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    2 Replies Latest reply on Dec 26, 2008 2:10 PM by Forensic.CPA

    LLC Questions

    switters Newbie
      I will be starting an LLC with a partner in California. I'm in the beginning stages of research and have not yet talked to a CPA or attorney.

      What is the best way to separate/distinguish between compensation for hours worked and for equity in the business? For example, I will be investing 90-95% of the start-up capital needed for the business and will be taking all of the financial risk. My partner will invest an equal amount of "sweat equity" in getting the business up and running, and at present we plan to work an equal number of hours once the business is established. One thought I had was to establish an ownership split based on what we each invest in the business (sweat equity + capital), and then simply determine an hourly wage and pay ourselves that wage based on how many hours we work. Does the sound like the best way to accomplish my purpose?
      If it is, I'm not sure I understand how each owner would be taxed. Is
      it possible to be both an owner and an employee of an LLC at the same
      time? Would the money earned as an employee be taxed differently than
      what flows through as owner income? Can the money paid to the owners for the hours they work be included in operating expenses?

      Using a hypothetical example, let's say that each owner works 80 hours at $20/hour. That means we each make $1,600 per month for the hours we work, an that this is included in operating expenses. (I'm not sure if this is possible.) Then let's say that after operating expenses are paid we have a net profit of $10,000. If we determine a 70/30 equity split, the net profit that flows through to owners would be $7,000 and $3,000 respectively.

      Now, from a tax perspective how would it work? Would each owner simply pay the same rate of income tax on all of the money they earn, regardless of whether it is paid as wages or as net profit flow-through? i.e. in the example above, one owner ends up making $8,600 ($1,600 in wages and $7,000 in ownership income) and the other makes $4,600 ($1,600 in wages and $3,000 in ownership income). Would they be taxed on the total sum (i.e. $8,600 or $4,600) at the same rate, or would their income from wages and income from ownership be taxed differently?
        • Re: LLC Questions
          switters Newbie
          I've done a little bit more research and I found the following blurb about S-corporations:

          For an S corporation, the rules on the self-employment tax are well
          established: as an S corporation shareholder, you pay the
          self-employment tax on money you receive as compensation for services,
          but not on profits that automatically pass through to you as a
          shareholder. For example, if your share of S corporation income is
          $100,000 in 2005 and you perform services for the corporation
          reasonably worth $65,000, you will owe the 15.3% self-employment tax on
          the $65,000 but not on the remaining $35,000.

          Using my hypothetical example above, If we were set up as an S-corp I would pay both self-employement (15.3%) and income tax (according to my bracket) on the $1,600 of wages, but only income tax on the $7,000 of profit? But with an LLC, I would pay both self-employment and income tax on all of the income I receive, whether it's from wages or ownership profit?
          • Re: LLC Questions
            Forensic.CPA Newbie

            By choosing the Limited Liability Company (LLC) as you legal form of business you actually have 2 options for your federal income taxes. You can elect to be taxed as a corporation (Salaries are paid on W-2s, and dividends are paid based on ownership) or as a partnership (Pass-through income on Form K-1 based on the terms of the partnership agreement). Using the partnership election you would then use draws from each partners equity account for funds removed from the business.