaranteed payments and salaries are the same thing. After all, both pay out a set amount on a recurring basis. There are some distinct differences between the two types of payments, though.
Guaranteed payments are not taxed payroll tax like salaries are. The earnings are reported on the member Form 1040 for income tax and on the Schedule K-1 for self-employment tax.
Also, guaranteed payments are reduced if the business becomes more profitable. That’s because the amount of the payment is the difference between the guaranteed payment and the distribution you get at the end of the year.
For example, if your guaranteed payments are $ 10,000 and your distribution of the business’ profit is $ 5,000, you’ll get a $ 5,000 guaranteed payment to make up the rest of the $ 5,000. If the business becomes more profitable next year and your distribution is $ 8,000, the guaranteed payment will be $ 2,000 to get to that $ 10,000 total.
How Much Should You Pay Yourself From an LLC?
The IRS requires that you pay yourself a reasonable amount from your LLC, but knowing exactly what “reasonable” means isn’t cut-and-dry. The IRS doesn’t provide much guidance, either.
This document states that reasonable compensation is “an amount that would ordinarily be paid for like services by like organizations in like circumstances …” In other words, it’s aligned with what other companies like yours pay the owner.
Here’s what it doesn’t mean: If you say that you make a $ 1,000 salary from an LLC that has another $ 100,000 in dividends, the IRS is going to be curious about it – and you don’t want to catch the IRS ‘attention at any point. Doing this may be a way to avoid payroll tax, but it’s also a good way to get audited – or worse.
Here’s how to figure out what a reasonable salary is
- Add up your personal expenses for the year. This is the minimum amount you need as compensation.
- Go over your bookkeeping (you may need to enlist the help of your accountant for this if you have one). Figure out how much the business can afford to pay you as compensation in addition to the bare minimum you need.
- Look at the earning statistics for your industry and role. Figure out the average salary for your job.
From there, you can pick a number that falls within a reasonable range considering all of the most important factors. If that still doesn’t seem like adequate compensation, you can consider a few other factors, such as:
- How large is the business?
- What’s the scope of your work?
- Do you have a lot of relevant qualifications and / or training?
- How many years of experience do you have?
If any or all of your answers to the above exceed the norm, you can pay yourself on the higher end of a reasonable compensation range.
We’ve mentioned it a few times, but it bears repeating here: The more dividends and the less salary you pay yourself, the less payroll tax you’ll have to pay. However, you need to strike an appropriate balance so you don’t interest the IRS in your books. This is when it pays to hire a reliable accountant if you don’t have one already.
Paying Yourself From an LLC: Covering Your Bases the Legal Way
However you pay yourself from your LLC, you have to keep it legal , which means covering your bases and creating a paper trail. In this section, we’ll touch on the how instead of the how much .
Keeping everything cool is pretty simple when you make a salary. You’ll be on the payroll, so getting money from the company, reporting your income and having taxes deducted is straightforward.
An Owner’s Draw is a little more complicated because you have to move money from a business account to a personal account. This is when figuring out how to leave a paper trail is most important. It’s necessary to have financial institution records that show how much you took from the company and deposited into a personal account.
Otherwise, the line between business and personal income becomes too blurry. If legal action or a lien is placed against you, the court may say that your LLC’s liability protection doesn’t apply and that your personal assets are at risk.
What leaves a paper trail? An online transaction or paper check. Keeping your LLC’s money in an envelope under your mattress and then taking some out here and there for personal spending won’t cut it.
The good news is that you can take as many draws on your own business’ profits as you want. As long as you’re leaving a paper trail, you’re safe.
Owner’s Draw vs. Salary: Which is Better?
As we’ve already covered, there are two basic ways to pay yourself if you’re the owner of an LLC: An Owner’s Draw (simply called a “draw” a lot of the time) or a salary. There are pros and cons to each compensation method.
Ultimately, the method you choose will be based on your LLC’s structure, but that can be partly decided by your personal preferences. For example, you can opt to set up a multi-member LLC as a corporation instead of a partnership, which means having a salary instead of taking draws.
Let’s also quickly go over the differences between these two methods, in case they’re not clear already, and further explain the pros and cons of each one.
With this method, you draw money from your business earnings.
You don’t have to rely on recurring income. Instead, you can draw as much as you want, whenever you want (when you have a sole proprietorship and don’t have to answer to other members, at least). There’s a lot of flexibility with this option, and you can take more or less depending on how well your business is doing.
