Are you and your business partner wondering how to pay yourself in your multi-member LLC? Today, I'm going to explain to you exactly what you need to do, the five steps you need to take to make sure that both you and your business partner can sleep better at night knowing that your LLC is properly taken care of, and that you're each being paid adequately based on your work in the business. Does that sound good? Let's do it.
Today I want to talk to those of you that are in business with somebody else about what you need to do to protect yourself and your business when it comes time to pay yourself.
This is a really hot, emotional topic for a lot of businesses when there are multi-members of that LLC. Now, if you're not in business with somebody else, if you have a single member LLC, which means that you're in business by yourself, then you can check out this video on how to pay yourself in your single member LLC.
Now, if you are in business with somebody else, you know how hard it can be. It's basically like marriage without sex, unless, that is, that you're in business with your spouse, in which case, you're a single member LLC in the eyes of the law. You may not have known that, but you are. A spouse, two spouses together, that's still a single member LLC. That's not a partnership. I bet you didn't know that, did you?
For the rest of you who decided to go into business with somebody that is not your spouse, this could be a boyfriend or girlfriend. This could be a colleague, professionally or personally. This could be a friend, a family member or somebody you met in college or university. This is for you. Whomever it is that you're in business with, you need to make sure that the two of you are on the same page about how you're going to pay yourself with your multi-member LLC. This is an incredibly important decision that you need to make. You need to be in agreement about how and when each of you are going to get paid and how much you're going to get paid.
If you can't agree on this, it's going to lead to a lot of infighting between you with the business. It's going to lead to problems regarding how you're going to be spending the money in the business. It's going to lead to a lot of animosity between the two of you, and ultimately, it could tear down both your friendship if you were friends before you got into business, and it could tear down the business itself, which is a problem, and that's something that you want to avoid, I'm sure.
Importance of an Operating Agreement
Obviously, there's a lot at stake here. I'm going to talk to you about the five things that you need to include in your operating agreement to make sure that all these things don't happen for you and your business.
In many of my videos, I talk about the importance of having a solid operating agreement, and that is never more important than when we're talking about a situation where you have a multi-member LLC. Now, I say multi-member LLC, but this could also be a corporation with multiple shareholders. It doesn't necessarily have to be an LLC. Or it could just be a general partnership where you haven't even formed a corporate entity, but you have multiple partners in the business. Basically, the idea of the operating agreement here is that you need to agree to all of these things before you start operating a business. It's kind of like, again, I'm going to go back to the analogy of a marriage, having a prenuptial agreement before you get into the marriage to make sure if the marriage goes south, that you know how you're going to handle things.
Now, if you are a single member LLC, you don't need to spend a whole lot of time on this because if you ever need to make a change to the operating agreement, you just make the change. It's a living, breathing document that can change as times change. But if you are a multi-member LLC and you want to make a change to your operating agreement, you need to think long and hard about how you're going to do that because there's somebody else on the other side that might have a say in whether or not you want to make a change to that agreement, and that's your business partner. In the course of a multi-member LLC, you can't just change the agreement anytime you want. All of you need to agree. And that's why it's important to get these things down at the outset.
Here are some of the main issues that you're going to need to face when negotiating an operating agreement for a multi-member LLC, and this is specifically in regards to what you need to do in terms of getting paid. There are a bunch of other issues that you're going to need to negotiate, but these are the most important issues you're going to need to deal with when you're talking about how you and your business partners are going to get paid. Ideally, you would agree to all these issues before you, number one, invest money into the business, or two, start actually operating the business. Sometimes that's not possible. Some of you are probably operating for years, and now you're wondering what you need to do. Well, you need to get an operating agreement in place as soon as possible before there are any problems with your business.
Let's go through these five issues that you need to deal with real quick. Number one, how are you going to get paid? Are you going to have a set salary, or are you going to get paid based on a percentage of revenue? Are you going to get paid when the business is profitable? Or are you going to get paid based on commissions? How are each of you going to get paid? That is the number one decision you need to make.
The second option is pay split. How are you going to divide up the pay? Are you going to be paid each 50-50? Are you each going to be taking equal draws from the business, or are you going to be doing something else?
