Key Takeaways

  • LLC payroll rules vary by tax classification: sole proprietorship, partnership, S corporation, or C corporation.
  • Members of LLCs taxed as sole proprietorships or partnerships typically take owner’s draws or guaranteed payments—not wages subject to standard payroll withholding.
  • LLCs taxed as S or C corporations can place members on payroll and must follow IRS rules for reasonable compensation and payroll tax withholding.
  • Owner’s draws are generally not subject to payroll taxes, but guaranteed payments and certain distributions may still be subject to self-employment taxes.
  • Accurate recordkeeping, estimated tax payments, and compliance with federal and state rules are critical to avoid penalties.

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.

Overview of LLC Taxes

For federal tax purposes, an LLC may elect taxation in one of three ways:

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).

Payroll Rules for Different LLC Tax Classifications

How LLC payroll is handled depends largely on the LLC’s tax classification with the IRS:

  • Sole Proprietorship (Single-Member LLC) – Members are not considered employees and cannot receive a W-2. Instead, they take owner’s draws from profits. Draws are not subject to withholding, but the owner must pay income tax and self-employment tax via quarterly estimated tax payments.
  • Partnership (Multi-Member LLC) – Members receive their share of profits and may also receive guaranteed payments for services rendered, regardless of the LLC’s profitability. These guaranteed payments are subject to self-employment tax.
  • S Corporation (Elected LLC) – Members actively working in the business must receive “reasonable compensation” as wages, with standard payroll tax withholding. Additional profits can be distributed as dividends, which are not subject to self-employment tax.
  • C Corporation (Elected LLC) – Members who work in the business are treated like corporate employees, receiving wages subject to withholding, in addition to any dividends paid.

Keeping payroll aligned with the LLC’s tax classification ensures compliance with IRS rules and avoids costly reclassification penalties.

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.

Sole Proprietorship

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.

Partnership

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.

Cooperative

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.

S Corporation

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.

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.

Owner’s Draws vs. Guaranteed Payments vs. Wages

LLC members can be compensated in three primary ways, depending on the entity’s structure and tax treatment:

  1. Owner’s Draws – Withdrawals from business profits. Common for single-member LLCs and partnerships. These are not considered payroll and do not have withholding, but owners pay self-employment taxes on their share of income.
  2. Guaranteed Payments – Fixed payments to members for their services, regardless of profits. These are taxable to the recipient and deductible for the LLC, and are subject to self-employment tax.
  3. Wages (Payroll) – Salaries paid to members treated as employees (S corp or C corp). Requires payroll tax withholding and employer contributions for Social Security and Medicare.

Maintaining clear documentation of these payments is essential for accurate tax filing and to substantiate the nature of each payment in case of an IRS review.

Setting Up LLC Payroll

If your LLC’s structure allows for member wages, you must set up payroll just as you would for any other employee:

  • Obtain an Employer Identification Number (EIN) from the IRS.
  • Register with your state’s labor and tax agencies.
  • Choose a payroll schedule (weekly, biweekly, or monthly) that complies with state requirements.
  • Withhold and remit federal and state income taxes, Social Security, and Medicare taxes.
  • File required payroll tax forms, such as IRS Forms 941 (quarterly) and W-2 (annually).

LLCs taxed as S corporations must take special care to determine reasonable compensation, which the IRS defines as payment that would ordinarily be paid for similar services in the market. Paying too little in wages to avoid payroll taxes can trigger audits and back taxes.

Frequently Asked Questions

1. Can LLC members be on payroll?

Yes, but only if the LLC is taxed as an S corporation or C corporation. Otherwise, members are typically compensated through draws or guaranteed payments.

2. What is “reasonable compensation” for an LLC taxed as an S corp?

It’s the market-rate salary an individual would earn for similar work. Paying less to avoid payroll taxes can result in IRS penalties.

3. Are owner’s draws subject to payroll taxes?

No, but they are subject to income tax and, for most LLCs, self-employment tax.

4. How do guaranteed payments differ from draws?

Guaranteed payments are fixed, taxable amounts paid to members for services or capital, regardless of LLC profits, while draws are distributions from available profits.

5. Do I need payroll software for an LLC?

It’s highly recommended if you pay wages, as payroll software automates tax calculations, filings, and compliance with state and federal laws.

If you need help with LLC member payroll, you can post your legal need on UpCounsel's marketplace. UpCounsel accepts only the top 5 percent of lawyers to its site. Lawyers on UpCounsel come from law schools such as Harvard Law and Yale Law and average 14 years of legal experience, including work with or on behalf of companies like Google, Menlo Ventures, and Airbnb.