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Ask The Experts: Payroll

Q: I just hired my first full-time employee and have established a payroll account and a process to do all the required payroll reporting and tax withholding. My question is, now that I have the system in place should I add myself to the payroll system and pay myself a set salary as a W2 employee and then change how I file my taxes? I currently include the LLC income and expenses on an IRS Schedule C under my personal income tax return.

A: Congratulations on creating a new job. Don’t forget that over 70 percent of all new jobs come from small business owners just like you, so keep up the good work. The easy answer to your question is that you should not add yourself to the payroll system. The key point is that the owner of an LLC who is filing as a sole proprietorship is NOT considered an employee of that Limited Liability Company (LLC). The taxable compensation that you will receive as the owner of the LLC will be exactly the same as if you were indeed a sole proprietor, which is the net income from self employment that will ultimately be reported on your Schedule C.

It is certainly a good idea from a management standpoint to allocate a set amount of income or cash flow to you as the owner and operator of the business, but from a tax standpoint those payments to you will be characterized as ‘owner draws’ and, by definition, do not constitute wages or salary and are not subject to any other employee or payroll reporting requirements. The bottom line to your question is that the wages paid to your new employee will not affect the cash payments that you make to yourself as the owner of the LLC, nor will those payments initiate a change in the way you currently complete your annual income tax return.

Always keep in mind that the tax reporting requirements for an LLC are somewhat confusing. The IRS does not recognize the LLC form of organization in a specific way, so each LLC must elect how it will be taxed by the IRS and therefore which forms and reporting requirements it will use. An LLC that has only one owner can elect to be taxed as a sole proprietorship or as a corporation. An LLC that has more than one owner may elect to be taxed as a partnership or as a corporation.

In either case, an LLC that elected to be taxed as a corporation would indeed treat its owners as employees in relation to the compensation designed to recognize their earned income from the entity. If you, as the sole owner of your LLC, had elected to be taxed as a corporation and therefore chose to file a Corporation tax return, Form 1120, then you would be required to pay yourself a reasonable salary based on the services that you provide to the LLC.

Since you file a Schedule C related to the operations of your LLC, you have elected to be taxed as a sole proprietorship, which for most small business owners is preferable. As such, you are not considered an employee of that LLC and therefore you should not pay yourself as an employee. So keep doing what you are doing and keep creating more new jobs. Well done!

Gene Fairbrother, Business Strategy Expert

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