Paying the Owners of a Limited Liability Corporation
One of the more common questions that new limited liability company owners (or their bookkeepers) have concerns how to pay the owners for their work. Are amounts paid to the owner wages? A draw on profits? Something else?
Limited liability companies are wonderful tools for small business entrepreneurs but their flexibility sometimes makes the bookkeeping complicated. Fortunately, you can follow a few simple rules to account for the amounts paid to the owners of a limited liability company.
Payments to Owners of Single Member Limited Liability Companies
Typically, the single member limited liability company is treated for income tax purposes as a sole proprietorship. When that's the case, the payments to the LLC owner should be treated as owner draws. And that's usually pretty easy to do.
If you're using a small business accounting program like QuickBooks or Microsoft's Small Business Accounting, the default chart of accounts provides an "owner draws" account.
If you're using a checkbook program like Quicken or Microsoft Money, you can just create an expense category called something like "draw," but note that amounts paid to the owner of a sole proprietorship aren't expenses. The draws don't get deducted on the proprietorship's tax return... nor does the draw get counted as income.
Fortunately, the single-member LLC should not need to file any special tax return (other than the Schedule C page that goes into the owner's regular individual tax return).
Note: The amounts paid to a sole proprietor are not taxable, but the sole proprietorship profit is taxable. In other words, if the sole proprietorship makes, say, $50,000 and pays out in draws $40,000, the $50,000 in profit is taxable. But the $40,000 isn't. Rather, the $40,000 is just a "draw" of profits.
Payments to Partners in Multiple Member Limited Liability Companies
In the case of a multiple member limited liability company, the LLC is typically treated as a partnership for tax accounting purposes. And this means that partnership accounting rules apply.
Amounts paid to partners for their work (like a salary) are called guaranteed payments and should be categorized using an expense category or expense account that uses a label such as "guaranteed payments." These guaranteed payments actually are deducted as business expenses on the partnership's tax return.
Amounts distributed to partners out of the profits (after paying any guaranteed payments) are treated as partner draws. As noted earlier in the discussion of how to treat owner draws in the case of a single member LLC, both QuickBooks and Microsoft's Small Business Accounting provide an "owner draws" account. (Sometimes the account will be called "partner draws," too, depending on how the accounting software is set up.)
The amounts paid to partners in an LLC treated as a partnership get reported on a K-1. The K-1 is included with the partnership's tax return. Each individual partner also gets a K-1 to show what he or she received.
Note: Sole proprietorship profits and partnership distributive, or "profit," shares in an active trade or business are subject to self-employment taxes. I've got an article at the LLCsExplained.com website that discusses this wrinkle in LLC taxation in more detail. Click here for more information. As noted in the preceding paragraphs, single and multiple member LLCs by default are treated as either sole proprietorhips or partnerships.
Payments to Owners of LLCs Electing Corporation Status
One of the reasons that accountants and attorneys love the limited liability company option is because LLCs can elect to be treated (for tax purposes) as either a C corporation or as an S corporation. But when an LLC makes one of these elections--and it doesn't matter whether the LLC has a single owner or multiple owners--the rules for paying the owners get more complicated.
Amounts paid to an LLC owner for working in the business should be treated as payroll. In other words, the amounts should be treated as regular old wages. For example, the employer (that is, the LLC) should deduct employee-paid payroll and income taxes from the payment. The employer should also calculate and remit employer-paid payroll taxes. LLC owners working as employees should also receive a W-2 at the end of the year to report any payroll they earned.
Amounts paid to an LLC owner for his or her ownership interest--this would be after any payment for wages--gets reported as a distribution or a dividend. Distributions and dividends are the corporation equivalents of owner draws in a sole proprietorship and partner draws in a partnership.
S corporations pay distributions. These distributions get reported to the IRS and to the shareholder receiving the distribution using a K-1.
Regular corporations, called C corporations, pay dividends. These dividends get reported to the IRS and to the shareholder receiving the dividend using a 1099-DIV.
Both distributions and dividends get treated in a manner similar to owner draws or partner draws in your accounting software.
About the author: Seattle tax accountant Stephen L. Nelson publishes two websites about small business taxation, www.scorporationsexplained.com and www.llcsexplained.com.