How to pay yourself from an LLC [updated in 2024]

Paying yourself from an LLC requires careful planning to align with IRS rules and support your business’s financial health. This post outlines best practices for LLC compensation to help small business owners make informed decisions for both personal and business finances.

26% of small business owners^[1] don’t pay themselves a salary—and it’s not necessarily because their business isn’t profitable.

This startling statistic highlights a common dilemma: many founders struggle to determine the right amount to pay themselves as their business grows, often due to a lack of clear guidelines or fear of compromising their business’s financial standing. Some even forego a paycheck altogether, choosing instead to prioritize business expenses over their own compensation.

This brings us to a very important question: Are you paying yourself enough? Or perhaps, are you paying yourself in a way that optimizes both your personal financial health and your business growth?

The complexity only increases when you run an LLC (limited liability company). Whether you’re a single member or part of a multi-member LLC, and even if you’re an employee of your own company, the IRS expects you to draw “reasonable compensation.^[3]“

Understanding how to pay yourself can make a significant difference in both your personal and business success. In this blog, we’ll explore the mechanics of paying yourself from an LLC, ensuring you manage your income smartly without blurring the lines between personal and business finances.

Understanding the types of LLCs

Before we talk about your paycheck and delve into paying yourself from an LLC, let’s first understand what an LLC is.

LLC stands for “limited liability company.” When setting up your business, choosing to operate as a Limited Liability Company (LLC) can be a smart move. This business structure offers you the legal safeguards of a corporation alongside the tax advantages of a sole proprietorship. Essentially, it allows you to enjoy the best of both worlds.

Let’s break down the types of LLCs and how each one could affect your paycheck, ensuring you get to enjoy your cake, and yes, eat it too!

1. Single-member LLCs

If you’re flying solo, a single-member LLC might be your go-to structure. In the eyes of the IRS, these are considered “disregarded entities^[4]. This doesn’t mean they don’t care about you—it means your business’s income and expenses are treated like those of a sole proprietorship.

You’ll report profits and losses on your personal tax returns, simplifying your tax situation without compromising your liability protection. 

Deciding how to pay yourself? It’s straightforward: take an owner’s draw, pulling money from your business earnings as needed. We’ll discuss this further in the upcoming section.

2. Multi-member LLCs

For those in business with partners, a multi-member LLC resembles a partnership. The profits of the business flow directly to your personal tax return, proportionate to your ownership stake. This setup fosters transparency among members and allows profits to be taxed just once, at the individual level. It enhances collaboration and flexibility in how profits are distributed among partners, ensuring everyone gets their fair share based on the business’s success.

3. Corporate LLCs

Some LLCs aim for a more structured approach by opting for taxation under Subchapter S (S Corp) or C (C Corp) of the IRS codes. This choice transforms the way an LLC compensates its members significantly.

If you opt for S Corp status, you can pay yourself a reasonable salary and then take additional profits as distributions, which can be taxed at a potentially lower rate. Opting for C Corp status, meanwhile, allows you to draw a salary and potentially receive dividends, which offers flexibility in managing tax liabilities but comes with its layer of complexity, including double taxation on dividends.

What’s next? Choosing how to pay yourself

Now that you understand the various LLC structures and the unique compensation mechanisms each one entails, the next step is to determine the most beneficial way to pay yourself. Your decision will impact how you manage your money as well as how you plan for the future of your business.

Paying yourself from an LLC—what’s the right way?

Selecting the best way to compensate yourself from your LLC isn’t just a matter of personal preference—it’s about finding the right fit for your business structure and ensuring compliance with tax regulations.

Here’s a closer look at the various methods available, tailored to suit different LLC setups.

1. Owner’s draws

For single-member and multi-member LLCs operating as partnerships, owner’s draws offer a simple method to access earnings. Simply transfer the desired amount from your business account to your personal account and record this transaction as an owner’s draw, reducing your owner’s equity. These draws and any profit distributions are reported on personal tax returns since these LLCs are pass-through entities.

The process for single-member LLCs is quite direct, involving merely the transfer of profits to the owner’s personal account and reported on Schedule C of the owner’s personal tax return.

However, for multi-member LLCs, handling profit distributions requires more care. It’s crucial to establish clear, documented procedures in the operating agreement to dictate the timing, amount, and conditions under which profits are distributed. This helps ensure that all members understand how and when they can expect to receive their share of the profits and avoid any potential disputes.

