Deducting a Salary for a Single-Owner LLC

By Jeff Franco J.D./M.A./M.B.A.

Creating a limited liability company for your business instead of operating it as a sole proprietor affects your ability to deduct the salary you pay yourself on a federal tax return. As the single owner of the LLC, which the IRS refers to as a single-member LLC, you can choose to subject your business earnings to corporate or sole-proprietorship taxation. However, you can always deduct the salaries you pay to employees under both forms of taxation.

Sole Proprietor Designation

The IRS automatically designates a single-member LLC as a sole proprietorship for federal tax purposes. Sole proprietors are responsible for reporting all earnings and losses of the business on their personal tax returns. This requires you to separately report your LLC earnings and deductions on a Schedule C or C-EZ to calculate the LLC’s taxable income. However, you then transfer this amount to your personal tax return and combine it with the other income and deductions that don’t relate to your LLC. As a result, the IRS will not recognize any payments you take from LLC profits as a deductible salary.

Electing Corporate Tax

If you prefer to pay taxes for your LLC earnings as a corporation rather than sole proprietor, the IRS allows you to make an election on Form 8832. When you choose to pay tax as a corporation, you can draw a salary for the services you provide and report a deduction for it on the corporate tax return. The IRS recognizes a corporation as a separate taxpayer, so you don’t report any earnings of the LLC on your personal return. Instead, you file the corporate return on Form 1120 or 1120A. However, you should realize that the burden of corporate double taxation can outweigh the benefits of taking a salary deduction. This is because your single-member LLC pays corporate tax on its earnings, but when you take a dividend payment from the after-tax earnings, you must pay a second tax on those payments on your personal tax return. In addition, you still need to report any salary you pay yourself on a personal tax return as well.

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Employee Salaries

Regardless of whether you choose sole-proprietor or corporate taxation for your single-member LLC, you can always deduct the salaries you pay to employees. The only requirement is that the salaries must be in exchange for services that an employee performs for the LLC and that the amount be reasonable. There isn’t a bright-line test for assessing whether an employee’s salary is reasonable. However, some of the factors to consider are the number of hours the employee works, the level of skill the position requires and the amount of responsibility she has.

How to Deduct

To deduct the salary payments you make to employees when reporting as a sole proprietor, you simply report the annual total in the “expense” section of your Schedule C, which will reduce the amount of LLC earnings that are taxable. However, if you elect corporate taxation, you can deduct the total amount of salaries you pay to yourself and other employees on the “salaries and wages” line of Form 1120.

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References

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