Funding Llc Investors

Paying people who invest in your LLC is not a difficult process, but it's important to know the right way to go about it. When you are one of the owners of an LLC, you are called a member. If the LLC is taxed as a normal LLC, its members cannot be employees or receive salaries. The profits and losses of the business are passed through to the members, who must report them on their personal income tax forms. Each member is taxed on their share of the profits according to their allocation percentage. When you set up the LLC, you decide whether the members will share profits equally based on their ownership percentage or on an allocation share that you determine. You can receive profits from the company throughout the year or at the end of the year.

Paying LLC owners as independent contractors

Independent Contractor vs. Employee

Firstly, it's important to understand the distinction between an independent contractor and an employee. An independent contractor runs a one-owner business and is typically a sole proprietor. On the other hand, an LLC owner who is considered an employee receives a regular paycheck and is treated like any other employee of the business.

Taxation Considerations

When you pay yourself as an independent contractor, you don't withhold payroll taxes from your paycheck. Instead, you pay self-employment taxes, which include Social Security and Medicare taxes, when you file your quarterly tax returns. This approach can be complex because you have to claim taxes as both the LLC owner and for your work as a contractor. Additionally, you may not end up saving any money on taxes using this method.

Administrative Requirements

Hiring yourself as an independent contractor requires additional administrative tasks. You must file IRS Form W-9 with the LLC, and the LLC must file IRS Form 1099-MISC at the end of the year. This adds to the complexity and paperwork involved in managing your business finances.

Passive vs. Active Ownership

One scenario where paying yourself as an independent contractor may be beneficial is if you are a passive owner who doesn't actively work in the business. In this case, you cannot pay yourself a wage as an employee, so becoming an independent contractor is your only option to receive compensation.

Bookkeeping and Compliance

The independent contractor arrangement requires strict bookkeeping practices. You must carefully track invoices, expenses, and payments to ensure compliance with tax regulations. Additionally, the likelihood of being audited when using independent contractors is higher, so maintaining accurate records is crucial.

Flexibility and Control

Hiring yourself as an independent contractor provides flexibility in terms of when and how you work. However, it's important to note that as an independent contractor, you don't have the same level of control over the business's day-to-day operations as you would as an owner-employee.

In summary, while paying LLC owners as independent contractors is a viable option, it may not always provide tax advantages or simplify your administrative tasks. It's important to carefully consider the implications for your specific circumstances and consult with a tax professional or accountant to make the most informed decision.

Paying LLC owners a share of profits

LLC owners, also known as members, can allocate profits and losses in proportion to their ownership stake or percentage interest. They can also distribute profits in different proportions to owners – this is known as a special allocation.

Special Allocations

Special allocations are typically granted to LLC shareholders or members who made a significant initial investment by giving them a higher profit share than their percentage ownership allocation.

Profit Allocation vs. Profit Distribution

Profit allocation refers to how profits and losses are divided among LLC members. Profit distribution refers to the disbursement of cash or property earned by the LLC that is then paid to the LLC’s owners. Allocation of profits to an LLC member does not necessarily imply the receipt of any distribution of funds or property by the member.

Default LLC Profit Allocation

Default LLC profit allocation follows ownership interest. State rules provide for the allocation of LLC profit according to each member's percentage of ownership interest. For example, if a two-member LLC's members have a 40% and 60% ownership interest, respectively, then the former would be allocated 40% of the LLC profits, and the latter 60%.

Alternate Profit Allocation Arrangements

Members may wish to have a profit allocation arrangement that differs from their ownership interests for various reasons. For instance, some members' capital contributions may consist of cash, while others may contribute property or services. In such cases, the members may decide on a profit allocation arrangement that provides the members who made cash contributions with a higher percentage of profits than their actual ownership percentage.

Documenting Profit Allocation

Regardless of the type of profit allocation arrangement the members agree on, it's crucial to document the arrangement in the LLC's operating agreement. If a profit allocation arrangement is not outlined in the operating agreement, then the state's default profit allocation rules will apply.

Taxation of LLCs

The IRS treats LLCs as pass-through entities, meaning that the LLC's income and losses flow through to the members and are reported on the member's individual tax returns. Single-member LLCs report taxes as a sole proprietorship, while multi-member LLCs report taxes as a partnership.

LLCs and Self-Employment Tax

LLC members are considered self-employed business owners and are therefore responsible for setting aside enough money to pay taxes on their share of the profits. Most LLC members are also required to pay self-employment taxes directly to the IRS.

