Introduction
Limited Liability Companies, or LLCs, are one of the most popular types of small businesses in Arizona. An LLC offers the benefits of business ownership without the personal liability that comes with standard proprietorships and partnerships.
It also strips away the complexity of a corporation, making it easier for Arizonans to pursue their dream of starting a business.
LLCs are referred to as tax pass-through entities because the business itself doesn’t pay income taxes. Instead, the owner(s) take a distribution of the company’s annual profits and report that income on their personal income taxes. This avoids the challenge of double taxation that corporations face, though it can make paying yourself a little confusing.
There are three ways that you can pay yourself as the owner (or member) of an LLC:
- Taking distributions from profits
- Paying yourself a salary
- Paying yourself as an independent contractor
Taking Distributions From Profits
The most popular way to pay yourself with an LLC is to take distributions of the company’s annual profits. This is the most flexible solution, as your annual income is pegged to the company’s profitability — not a set salary.
In a single-member LLC, the sole owner has a 100% claim to the company’s annual profits. In a multi-member LLC, each owner shares a percentage of the profits based on their percentage of ownership in the company. In either case, the member’s percentage is often referred to as their capital account.
For example, if your single-member LLC has an annual profit of $200,000, you can take a distribution of up to $200,000. In a multi-member LLC where your ownership stake is 50%, you could take a distribution of up to $100,000.
Of course, most people like to get a paycheck more often than once a year. Based on your year-end profit projections, you could set up a draw on a regular basis to provide consistent income throughout the year.
It doesn’t matter if the draw is weekly, monthly, or quarterly — the amount just needs to be based on accurate profit projections. If you reach the end of the year and there are excess profits that you didn’t draw during the year, you can take a one-time distribution or leave those profits in the capital account for next year’s draws.
When tax season arrives, the owner of a single-member LLC will simply need to file a Schedule C with the IRS to report the profits and losses of the LLC on their personal tax return.
For multi-member LLCs, the company would need to file IRS Form 1065 to report how the profits are divided among the members. The members would then report their share of the profits on a Schedule K-1.
Paying Yourself a Salary
LLC members also have the ability to pay themselves a salary. You must qualify as an employee of the company by actively working in the business with an actual role and real responsibilities, but that shouldn’t be a problem as most LLC owners can check those boxes.
As with a corporation, employee wages are deducted from the company’s profits as an operating expense. So, any salary you take will have a direct impact on your ability to take distributions from profits.
If you choose this route, the IRS expects you to pay yourself a reasonable wage that reflects industry norms. You’ll be at serious risk of an IRS audit if you choose a massively inflated salary that doesn’t reflect similar-sized businesses in your industry, or if the company’s profits don’t justify the salary.
In the same breath, you can also pay yourself (and any other employees) bonuses. Just be sure bonuses are in line with the employee’s salary if you don’t want to raise any red flags with the IRS.
One area where paying salaries to LLC owners can get a little tricky is when you’re dealing with a multi-member LLC. When LLC members are equal participants in the company, you can’t just pay one salary while the other members take distributions — it’s an all or nothing approach in this scenario.
However, if you have an active management role and the other LLC members are silent partners who simply provided the capital, you could pay yourself a salary and bonuses without setting up salaries for the other owners.
Should you choose to pay yourself a salary, you’ll need to file IRS Form W-4 and withhold payroll taxes from your paychecks. Come tax season, the LLC must issue you a W-2.
Paying Yourself as an Independent Contractor
This is the least popular route for paying yourself from an LLC, but it’s certainly an option. Freelancers who perform irregular work with unpredictable income streams occasionally choose this route, though it’s worth noting that taking distributions from profits would be easier.
Paying yourself as an independent contractor would require filing IRS Form W-9 with the LLC. At the end of the fiscal year, the LLC would then issue IRS Form 1099-MISC to report your income for personal income taxes.
Payment Options are not Mutually Exclusive
As the owner of your LLC, you have the right to dictate how and when you’re paid. If you’d like to pay yourself a regular salary throughout the year and take a lump sum distribution of remaining profits at the end of the year, that’s perfectly acceptable.
The only combination the IRS will not allow is claiming yourself as an employee and an independent contractor. By definition, you cannot be both.
If you’re having a hard time deciding the best way to pay yourself from your LLC, talk it over with a small business attorney or accountant. An experienced professional can help you establish a plan that maximizes your income while minimizes your tax burden.
Can You Elect to Not Pay Yourself From an LLC?
In some cases, entrepreneurs choose to keep profits within their business to fuel growth rather than take personal income. That’s perfectly acceptable, though you’ll still have to report the business profits each year on your personal income tax return. As a tax pass-through, the tax burden always falls to the LLC members — not the business itself.
Working With a Small Business Attorney in Arizona
Creating a new business is exciting and is filled with important decisions to make, like which type of business entity best suits your business. Understanding exactly which type of business entity your company should use is not always simple, as each business entity type comes with different benefits and drawbacks.
Having an experienced small business law attorney by your side will have countless benefits, such as explaining the differences between your options (LLC, Sole Proprietorship, S Corporation, etc.) and the advantages and disadvantages each would have for your company.
JacksonWhite has a team of lawyers dedicated to providing legal counsel to Arizona small businesses. The benefits of working with a small business attorney highly outweigh the costs of hiring one, especially during the early phases of a company’s creation. Contact us today to discuss your business needs and we will help set you on a course for success.
Call JacksonWhite’s Small Business Law Team at (480) 464-1111 to discuss your case today.