How should members of a limited liability company be compensated? I understand it may be better for tax purposes for the LLC to be treated as a corporation. Is that true?

A limited liability company is one of many ways — including corporations, partnerships and sole proprietorships — that a business can be organized.

Limited liability companies are taxed as partnerships, and they are popular with small-business owners. Owners, or members, of LLCs are treated as employers for tax purposes. Earnings and losses pass through to the owners and are included on their personal tax returns.

When it comes to compensation, LLC members do not receive a W-2 form. They are not subject to income tax withholding, and they are not eligible for certain tax-favored fringe benefits that are available only to employees, such as some health benefits.

Since 2003, however, self-employed people can deduct 100% of their medical insurance premiums on their individual income tax returns.

When LLC members get paid for services rendered to the company, the payments are considered "guaranteed payments" for tax purposes, meaning they are reported on a Schedule K-1 at the end of the company's tax year.

The LLC members will need to make quarterly estimated tax payments on their Schedule K-1 income to avoid estimated tax penalties.

Some limited liability companies elect to be treated as corporations for tax purposes so that their members can avoid the self-employed treatment and the unfavorable fringe benefit rules.

However, making the decision to treat a limited liability company as a corporation involves tax drawbacks as well and should be done only with the advice of a knowledgeable professional.

This strategy may not make sense in many situations and should only be undertaken after full consideration of all the consequence because it would be giving up many of the benefits that caused you to choose an LLC in the first place.



Stephen Kunkel

CPA and Southern California director of taxes at CBiz, a national business service firm