Can LLC Members be Paid as Employees of the Business?

If you’ve done any searching online, you’ve probably read that limited liability company (LLC) entity offers flexibility when organizing the management and economic structure of the company. And because of this flexibility, the LLC quickly became the most popular entity to form in order to shield personal assets from business liabilities. One of the areas where LLCs offer flexibility is how to structure payments to owners of the business. Today’s post discusses the fact that owners of an LLC can only be considered “employees” if the LLC elects to be taxed as a corporation.

Can LLC Members be Paid as Employees?

Members (owners) of an LLC cannot be considered “employees” of the business unless the LLC elects to be taxed as a corporation–either an S corporation or C corporation. Below is a break down of how an LLC can be taxed and how this affects the compensation for owners:

Choosing the right entity

Default Taxation for LLCs

For tax purposes, an LLC is by default a pass-through entity—i.e. any money that comes into the business will “pass-through” to the individual members of the company regardless of whether they receive distributions, and the members are required to report their share of any income or loss on their individual tax returns. For example, if the business has $10,000 in net profit and has two Members who each own 50% of the business, then each Member will owe tax on $5,000 regardless of whether or not the LLC distributes any cash to the Members. In this situation, the LLC is being taxed as a partnership and the owners cannot be employees and are not allowed to pay themselves a salary. Instead, the LLC can distribute cash to owners and those distributions are subject to self-employment taxes.

LLCs Can Elect to be Taxed as Corporations

S Corporations: An S corporation refers to the tax treatment of the entity. That is, an S corporation is not a type of entity, but a type of tax status—specifically subchapter S of the U.S. Tax Code governs the tax treatment of entities that elect to be taxed as an S Corporation. When you form an entity, whether it’s a corporation or an LLC, you can elect for the entity to be taxed as an S corporation.
Paying Owners of LLCs

As I discussed above, an LLC is by default taxed as a pass through entity. An S corporation also offers pass-through taxation. So why would you elect to have your pass-through LLC taxed as a pass-through S corporation? Because an LLC that elects to be taxed as a S corporation can have its owners be employees of the LLC and pay them a regular salary that is subject to standard federal withholding taxes (and not self-employment taxes). Depending on the individual financial circumstances of each owner, electing to be an employee versus an owner (and having to pay self-employment taxes) can have a significant tax impact.

C Corporations: Corporations are taxed quite differently than partnerships. Corporations are subject to double taxation—money that comes into the corporation is taxed as corporate income, and the same money is taxed again when it is distributed to shareholders as dividends or to employees as wages. When you form an LLC, you can elect to be taxed as a C corporation and the owners of a C corporation can be employees and be paid salaries. Again, depending on the individual financial circumstances of each owner, electing to be an employee versus strictly an owner (and having to pay self-employment taxes) can have a significant tax impact. You should always consult with an accountant about your personal financial situation to see which option will best minimize your tax liability.

If you have any questions about choosing the best entity structure for your small business, please comment below or contact me today.

Photo: Daniel Oines | Flickr
Photo: 401(k) 2012 | Flickr

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