Q: My partners and I recently formed an LLC (limited liability company). What's the best way for us to pay ourselves? Should we take occasional "draws" or monthly salaries? We are very confused about all the options and their tax implications.
--J.C., San Francisco
A: It's common, and typically recommended, for partners in an LLC to take regular salaries, experts say. In an LLC taxed as a partnership, members fall into the self-employed category, which means they must pay SECA (the self-employment form of FICA tax) on net earnings from their self-employment -- which includes income or loss from the LLC.
"The individuals will pay the same amount in income and employment taxes whether some of what they receive is paid in the form of 'salary' or it is all paid out in the form of a distribution of profits from the limited liability company," says Mike Dubetz, a member in the Denver office of the law firm Sherman & Howard LLC.
HIRING HINDRANCE. That means the form of compensation you take -- profit distributions ("draws") vs. salaries -- is less important for you and your partners than it would be if you had formed, say, an S Corporation. In an S Corporation, a partner can shelter some income from employment taxes by taking part of the business income as a shareholder distribution -- rather than as compensation for employment. This doesn't hold true in an LLC, Dubetz says.
Regardless of its form, compensation makes sense for you and your partners for many reasons, says Jim Sillery, vice-president in the Chicago office of Pearl Meyer & Partners, the executive compensation practice of Clark Consulting.
"Companies have found that 'holding down' partner compensation can place a significant burden on their ability to hire outside executives," Sillery says. "Holding down partner compensation also impedes the accumulation of wealth and may make the future transition of ownership more difficult."
TAX ADVANTAGE. While owners of startups often try to speed the journey to ROI by foregoing salaries, the amount of compensation that would be paid to them typically isn't enough to materially improve the balance sheet, Sillery says. And the money retained by the company -- rather than paid out to partners -- could fall prey to creditors and increase the company's income and employment tax burden.
If you need another reason to pay yourselves regular salaries, Sillery has one: An individual's effective tax rate will likely equal less than your corporate tax rate. That means compensating yourselves for your hard work and innovation could truly pay off in the long run.
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