A limited liability company (LLC) is a business entity that offers liability protection for owners, as well as pass-through taxation, much like a sole proprietorship. Owners of LLCs are called members. If you’re forming an LLC, it’s important to know how ownership works.
Everyone who owns part of the LLC is called a member. Usually, the members have contributed capital to the company or have ownership for other contributions, such as the role they play in the company. The proportion of each member’s ownership is generally based on the amount of their contribution, but it can be proportioned in any way that the members agree upon. All members get a share of profits based on their ownership percentage, as well as voting rights and other rights that are defined in the operating agreement.
Members can be individuals, corporations, or other LLCs. An LLC must have at least one member, and the number of members it can have is unlimited. The exception to this comes if the LLC chooses to be taxed as an S-Corp, and then the number of members is limited to 100.
What Is an Operating Agreement?
An operating agreement for a limited liability company (LLC) is an important legal document that details who owns the business and also provides essential information pertaining to member duties. An LLC operating agreement establishes the financial relationship between members and the basics of the working relationships between those members and the managers who oversee daily operations.
An operating agreement is not usually required but is highly recommended. The operating agreement should clearly define the following:
- The percentage of each member’s interests in the LLC
- How profits and losses will be allocated to each member
- Each member’s rights and responsibilities
- The management structure and management roles of members
- The voting rights of each member
- Rules for meetings and voting
- What happens when a member sells their interest, becomes disabled, or dies
An LLC operating agreement provides legal and financial recourse for a number of situations. If conflicts arise between LLC owners pertaining to any of the following issues, the operating agreement will provide clarity.
The specific language of the operating agreement details exactly how such conflicts will be resolved. This document details how the business is structured, the dynamics of operations, and more.
Though certain states have default rules on the books that address some of the potential challenges that might arise between LLC members, the LLC operating agreement has the potential to override such presumptions.
What is an S-Corp?
An S-Corporation refers to the tax classification of the business. It is a business that, by meeting certain requirements, can be taxed as an S-Corporation. An LLC can choose to be taxed as an S-Corp. In an S-Corporation, income is passed through directly to shareholders, without that income being taxed as corporate income, therefore the business is not responsible for corporate taxes. Instead, it is taxed as a partnership.
An LLC can be classified as an S-Corp if it has 100 or fewer members. Members pay taxes on their pass-through income at their personal income tax rates. S-Corp shareholders can only be individuals, specific trusts and estates, or certain types of tax-exempt organizations.
S-Corps use Form 1120S to file their taxes, which is used to report the income, losses, and dividends of S corporation shareholders. S-Corp shareholders do not pay self-employment taxes, which is the primary advantage of S-Corp status compared to sole proprietorship or partnership.
How LLC Members are Paid
How you get paid as an LLC member depends on how you are taxed. If you have not chosen S Corp status for your LLC, you will be taxed as s sole proprietorship if you are the only member, or as a partnership, if you have more than one member.
As the owner of a single-member LLC, you’re able to receive all of the profits. If the company makes $100,000, you can receive $100,000.
You can receive distributions all at once, or you can receive portions periodically. To pay yourself distributions, simply write yourself a check from the business bank account. Then record the withdrawal on your books as an owner’s draw, which reduces your owner’s equity account.
You will report all profit, not just your draws, on Schedule C of your personal tax return. You’ll also be required to pay self-employment taxes on your draws.
In a multi-member LLC, members of the LLC can also take draws from the profits. Draw amounts are based on each member’s ownership percentage. For example, if there are two members and each owns 50% and the business makes $100,000, each member can draw $50,000.
Each member pays taxes on their share of profit based on Schedule C of their personal tax return, as well as self-employment taxes. If you are taxed as an S-corporation, you cannot be paid in draws from your LLC. You must be paid as an employee of the LLC.
To become an employee, you’ll file a W-4 form. Then you can pay yourself a salary and will receive a W-2 for tax purposes. You must have an active role in the LLC to be an employee. If you are a silent member, uninvolved in LLC operations, you cannot receive a salary or be an employee. If your LLC has more than one member and all members play active roles in the company, you cannot receive a salary if the other members are not salaried. Either all active members receive a salary, or none do.
The wages you’re paid will be an expense of the LLC, deducted from profits just like any other expense. Per IRS rules, your salary must be within industry norms for the role you play, so you can’t pay yourself an unreasonable amount. Keep in mind that as an employee, income tax and employment taxes will be withheld from your salary checks.
To summarize, an LLC can have an unlimited number of members unless it is taxed as an S Corp. With S-Corp status, the LLC can only have 100 or fewer members. The operating agreement will clearly define the ownership percentages of the members and the rights of the members, so it’s a very important document to have, though it’s generally not required by law. It’s recommended that you get the advice of an attorney when forming your LLC so that all your documents properly protect the rights of all members.