An LLC is a popular type of business structure these days, mostly because of its flexibility and ease of setup. Almost every LLC owner I’ve worked with, though, didn’t have a clue about whether they should be on payroll or take a draw.
What most people don’t understand is that an LLC is a state designation, not an IRS designation. Even though you choose to be an LLC, you still have to choose to be something else to the IRS. So, what does this mean?
LLC: If you do not choose anything with the IRS and leave the designation as LLC, your status simply defaults to sole-proprietor or partnership; you and the business are one and the same (or you and your partner).
• A business distributes payroll wages to employees, who do not share any risk or profit from owning the business.
• A sole proprietor/partnership pays taxes on the profits regardless of whether they take cash out of the business or not. On that same vein, a sole proprietor/partnership can also take more money out of the business than profit (though that’s not a good idea!), or they can leave all the money in the business. Either way, the IRS sees it the same.
Corporation: If you choose to incorporate, you are essentially asking that the business be recognized as something separate from you. It is treated like another person, called an “entity”.
• A corporation, because it is a separate entity, has you, the owner, on payroll as an employee of the company. If there is profit, you can then take a distribution based on your ownership.
I often encounter business owners that thought they were incorporating by becoming an LLC and put themselves on payroll. The first thing I do is take them off payroll and put them on recurring draws. These are called “Guaranteed Payments” and can be treated as a regular expense. The difference being that no payroll taxes are deducted and instead self-employment tax applies.
Still not sure where you stand? That’s okay—this is confusing! Try this:
1. Confirm that you were not set up as a corporation. Ask your attorney or legal service. It would have likely been much more expensive to set up as a corporation and you would have received a binder and letters from the IRS.
2. After confirming you are a sole-proprietor or partnership, remove yourself from payroll if you are taking a salary and having taxes deducted.
3. You can still use the payroll service to issue checks; just don’t have them deduct taxes. My preference is to set up an automatic payment straight from the bank account twice monthly.
Been on payroll for a while? Don’t panic – there’s no penalty except for paying slightly more on your payroll taxes. There are benefits to consider as well: being on payroll contributes to your Social Security and Medicare, so if you haven’t been contributing to retirement this might be a good backup plan.