While startup founders can pay themselves through an LLC, the Internal Revenue Service (IRS) doesn’t particularly like it. If you’re a founder considering this option, you should know that you may get extra attention from the IRS.
What is an LLC?
LLC stands for limited liability company, which is a business structure that protects the owners of the LLC from being personally responsible for any debts or liabilities. LLCs are a hybrid of corporations and partnerships or sole proprietorships. Owners are generally called “members.”
Generally speaking, the IRS prefers that founders don’t pay themselves through the LLC. They will look at you, the founder (who is actually a major stock owner), and question why you are being paid this way. They will almost definitely be thinking that you are trying to avoid payroll taxes by getting a 1099 instead of W-2 earnings.
As an owner, if you’re being paid through the LLC, then you’re basically self-employed. When you work for an employer, that employer withholds payroll taxes. Startups can use a number of different payroll systems to handle employee paychecks and withhold taxes. But if you’re considered self-employed, then you’re required to pay a self-employment tax, which is equal to the Social Security and Medicare taxes collected from businesses and their employees. The self-employment tax isn’t the same as income tax.
Don’t Avoid Payroll Taxes
Payroll taxes are a very lucrative source of income for governments, from local governments all the way up to the federal government. So they definitely don’t want you to avoid paying them. In order to verify that you’re paying your self-employment taxes when you’re paid through an LLC, you’re at risk of being audited. This may not be a common occurrence, but you should be worried about it happening nevertheless.
Startup Founders Should Be Paid as an Employee
Here at Kruze we always recommend that a founder is paid as an employee. It’s a much cleaner way of doing it. It also means you’ll stay compliant. Being paid as an employee means you’re paying all of your payroll taxes and you don’t have to really worry about being audited. Therefore, we highly advise it over getting paid through the LLC. If you’re trying to set up a payroll process, we encourage you to read our reviews of different payroll systems that Kruze clients use.
Like with everything, there can be extenuating circumstances that may cause founders to be paid through their LLC. Maybe the founder left the startup, maybe there is something else going on in their life, or maybe something else is happening within the company that changes the situation. However, generally speaking, it’s better if the founder is paid as an employee. They are an employee of the company, after all. They pay taxes, everyone’s happy, and you don’t get audited.
If you have any other questions on payroll taxes, LLCs, startup investing, startup accounting, taxes, or venture capital, please contact us.