Let's say that you and your husband form a limited liability
company (LLC) with your husband's friend Joe to run a flower
shop. The three of you are equal partners (or "members"
in LLC language) in the LLC and make equal contributions to the
LLC's capital. During your first year in business, you and your
husband will be doing all the work, as Joe has a full-time job.
You'll also have a part-time employee, Jim, who'll work two
days a week to create your floral arrangements and be paid by the
hour. Because Joe won't be working in the business this year,
you and your husband want to pay yourselves 100 percent of the
LLC's profits as salaries. Can you do this?
Let's take the easy part first. LLCs, like any other
business, can have employees, so whatever you pay Jim will be a
business expense of the LLC and will be fully deductible to the
LLC. Just be sure you pay all federal and state employment taxes
(such as FICA and FUTA) on Jim's wages.
Now for the amounts you and your husband will take out of the
business. Generally, state LLC laws prohibit members from being
compensated at all, or having their expenses reimbursed, unless the
members agree otherwise. So your LLC operating agreement should
include a provision that 100 percent of the LLC's profits
during the first year of operation will be payable as compensation
to you and your husband. Make sure Joe signs off on that
provision.
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Now for the tax stuff. LLC members owning more than 5 percent of
the business aren't considered "employees" for tax
purposes and so do not receive deductible wages. What they get
instead is a percentage (called the "distributive share")
of the LLC's profits and losses, which is specified in the
operating agreement. Because the exact amount of any member's
distributive share can't be determined until the end of the
year, LLC members usually take a "draw"--an advance
against their anticipated distributive shares--out of the LLC
checking account each pay period, and then frantically sort
everything out in the last few weeks of the year.
So you and your husband will each have a distributive share of
one-third, or 33.33 percent. By including a provision in your LLC
operating agreement allowing you to take 100 percent of the profits
during the first year, however, you increase your distributive
shares to 50 percent each. You will each have to report 50 percent
of the LLC's profits as income on your personal tax returns
(Form 1040) and pay both income and self-employment taxes on the
full amount. You won't have to pay federal or state employment
taxes (FICA or FUTA) on the amounts you draw out of the LLC, but
you won't be able to claim unemployment benefits if the LLC
fails because you're not "employees."
Alternatively, according to CPA and tax expert Peg O'Donnell, "you could
just elect voluntary withholding and have taxes taken out each time
you make a withdrawal." You'll be doing this for Jim
anyway, so why not?
Now what about your husband's friend, Joe? As long as 100
percent of your LLC's profits during the first year are fully
distributed to you and your husband, Joe shouldn't have to pay
income or self-employment taxes. If less than all the LLC's
profits are distributed, however, he'll have to pay taxes on
one-third (33.33 percent) of the undistributed profits. This is
called "phantom income" and is one of the burdens of
being a passive investor in any LLC. To be safe, you should put a
provision (called a "gross-up clause") in your LLC
operating agreement requiring the LLC to reimburse the tax
liability of any member who incurs "phantom income"
resulting from his membership in the LLC. That will take some money
out of your pockets come tax time next year, but it'll keep Joe
happy until he's ready to roll up his sleeves and get to
work.
Cliff Ennico is host of the PBS television series
MoneyHunt and a leading expert on managing growing companies.
His advice for small businesses regularly appears on the
"Protecting Your Business" channel on the Small Business
Television Network at www.sbtv.com. E-mail him at cennico@legalcareer.com.