We have an Oklahoma LLC with just two members, both active in the business. My partner says he wants to be put on payroll as a W-2 employee and take a salary instead of taking profit distributions. I am concerned this creates tax problems and sets a precedent. He says it is simpler for his personal budgeting. We have never had employees before. Does anyone have experience with this? I want to understand the implications before I agree.
LLC Pay
My Oklahoma LLC partner wants to take a salary instead of profit distributions
If your partner becomes a W-2 employee, the LLC needs to run payroll, withhold taxes, pay employer-side FICA, and file quarterly returns. But here is the big issue: you cannot have one member treated as an employee and the other as a self-employed owner without inviting scrutiny. The IRS may reclassify distributions or challenge the arrangement. It would be cleaner to either both be employees or neither. Also, Oklahoma has its own unemployment tax and withholding requirements once you have employees.
Is the LLC taxed as a partnership? If so, a partner cannot be a W-2 employee of thhe partnership. Guaranteed payments are the correct mechanism. If you elect S-corp status, then reasonable salary becomes required for active shareholders. But that is a different setup. Have you considered an S election?
What does your operating agreement say about compensation and distributions? That document should control. If it is silent, you need to amend it before making any changes.
I have seen this go badly. Partner takes salary, other partner takes distributions. At tax time the salary partner has withholding and the distribution partner does not. Resentment builds. Make sure you both understand the cash flow differences.
Exactly. And if he is taking a salary, that reduces the profit available for distributions. You need to model the numbers. His salary is deductible to the LLC, which lowers your distributive share of income. That may or may not be fair depending on the amount.
This might be a dumb question, but why does he want a salary? Is it just for budgeting? Could you instead set up a fixed monthly distribution that approximates a salary? That would avoid payroll entirely.
He says he wants the predictability and the withholding so he does not have to worry about estimated taxes. He also likes the idea of contributing to a retirement plan through payroll. But I am worried about the legal and tax structure. I do not want to create a situation where the IRS says we have been misclassifying him for years.
If the LLC is a partnership, he cannot be a W-2 employee. Period. You could pay him a guaranteed payment, which is essentailly a salary for tax purposes but without withholding. He would still need to make estimated payments. If he wants withholdin, you would need to elect S-corp status and both of you take reasonable salaries. That is a bigger change.
Another angle: Oklahoma LLC fees and annual filings do not change, but payroll adds administrative burden. You will need an EIN, payroll software, workers comp insurance possibly, and unemployment insurance. That is a lot of overhead for two people.
Workers comp in Oklahoma is not always required for LLC members, but if he is a W-2 mployee, he is an employee and you likely need coverage. That is an added cost. Check with your insurance agent.
Also consider self-employment tax. As a partner, he pays SE tax on his distributive share. As a W-2 employee, he pays FICA on wages and the LLC pays employer FICA. The total tax burden may be similar, bbut the incidence shifts. You need to run the numbers with a CPA.
If he wants retirement plan contributions, a solo 401k or SEP IRA might work for a partner without payroll. You can contribute based on self-employment income. That could address his concern without the W-2.
I am not a tax professional, but I have been in an LLC where one partner wanted a salary and it caused endless arguments. We ended up dissolving and forming separate entities. I would get everything in writing and maybe talk to a business attorney before agreeing.
If you do go the S-corp route, you both need reasonable salaries based on market rates for your roles. The IRS has been cracking down on S-corp owners who take low salaries to avoidd FICA. That could be a headache if you are not prepared.
What is the long-term plan? If you plan to bring in more members or investors, having a payroll structure might be more scalable. But if it is just the two of you, simplicity might be better.
I appreciate all the points. We are going to sit down with our CPA next week and discuss the partnership vs S-corp issue. I will bring up the guaranteed payment idea and the retirement plan alternatives. It sounds like we need to model the tax impact carefully before making any changes.