LLC Member Payroll: Everything You Need to Know
With LLC member payroll, the Internal Revenue Service can treat the LLC as a partnership, corporation, or as part of the LLC's owners' personal tax returns.3 min read
Overview of LLC Taxes
For federal tax purposes, an LLC may elect taxation in one of three ways:
- Sole proprietorship (one member of the LLC)
- Partnership (with two or more LLC members)
- Corporation (unlimited LLC members)
The tax election is usually made at the time that the business is formed. The election must be decided by the time the filing of the first income tax return is due.
If an LLC elects to be taxed as a sole proprietorship, then it cannot pay wages to any member nor does the member receive a W-2 form or have Medicare, Social Security, or income tax withheld.
If the LLC elects taxation as a partnership, the same rules apply to no wages being paid and no taxes withheld.
Salaries may be paid, however, in the form of "guaranteed payments" and profit distributions from the LLC. In this situation, members would:
- Pay federal and state personal income tax.
- Pay federal self-employment tax (SE) on the guaranteed payments.
- Pay tax on their share of the pass-through net income on personal tax returns.
- Pay quarterly estimated taxes.
Anytime repayment is made or when the partnership is permitted to use capital, it is considered a service and qualifies for guaranteed payments to be made to members.
Payroll taxes are not withheld from guaranteed payments, but estimated tax payments may be required, depending on their tax situation. Guaranteed payments are subject to self-employment tax (SE).
Types of Business Entities
As the owner of a business, it is your decision how the company is structured. You may choose to be a sole proprietorship, a limited liability company (LLC), a partnership, an S corporation, C corporation, or cooperative.
This is the most basic type of business entity. With this business structure, all assets and liabilities belong to the business owner. In this case, income is reported on a Form 1040 along with a Schedule C. You will also be responsible for making quarterly estimated tax payments.
Unless members meet the requirements to be considered an actual employee, any salary paid by the LLC is considered a profit distribution.
A partnership is not responsible for paying income tax as a partnership. Instead, the company profits are passed through to its partners.
The partnership will file Form 1065 and Schedule K-1 for the partners for tax purposes. Form 1065 is a report of the LLC's income and expenses. Schedule K-1 reports each member's share of the net profit and loss of the LLC. Members report the amounts from Schedule K-1 on Schedule E of Form 1040.
Limited Liability Company
A limited liability company combines the partnership aspect of passing through the profits with the limitations in liabilities afforded by a corporation. Profits are passed through to the members and taxed as personal income.
LLC business structures are covered by rules that vary from state to state. It is recommended to consult with a tax advisor to get a thorough understanding of how the rules apply to your business.
A cooperative has specific rules for membership and operations. It is similar to an LLC and does not pay federal taxes. Its profits are also passed through to the members of the cooperative.
An S corporation allows you to incorporate your business and have it taxed separately. You also have the option to set the business up as a pass-through entity, like a partnership.
When an S corporation is taxed as a separate entity, the business owner and any employees may experience tax savings since only wages are taxed.
An LLC may choose to file as an S corporation for tax purposes. Check with your state as not all states recognize the distinction between an S corporation and a C corporation.
The C corporation is the least popular business entity for small businesses due to complicated setup procedures and costly administrative fees.
Double taxation is considered a major drawback for choosing the C corporation business structure. As a C corporation, the business is taxed once when profits are made and again when dividends are distributed to its stockholders.
An advantage of a C corporation is the ability to offer stock in exchange for an ownership stake.
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