Most state laws and federal tax regulations generally view an LLC member as an investor rather than an employee. This classification generally does not change when the member actively engages in management activities. Unless a member meets the requirements of a bona fide employee, any salary the LLC pays the member is deemed a profit distribution.
LLC owners usually have the right to actively participate in managing the business. The amount of services a member provides is not determinative of her status as an employee. However, in limited circumstances, an LLC may classify a member as an employee if the other members delegate specific management functions to that particular member. For example, if a 50-member LLC elects two members to oversee the daily operations of the business and have management authority not provided to other members, those members may receive a salary from the LLC. However, if you obtain a membership interest in exchange for a promise of future services, you may not receive a salary when performing those services.
Most owners who invest in an LLC business seek a return on that investment through membership interest appreciation and distributions of business profit. An LLC member has no authority to force an LLC to distribute profits even when providing services. However, if the LLC decides to make a distribution, any member who does not receive payment has a legal claim against the LLC as a creditor. Furthermore, unlike an employee’s compensation, members are subject to personal income tax on the LLC’s earnings irrespective of whether they receive a distribution or not.
One exception to the rule allowing a member to collect compensation for services is during the winding up process during dissolution. When the LLC decides to cease all business operations, the business must wind up by liquidating the LLC’s assets. The winding up process need not be done by the members; however, if they do provide services during the process, each member may collect a salary or other compensation only during that period.
Regardless of whether the employee is a member or non-member, the salary an LLC pays for services may be deductible to the LLC and its members if the employment relationship meets IRS requirements. An employee’s salary is deductible if it is reasonable in light of the services the employee provides to the LLC. The services the LLC receives must be ordinary and necessary to the operation of the business insofar as similar industries require identical services. When the IRS evaluates the reasonableness of the salary, it takes into consideration the employee’s work and salary history, the number of working hours, the level of responsibility, complexity of the position and the cost of living in the LLC’s geographic area.