Remember, both owner’s draws and profit distributions are subject to self-employment taxes. For multi-member LLCs, each member’s share of the profits, as determined by the operating agreement, is subject to these taxes, even if not distributed in full. This tax responsibility underscores the need for careful tax planning and possibly consulting with a tax professional to manage liabilities effectively.

How to ensure safety and clarity in your compensation

Paying yourself a salary from your LLC is straightforward since it involves regular payroll procedures. But when it comes to owner’s draws, things can get a bit trickier.

The key to handling owner’s draws effectively is to maintain thorough documentation. Every time you withdraw money, ensure there’s a financial record showing how much was taken. This is crucial not just for keeping your books straight, but also for legal protection. Without a clear record, it can be hard to distinguish personal finances from business operations, which could complicate matters if your LLC faces legal scrutiny.

For simplicity and clarity, transferring funds via check or online transfer is advisable. Avoid taking cash directly from the business, as it’s harder to track and could pose issues.

Remember, as a business owner, you have the flexibility to take draws as needed, but always ensure there’s a solid paper trail to back up every transaction.

2. Guaranteed payments

Incorporating guaranteed payments into the compensation structure of a partnership LLC can help stabilize income streams for partners, making financial planning more predictable and securing the operational integrity of the business during critical growth periods.

Guaranteed payments provide a fixed income to members, which is particularly beneficial for partners needing consistent financial inflows to manage personal finances. These payments are deductible expenses for the LLC and are taxed as ordinary income to the members, regardless of the profitability of the LLC.

It works similarly to owner’s draws and partners can withdraw their earnings just like a sole proprietor would in a single-member LLC.

Despite this similarity, the taxation for partnerships features unique aspects due to its pass-through entity status. The business itself isn’t taxed directly. Instead, it reports its income to the IRS using Form 1065^[5], and then each partner is taxed on their individual share of the earnings, as detailed in the partnership agreement.

At the end of the financial year, each partner receives an IRS Schedule K-1^[6], documenting their portion of the income, which is then used to file their personal income tax returns.

It’s crucial to note that partners are taxed on their entire share as outlined in the partnership agreement, regardless of the actual amount drawn during the year. For example, if a partner is entitled to 30% of the earnings but only takes half of that in draws, they still owe income taxes on the full 30%.

Additionally, the drawn amount is subject to self-employment taxes, which currently stand at 15.3%. This tax covers Social Security and Medicare.

3. W-2 salaries

If your LLC is taxed as an S-Corp or C-Corp, it’s mandatory to pay yourself a salary as an employee of the company.

This regular salary should align with IRS guidelines for “reasonable compensation” and will be subject to payroll taxes. Structuring your pay this way helps to clearly separate personal and business finances and can facilitate tax savings, as payroll taxes are automatically withheld.

Beyond the salary, you are entitled to take a portion of the company’s profits in the form of dividends. The amount and frequency of these dividends should be specified in your articles of incorporation. Dividends provide a significant tax benefit as they are not subject to payroll taxes, potentially lowering your overall tax burden. However, it’s crucial to manage the balance between salary and dividends to meet the IRS’s reasonable compensation requirement and to avoid issues with under-compensation.

For C-Corps particularly, keep in mind the aspect of double taxation: the corporation pays taxes on its profits, and dividends distributed to shareholders are taxed again on their personal tax returns. This dual layer of taxation emphasizes the need for strategic planning in how profits are distributed.

In both S-Corps and C-Corps, ensuring that distributions of profits through dividends do not conflict with reasonable compensation standards is vital. This balance ensures that while you benefit from lower-taxed distributions, you remain compliant with tax regulations.

4. Equity distributions

Particularly relevant for LLCs opting as corporations, equity distributions tie compensation to the success of the business.

This method is beneficial for aligning the interests of the members with the performance of the company, fostering a vested interest in its growth. Like profit distributions, they provide potential tax benefits but must be managed carefully to comply with IRS guidelines regarding reasonable compensation.

5. Reinvestment strategies

Reinvestment strategies offer a unique approach to compensation that emphasizes long-term growth over immediate payouts:

Instead of taking profits out as personal income, you reinvest them back into the business. This strategy is often used by LLCs in growth phases, where capital is crucial for expansion, marketing, or product development.

