Understanding Variable Compensation among LLC Owners
Limited Liability Companies (LLCs) are a popular business structure due to their flexibility and advantageous liability protection. One common question that arises among LLC owners is whether they can pay themselves different amounts. The answer lies in understanding the nature of an LLC, its taxation structure, and the operating agreement that governs the distribution of profits.
Understanding the LLC
An LLC is a business entity that combines the limited liability protection of a corporation with the flexible tax treatment of a partnership. It allows owners, known as members, to enjoy personal liability protection while retaining the ability to allocate profits and losses in a way that suits their needs.
Profit Distribution and Operating Agreement
The distribution of profits in an LLC is typically determined by an operating agreement. This agreement outlines the rules and regulations governing the management, operations, and financial aspects of the company. The operating agreement provides flexibility and enables LLC owners to tailor the distribution of profits according to their preferences, as long as it complies with state laws.
Different Types of LLC Ownership Interests
LLC ownership interests can be divided into units or percentages, commonly referred to as membership interests. These interests represent each member’s share in the company and their entitlement to profits and losses. Members may hold different ownership percentages based on various factors such as initial investments, contributions, or special arrangements.
Distributing Profits Unequally
LLC owners can agree to distribute profits unequally among members, as long as it is stated in the operating agreement and complies with the law. This approach is known as “distributive shares” and allows members to allocate profits based on their ownership percentages. For example, if one member owns a 60% interest and the other owns a 40% interest, they may agree to distribute profits accordingly, such as 60% to the first member and 40% to the second.
Compensation for Work and Services
In addition to profit distributions, LLC owners may receive compensation for the work and services they provide to the company. This compensation, often referred to as a salary or guaranteed payment, is separate from the profit distributions and is typically based on a mutually agreed-upon arrangement. The operating agreement can outline the terms and conditions regarding compensation and whether it will be the same for all members or different based on individual roles and responsibilities.
Tax Implications
LLCs are generally considered pass-through entities for tax purposes, which means that the company itself does not pay taxes. Instead, profits and losses are passed through to the individual members, who report them on their personal tax returns. Members are responsible for paying taxes on their share of the profits, regardless of whether the distributions are equal or unequal.
Conclusion
LLC owners have the flexibility to distribute profits unequally among members as long as it is specified in the operating agreement and complies with state laws. The ability to pay different amounts to LLC owners allows for customized profit-sharing arrangements based on ownership percentages and other factors. Additionally, members may receive compensation for the work and services they provide to the company, which can be different for each member. It is important for LLC owners to consult with legal and tax professionals to ensure compliance with applicable laws and regulations when determining profit distributions and compensation within their LLC.
Video Transcript
Can You Pay Two LLC Owners Different Amounts?
So imagine two business owners start an LLC and maybe one works as CEO and one is a software coder. And they might agree at one point they will get paid the same amount. In fact, many times in the beginning, they don’t get paid anything because the company hasn’t made money yet. But as the company starts making money, the business owners want to get paid. And the question then is, can they get paid different amounts? The short answer is if they agree, absolutely. If the business owners agree on what they will each get paid, they can get paid different amounts. But what often happens is business owners don’t agree. And so in that case, you have to look at a couple of different things.
What Happens if Business Owners Don’t Agree to Get Paid Same Amounts?
First, you look at in the operating agreement of the LLC, is there anything that talks about how the owners will get paid or how profits will be divided? Usually, profits are divided. But that is after employees are paid. And if the owners are working in the company, the owners are getting a wage for working in the company or a salary or whatever that looks like. So it is quite common for owners to agree in the beginning, they are both going to get paid the same amount, but then as their responsibilities, are different, the owner with greater responsibilities believes he or she should get paid more.
So what do you do about that? Well, as far as the owners are concerned, they need to come to some agreement. The law basically says you can pay a fair market wage to each person. And so if the owners cannot come to an agreement, What do you do? Because obviously, if they can come to an agreement, fine. We don’t have an issue. If they can’t come to an agreement, the law generally says pay each individual a fair market wage for the work they are performing or the job responsibilities that they have. Okay, so that assumes there is no prior agreement. So if they didn’t have any agreement in place, then we look to fair market wages for the particular position.
What to Do When a Person Can’t Maintain the Position They Were Given?
Now that there is a special issue if a person can’t maintain the position they were given and they are given less responsibility. And in most states, the law is you have to go out of your way to accommodate them to help them do the job that they originally given. And if that is simply not possible, then you need to accommodate them for the next available or next best type job that they actually can perform. This comes up a lot as people age and technology improves and changes. You can find that a senior business owner may struggle with the new technology implemented in the company. And the law basically says you need to get them an assistant who can help them with that technology or get them some training that can help.
How Do You Figure Out What a Fair Market Wage is for a Person?
Okay. But going back to the issue now. How do you figure out what a fair market wage is for a person? Well, that is whatever would be paid in the marketplace if you hired a person to do that job. So, for example, if it is a three-employee company and you need a manager with entry-level management skills, because there are only three people and the manager is one of them, that is going to be a much lower fair market wage than if the company has a hundred employees and needs a CEO to manage the entire organization. So you look at the job sites online to see what would a person get paid for that type of position. And of course, it is going to be a range, you know, so for example, you might see a range of $70,000 to $100,000 for a particular position. Well, now you know that that is the range that you need to be in for that fair market compensation. Another way that you can handle this is hire an outside compensation expert to set the wage for each one of the owners who work in the company. That way, you are delegating to an expert who is objective and applying the law. And it is not a personal decision among the owners. So that is another way that you can do that. All this stuff should be done with the advice of a good attorney.
Conclusion
All right, that wraps it up for our questions today. If you have other questions, put them in the comments below. I am Aaron Hall, an attorney for business owners and entrepreneurial companies. You can learn more about me at aaronhall.com. And if you would like to sign up for our free resources, go to aaronhall.com/free. If you would like more videos like this, you can follow us on TikTok, Instagram, Twitter, and other social media platforms. Just search on social media for Aaron Hall Attorney. It was great to be with you here today.