Paying LLC owners a salary

There are several ways to pay yourself a salary as an LLC owner. The best option for you will depend on your business structure and personal circumstances. Here is an overview of some of the most common methods:

Owner's Draw (Profit Distributions)

Any LLC owner can pay themselves through profit distributions, also known as an owner's draw. This is a simple process for single-member LLCs, as all profits are considered personal income. Multi-member LLCs, on the other hand, will need to outline in their operating agreement how much and how often distributions can be made to each member. It is important to note that owner's draws are subject to self-employment taxes, which can increase the amount of profits lost to taxes.

Wage as a W-2 Employee

Paying yourself a wage as a W-2 employee is one of the most advantageous ways to get paid from your LLC. This method provides a predictable income and ensures you only pay self-employment taxes on your designated salary. To pay yourself a wage, you must be actively working in the business and comply with IRS rules, including paying yourself "reasonable compensation" within industry norms.

1099 Independent Contractor

While it is possible to pay yourself as an independent contractor, this method is generally not recommended for small businesses as it does not offer any tax advantages. As an independent contractor, you will need to pay self-employment taxes on your income, just as you would with a wage. This method may be beneficial if you are a passive business owner who does not actively work for the LLC, as you cannot pay yourself a wage in this case.

Keep the Money in the Business

If you choose to reinvest all company profits back into the business, you will still need to pay income taxes on any profit generated. This is because LLCs are treated as pass-through entities, and any profit will be included in your income for tax purposes. If your LLC is taxed as an S-corp, you must also claim any company profits on your personal tax return, even if you do not take a salary or distribution.

Paying LLC owners through a capital account

The primary use of a capital account is to record the value of the member's percentage of ownership; this is based on the amount of their initial investment and their share of profits and losses. The account also keeps track of any additional capital contributions made throughout the life of the LLC.

The balance of the capital accounts will be adjusted to reflect the LLC's profits and losses, which are often shared among members according to their membership percentages. However, different percentages may be used as long as they are outlined in the LLC's operating agreement.

Additionally, the capital account should be adjusted to account for any distributions that may be made from the LLC to its members. For example, if the LLC gives cash to any of its members, the amount given must be subtracted from the capital account balance.

Capital accounts can be created and maintained by another accounting system or the company's accountant or bookkeeper. It is important to keep accurate records of each owner's capital account to ensure the continued operation of the business and to facilitate payments to members if the business ceases to operate.

Paying LLC owners by investing in their work

LLCs, or limited liability companies, are a great way to organize your company to protect yourself from liability. However, as an LLC owner, you might wonder how you can get paid. This is especially true if you are not an employee of the LLC. There are several ways to go about paying LLC owners or members.

Rules for Paying LLC Owners

When you are an LLC owner, you are called a member. If the LLC is taxed as a typical LLC, its members cannot be employees or receive salaries. One of the benefits of an LLC is that the business entity does not pay taxes. Instead, the profits and losses of the business are passed through to the members, who must report them on their personal income tax forms. Each member is taxed on their share of the profits according to their allocation percentage.

When setting up the LLC, you decide if the members will share profits equally based on their ownership percentage or on an allocation share that you determine. For example, if there are three members, each owning a third of the company, and allocation is equal to ownership, they must report one-third of the profits or losses on their taxes.

The exception to the rule about members not being employees is if the LLC elects to be taxed as a corporation. In this case, the LLC itself pays taxes directly to the IRS, and members can be employees and receive salaries.

Receiving Profits as an LLC Owner

As an LLC member, you can receive profits from the company throughout the year or at the end of the year. When setting up the LLC, you and the other members create a capital account. The amount you invest in the company and any profits that belong to you go into this account. Any time you take a "draw" of funds, money is withdrawn from your share of the capital account.

If you've withdrawn funds from the capital account throughout the year, your share of the profit at the end of the year will be placed in the capital account, paying back your draw. You can choose to withdraw any additional profit at that time. Any funds you withdraw or receive are not directly taxable as income like a salary would be. Instead, you are taxed strictly on your percentage of the profit or loss of the company itself. That means if some profit is kept in the company and not paid out, you would still pay tax on it even if you didn't withdraw that profit.

Working as an Independent Contractor for Your LLC

Another way to get paid by your LLC is to hire yourself as an independent contractor. For example, if your LLC needs a new logo, you can hire yourself to design it and get paid for that work. You will have to pay self-employment tax on this income.

You can decide not to receive any profit distributions and keep the money in the company if you choose. However, you will still pay income tax on your share of the profits, whether you withdraw them or not.

Bringing on Individual Investors

If you bring on individuals as investors in your LLC, it is essential to craft a well-thought-out operating agreement or modify your existing one to cover various scenarios. This agreement addresses issues such as the sale of an ownership stake, profit distribution schedule, management control, and strategic focus. A clear operating agreement ensures your business continues to run smoothly with the new capital brought in from individual investors.

Frequently asked questions