By reinvesting profits, you can defer personal income tax on those amounts, potentially lowering your immediate tax burden. However, you must still adhere to IRS guidelines regarding reasonable compensation, ensuring that any salary you take is justified and compliant.

Is it suitable for all LLC structures?

This method is particularly effective in S-Corps and C-Corps where owners can draw reasonable salaries and reinvest additional profits to avoid higher taxes on dividends.

While traditionally more common in corporate structures, reinvestment can also be a viable strategy for LLCs treated as pass-through entities, especially when the owners are looking to scale the business rapidly.

Using reinvestment strategies requires careful planning and a clear understanding of both your business’s growth goals and your personal financial needs. It’s essential to balance the need for personal income with the benefits of reinvesting in your business’s future.

Additional compensation options for LLC owners

Performance-based bonuses: Consider implementing a bonus system tied to specific business performance metrics. This strategy will boost your motivation to achieve key goals and also directly link your earnings to the company’s success.

Loan repayments: If you’ve injected personal funds into your LLC, consider structuring the repayment of this loan—including interest—as part of your compensation. This method allows you to recoup your investment gradually as the business grows.

Expense reimbursements: Setting up a clear reimbursement policy for out-of-pocket expenses that benefit the LLC is also a great idea. This ensures you’re compensated fairly while maintaining compliance with IRS regulations. It’s important to keep meticulous records to differentiate these reimbursements from profit distributions.

Retirement contributions: If your LLC’s structure permits, making contributions to a retirement account, such as a Solo 401(k) or SEP IRA, can be a tax-smart method of compensation. This method will facilitate tax savings and also support your future financial planning.

Deferred compensation plans: You can establish a plan to defer a portion of your income to a future date. This approach is excellent for strategic tax planning and reinforces your long-term commitment to growing the business.

Understanding “reasonable compensation” according to the IRS

When managing compensation through your LLC, especially if it’s taxed as an S-Corp or C-Corp, the concept of “reasonable compensation” becomes crucial. The IRS scrutinizes the balance between salary and dividends to ensure business owners are not manipulating payroll taxes by minimizing salary in favor of higher dividends.

What does “reasonable” mean?

The IRS does not provide a clear-cut definition of what constitutes “reasonable compensation,” which leaves many business owners guessing. However, the principle behind this concept is to ensure that the salary paid reflects the value of the work performed by the owner, commensurate with industry standards.

How to determine a reasonable salary?

1. Assess personal expenses: Start by calculating your annual personal expenses. This gives you a baseline of the minimum you need to earn to sustain your lifestyle. While not a definitive guide for your salary, it helps ensure you don’t underpay yourself.
2. Evaluate business affordability: Review your business’s finances with an accountant to determine how much the business can realistically pay you without jeopardizing its financial health. This involves looking at cash flow, profit margins, and future financial projections.
3. Industry salary benchmarks: Research what others in your industry and in similar roles are paid. You can find this information through industry surveys, online salary databases, or discussions with peers. This benchmarking is critical because it contextualizes what “reasonable” means within your specific industry and role.
4. Balance salary and dividends: The key is finding a balance that minimizes tax liabilities while adhering to IRS guidelines. Paying too little in salary and too much in dividends might trigger an IRS audit. The goal is to pay yourself a salary that is justifiable as compensation for your work, with any excess profits distributed as dividends.

Why is it important?

By setting a salary that aligns with these principles, you not only comply with tax laws but also reinforce the credibility of your business operations. It’s a strategy that supports both legal compliance and financial efficiency. Keep in mind that the IRS might compare your compensation with that of other business owners in similar roles. If your salary is significantly lower than the norm but dividends are high, it could raise red flags.

The bottom line

Whether you’re taking an owner’s draw or setting up a salary, paying yourself as an LLC owner is all about balance. You need to ensure that you’re compensating yourself fairly while leaving enough in the business to keep operations running smoothly and support future growth.

For corporate LLCs, paying yourself through a salary adds another layer of complexity, with tax implications that need careful handling. You want to ascertain your salary is reasonable, your payroll is compliant, and your business remains on solid financial ground.

That’s where CoCountant comes in. Our bookkeeping services keep your financial records organized and accurate, so you always know where your business stands. With us, you can ensure your compensation strategies are aligned with both your financial goals and IRS regulations.