A Google Search Asks: Can an LLC pay its Members a Salary?

GoogleCourtesy of Mybloglog, I can actually see what people were searching for when they  clicked on my blog.  One of the  google searches that caught my attention was:  "Can an LLC pay its members a salary?"

Lonely internet surfer at 4:32 a.m on a recent Monday, this belated answer is for you:

Not really.

Absent a special election, a limited liability company (LLC) is treated as a partnership for federal tax purposes.  That means that payments by the LLC to its members cannot be considered wages paid to an employee, but distributions of the LLC to its members.  While there is considerable uncertainty regarding the question whether some payments to a member can – under certain circumstances – be treated as wages, most payments can clearly not be considered wages.

What is the difference?

An employer can deduct taxes from the employee’s paycheck and pay such taxes directly to the government.  Employer and Employee are liable one-half each for social security tax and Medicare (FICA). FICA is due at a rate of 12.4% of the first $94,200 (2006) of wages paid to the employee and Medicare is 2.9% of all wages.  The employee is not required to do any paperwork with respect to FICA, rather the employer files and collects the employee’s 50% share by withholding from wages. 

In contrast, members of an LLC generally have to pay self-employment tax (SECA) on the distributions received from the LLC. The rate of SECA is the same as FICA, but the LLC does not have an obligation to pay half of that amount.  The member is obligated to file for self-employment tax and generally includes the self-employment tax in his or her quarterly estimated tax payments.  However, the member can deduct 50% of the self-employment tax from his or her taxable income.

As I mentioned, there is no clear answer to whether some payments to a member of an LLC could be treated as wages.  In addition, there is also considerable uncertainty as to whether some payments to members of an LLC should not be subject to SECA (for example, payments to passive members of the LLC, i.e. members who do nothing in respect of services for the LLC or management of the LLC).

Despite these uncertainties, there is no shortage of possible structures to avoid the LLC salary and SECA issues.  All of these structures try to accomplish that the (working) member holds his interest in the LLC through a separate entity, i.e. separate from the LLC that is receiving the services provided by the member.

If you are in the mood for a heavy dose of tax law and in-depth answers to these questions, check out "Taxation of Partner Compensation:  FICA, SECA or Nothing" by James B. Sowell of Deloitte Tax LLP (also available through PLI).

James B. Sowell comments:

….one still sees a great number of situations in practice where an employee of a partnership has received an interest in the partnership and continues to be treated as an employee. One reason for this situation is simply the failure by many advisers to recognize the importance of this issue. Others believe that as long as withholding taxes are being paid to the government, nobody is harmed, so the Service should not have any stake in challenging the classification.

****Legal Information is not Legal Advice****

About Imke Ratschko

Imke Ratschko is a New York Attorney helping small businesses, business owners and entrepreneurs with all things "Small Business Law," such as litigation, contracts, business owner disputes, shareholder and operating agreements, sale or purchase of a business, investors, and starting a business. You can reach her at 212.253.1027.

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