How the Author/Owner of an LLC S-Corp Should Pay Themselves
As an author or business owner operating under an LLC that has elected S-corporation (S-corp) status, understanding how to pay yourself properly is crucial. Your compensation structure not only affects your personal income and tax liability but also plays a critical role in maintaining the corporate veil that protects your personal assets from business liabilities.
There are a few things to know when it comes to paying yourself from your LLC S-corp such as tax implications, and how to ensure compliance with IRS regulations while maintaining the corporate wall. We'll do our best to cover them here.
Understanding S-Corp Status and Its Tax Benefits
Before diving into how to pay yourself, it is important to understand why many LLC owners elect S-corp taxation. The primary advantage of an S-corp election is reducing self-employment taxes.
Key Tax Advantages of an S-Corp Election:
Avoidance of Double Taxation: Unlike a C-corporation, where profits are taxed at the corporate level and again as dividends, an S-corp passes income directly to shareholders (owners), avoiding double taxation.
Lower Self-Employment Taxes: As an LLC taxed as a sole proprietorship or partnership, all profits are subject to self-employment taxes (Social Security and Medicare). An S-corp allows owners to classify some earnings as distributions, which are not subject to these taxes.
Tax-Deductible Business Expenses: Owners can deduct business expenses, including home office costs, equipment, and professional services.
How to Pay Yourself from an LLC S-Corp
There are two primary ways an owner of an LLC S-corp can pay themselves:
1. Reasonable Salary
The IRS requires S-corp owners who actively work in the business to pay themselves a "reasonable salary." This means an amount comparable to what someone in a similar role would earn in the market.
Why is a Reasonable Salary Important?
Prevents the IRS from reclassifying distributions as wages, which would result in unpaid payroll taxes, penalties, and interest.
Ensures compliance with tax regulations and avoids audits or scrutiny.
How to Determine a Reasonable Salary
Factors to consider include:
Industry standards for similar job roles
Business profits and revenue
Experience, responsibilities, and location
IRS guidelines and case law
To determine a fair salary, use resources like the Bureau of Labor Statistics, industry surveys, or consult a tax professional.
2. Owner's Distributions (Dividends)
Once a reasonable salary has been paid, additional profits can be distributed to the owner as dividends. These distributions are not subject to self-employment taxes, making them a tax-efficient way to withdraw earnings.
Tax Implications of Distributions:
Not subject to Social Security and Medicare taxes (saving approximately 15.3%)
Reported on Schedule K-1 of your tax return
Still subject to income tax
Example Breakdown:
If your business earns $120,000 in net profits and you determine a reasonable salary of $60,000:
Salary ($60,000): Subject to payroll taxes (Social Security and Medicare)
Distributions ($60,000): Not subject to payroll taxes, only income tax
Maintaining the Corporate Wall (Corporate Veil)
An LLC’s corporate veil protects the owner’s personal assets from business liabilities. However, improper compensation practices can jeopardize this protection.
Best Practices to Maintain the Corporate Veil:
Keep Business and Personal Finances Separate: Use separate bank accounts and credit cards for business transactions.
Document Salary and Distributions: Maintain payroll records and issue W-2s for salary payments.
Pay Payroll Taxes and File Forms: Ensure compliance with IRS payroll tax requirements (e.g., Form 941, Form 940).
Record Keeping and Meeting Minutes: Maintain records of salary determinations and corporate decisions.
Avoid Excessive Distributions: Ensure distributions do not exceed company profits to avoid being classified as disguised wages.
Tax Reporting and Compliance
Forms Required for Payroll
Form W-2: Reports salary payments
Form 941: Employer’s Quarterly Federal Tax Return
Form 940: Federal Unemployment Tax Return
Form 1120S: S-corp tax return to report business earnings and distributions
Schedule K-1: Reports dividends and profit distributions
Estimated Taxes for Distributions
Since S-corp distributions are not subject to withholding taxes, owners should pay estimated taxes quarterly to avoid penalties.
Conclusion
Paying yourself properly as an LLC S-corp owner is essential for tax efficiency and corporate compliance. By paying a reasonable salary and distributing profits strategically, you can minimize tax liabilities while ensuring IRS compliance. Equally important is maintaining the corporate veil by adhering to best financial and legal practices. Consulting with a tax professional can further ensure you structure compensation in a way that maximizes benefits and maintains legal protections.