Note that while you can take out money whenever you want, it’s easier for bookkeeping to make draws at semi-regular intervals and to draw the same or around the same amount of money each time.
For business owners who aren’t great money managers, this could lead to taking more out of the business than the business can afford. Sometimes, a lot of flexibility is too much for people who struggle with being financially responsible.
Also, taxes aren’t automatically deducted when you make draws, as they are with the salary method. You’ll have to report your draws to the IRS and pay taxes on them when you file. As a result, this method requires more tax planning, paying quarterly taxes and paying self-employment tax.
When you take a salary instead of a draw, you’re regularly paid a set amount of money, just like a regular employee.
You always know how much you’re making and when you’ll be paid. Not only is cash flow reliable, but administrative tasks are made much easier, too, both personally and for the business.
This is especially true around tax time because personal state and federal taxes will have already been deducted from your payments. Also, it’s also easier and better to show a fixed, steady income when you go to apply for credit, get a mortgage, sign a lease, etc.
On the flip side, if your business starts to do really well, you won’t automatically earn more of an income. And if your business needs more money because sales are flagging, you’ll still be taking the same amount in compensation, which could leave too little for the company to function.
Another potential problem with the salary method is that you have to determine the amount of a reasonable salary in order to keep the IRS off your back.
How to Increase Your Salary
Let’s say you’ve opted to take a salary instead of making draws, and you feel it’s time to give yourself a raise. While increasing your compensation isn’t as easy as simply taking a higher draw or drawing on your business account more frequently, it’s not nearly as difficult as you think, either.
In essence, your salary can evolve as your business does. That means you can adjust how much you take based on your business’ performance and your personal needs.
Once your business is at the break-even point, consider correlating bonuses or salary increases with the business’ performance. Choose from these three options for doing this, and keep in mind that you can do whichever one you pick every year as your business continues to grow, meaning your bonuses and / or salary can be higher each year:
Lump-Sum End-of-Year Bonus
Look over your business’ profits for the past year and calculate a bonus for yourself that’s based on its growth after the break-even point (if that point occurred in the same year). For example, if your business’ net profits increased by 15%, you can take a lump-sum bonus of 15% on top of your regular salary.
Instead of taking a matching percentage to your business’ growth at the end of the year, spread it out throughout the year as quarterly bonuses. To do this, you’ll take the same percentage as in the lump-sum bonus method (the growth percentage after the business’ break-even point) and split it up into four payments, one each delivered every three months.
Adjust Your Salary Based on Business Growth
With this option, you simply adjust your salary to match how much your business has grown. This is the best option if you would rather see a pay increase in your paychecks than in less-frequent bonuses.
For example, if your business grew by 40% during the last year (after the break-even point), you would multiply your current salary by 140% to get your new salary. If you currently make $ 80,000 per year, you’d start making $ 112,000 per year, split up into your regular payments (like weekly or bi-weekly).
In case you still have questions about paying yourself when you own an LLC, let’s go over a few of the most common ones.
Answer: In terms of taxes, single-member LLCs are considered sole proprietorships, which means the owner cannot take a salary. Instead, the owner can make draws on their business account to deposit money into their personal account.
Answer: An LLC can get a tax refund only if it’s considered a C corporation. That’s because the only business entity that qualifies for a tax refund is a C corporation. The profits of a C corporation are taxed separately, which is what sets this type of business entity apart.
Answer: Unless your LLC is set up as a corporation, in which case you and the members will receive a salary that’s already taxed throughout the year, you should put aside 30% of your income for taxes. If you want to be extra careful, you can put up to 40% aside to cover both federal and state taxes.
Answer: Technically, yes, you can pay yourself as a contractor if you’re the owner of an LLC. However, there isn’t much of a reason to do so. As a contractor, you’ll have to file a W-9 with the LLC, and the LLC will have to file back a 1099-MISC for your tax return. You’ll have to pay a self-employment tax of 15.3% on any earnings over $ 400, too.
Ultimately, it won’t benefit you to set yourself up as a contractor of your LLC, and the paperwork will be heftier than if you paid yourself in one of the more traditional ways.
It’s difficult enough to get a small business off the ground and run it every single day. The last thing you want to worry about is if you’re paying yourself enough. You deserve compensation for the hard work you do, and even the IRS thinks so – that’s why they require that every LLC owner makes a reasonable amount of income.
The good news is that you can start paying yourself even if you don’t have an accountant, and figuring out how much money to take for yourself isn’t as complicated as you probably think.