As a CPA, people come to me for answers to many of life’s mysteries. And as long as that answer is somewhere in the IRS code, I can help. Recently, a client asked me about how he and his partners could receive biweekly or monthly distributions from their LLC. Could they actually be paid a salary?
Well, it depends. There are two ways that a multi-member LLC can be taxed – as a partnership, or as a corporation. The default is as a partnership, which is a pass-through entity. That is, the LLC itself is not taxed; the profits or losses of the business are passed onto the owners for taxation at the individual level. A corporation, by contrast, is usually taxed as a separate entity before profits are distributed to owners. The exception to the rule is if the corporation makes a (Subchapter) “S election”; rendering it an “S-corp”. S-corps like partnerships are pass-through entities.
The other thing to consider is the definition of “salary”. Normally when we think of a salary, it’s paid to us in our role as an employee of a company, and takes into account payroll taxes, unemployment insurance, and benefits costs. This person would receive a W-2 form from the company at the end of the year summarizing total salary paid and deductions.
An expanded definition of salary could include payments for services made to individuals as contractors. In this case, the individual would be paid for specific services, and receive a summary of payments on a 1099-Misc form at the end of the year. Normally no taxes are withheld by the company and no benefits are provided.
So in the situation where an individual is a member (owner) of an LLC, which is taxed as a partnership, can the individual draw a salary as an employee? The answer is no. The support for this statement is not directly referenceable in the IRS code, but has been developed by court cases over the years. These cases have involved interpretations of Section 707 of the Internal Revenue Code, which discusses transactions between partners and a partnership. The IRS further clarified in Rev. Rul. 81-301 that payments made to partners in a “capacity other than as a partner” would be treated similar to payments made to a contractor, not an employee.
So, if a partner in an LLC wants to receive periodic payments other than a year-end distribution of profits, what are the options? If the LLC is taxed as a partnership, there are two:
– draw against partnership profits
– guaranteed payments for services or use of capital
Note that one is taxable to the recipient, and the other is not. If the distributions are considered guaranteed payments, they will be ordinary income (K-1, Part III line 4) to the partner, and deductible to the partnership. Guaranteed payments are made for services performed by the partner or for use of capital, and are made regardless of the profits of the partnership. Both of these are key. However if the payments are structured as a minimum distribution of partnership earnings to the partner (who may or may not participate in the business), then they will not be taxed separately. See example:
– $20 guaranteed payment regardless of partnership profits
– partner share of profits is 25%
– partnership profits (after deduction of guaranteed payment) is $100
– partner’s K-1 shows $20 guaranteed payment and $25 of partnership profits
If however the partnership agreement called for quarterly $5 draws against profits, given the set of facts above the total $20 would not be considered a guaranteed payment but part of the distribution on the K-1. The amount reported on the K-1 would be $30 (because the $20 was not deducted).
In either case, it’s important to document in the LLC operating agreement what any fixed payments are – either draws or guaranteed payments.
If the LLC elects to be taxed as a corporation, either S-corp or C-corp, the members (now owners vs. partners) can pay themselves “reasonable compensation” as salary. The amount paid will be reflected on a W-2 issued by the company to the owner at the end of the year.