LLCs and Salaries


I get asked all the time about how to set up an LLC with a salary. It’s not hard, but there are some things you need to make sure you do ahead of time to make it work.

First, you need to make sure your LLC has made the right tax election. Only LLCs that have elected to be taxed as either an S or C Corporation tax status may pay W-2 style salaries to their members. If your LLC hasn’t made this election, you can’t pay a salary. How can you tell? Take a look at your past tax return. If your LLC reported its taxes on either an IRS Form 1165, or as a schedule on your personal 1040 return, then you cannot pay yourself a salary.

Now, if your LLC is in its first year of operation and you haven’t yet filed a tax return, you can apply to change your tax election before that tax return is filed. Otherwise, you can still change the tax election, but it will likely require you to get some help from your CPA or tax preparer.

There’s also another option. You may have heard the term guaranteed payment in connection with an LLC. This is a type of salary that can be paid to a manager, in an LLC that has not made a C or S Corporation election.

To make a guaranteed payment, you are trying to recharacterize part of your income as a type of salary. You won’t have payroll taxes on that portion of the money, but you will have to pay self-employment tax.

Traditionally, we have seen guaranteed payments used in manager-managed LLCs, as a way to compensate managers for the extra work, and as a way to make a clear tax distinction between passive investors and the LLC operators.

It’s not the most popular type of payment because it’s tricky and often challenged by the IRS. But we did see a resurgence of the idea a couple of years ago, when the IRS was auditing Real Estate Professionals. Taking a guaranteed payment was one way to demonstrate active material participation on a property.

There are many variables when you’re structuring a business. That’s why it’s hard to go through a quick-service website. Unless you talk to someone who’s got some knowledge and experience on both the tax and the legal side, it’s hard to know what you don’t know. And that can leave you vulnerable.
 
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