Third option. What if one of you stops pulling your weight? What if one of you just steps away from the business and decides, “I'm done with this business. I want to go somewhere else,” but that person still owns 50%, and they're still legally entitled to their cut? What do you do then?
Fourth option. Bonuses. When and how are you going to pay them?
And fifth option. You need to include some buyout provisions.
Issue #1 – Pay Options
Let's go through those one at a time. The first issue that you need to negotiate is pay options, and how are you going to get paid? A multi-member LLC is very similar to a single member LLC, and then you get paid basically by writing a check or transferring money from the business bank account to your personal bank account. But how do you decide when that is going to happen and how much is going to get paid at the time that that happens? You can do this either by just writing a check to each of you from the business, or you can do that by each of you having a set salary.
But let's say you set a salary. Let's say your salary is $5,000 a month, and each of you are supposed to get $5,000, plus payroll taxes, of course. That's going to be roughly $11,000 a month. Well, what if the business didn't make that much money? And what if there's not enough money in the operating account to pay that salary? Or what if there is enough money in the operating account to pay that salary, but one of you decides that, you know what? I don't want to take a salary this month because I want to leave the money in the business because the business needs that money to invest in advertising, equipment, employees, whatever it is you need to pay. And what if the other person doesn't agree with that? What are you going to do? That's the number one issue is, how are you going to agree to pay yourself?
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Now, I've talked about this before, but my advice is, generally speaking, you should look at the Profit First Formula by Mike Michalowicz and pay yourself according to that. You don't have to do it that way. You can do it any way you want. But that's something that I highly recommend you take a look at.
Issue #2 Pay Split
The second thing that normally comes up is the pay split, and this is how much are you going to pay yourself versus how much you're going to pay your partner. This can frequently become a problem later on down the road where one person is pulling more weight than the other person. In other words, let's say one person is doing all the marketing, and they're bringing in all of the clients, and the other person is doing all the backend work. And so the person that's doing the marketing feels like they should be paid more because they're the ones responsible for doing all the rainmaking for the business. But the other person feels like maybe they should be paid more because, without them, you wouldn't be able to deliver on the products or services that you're providing to all those clients. And so there can become discrepancies about how that's going to work, and that can be a big problem. So you need to decide from the outset, how are you going to split up the pay?
Another time where this can become a problem is where one person has basically put in more money into the business, and the other person has put in more sweat equity. Well, initially, you might agree that that's going to be a 50-50 split, but what happens when a year or two down the road, the person that's doing this sweat equity is doing all the work for the business, and it's grown substantially, and now they're in a place where they can basically buy out the person who just provided the financial capital for the business, but that person doesn't want to be bought out. They just want to continue to get 50% of their cut. What do you do with that situation? That is another big problem that comes up. That's something you need to agree on ahead of time. Is it going to start 50-50 and then slowly change over time? Or are you going to start out at 40-60 or something else. Whatever you decide to do, you need to make sure you have that in the operating agreement.
Issue #3 – A Partner Stepping Away
The third issue that comes up is what happens if one of the partners stops pulling their weight. In other words, let's say they have another opportunity that comes their way, and they decide they no longer want to be in your business, or they don't think your business is going to be successful, and they want to step away. Or let's say the two of you actually are married, and you get a divorce, and then one of you decides you don't want to be in the business anymore because you got divorced.
There's all sorts of issues that can arise when you're in a business with somebody else, and you need to figure out what you're going to do if one person decides to step away. And how do you define stepping away? If they're gone for six months and then they come back or if they're gone for a month and then come back or if they're gone and they just never come back? How do you define that? Those are issues that frequently need to be resolved and put into an operating agreement so that you can hammer them out ahead of time so that you can avoid potentially costly litigation from a disgruntled partner if they've moved away from the business, but they still feel like they're entitled to distributions from the business.
Issue # 4 – Bonus
The fourth thing that you need to decide is bonuses. Let's say you've got the salaries figured out, but your salaries are low. At the end of the year, you want to take a distribution from the business. But how much are you going to take? How are you going to decide when you're going to take that? What benchmarks do you have to hit to make sure that happens? These are things that need to be decided and agreed to in advance in the operating agreement. And kind of in line with this, you need to think about, well, what if you do start your salaries out really low, and you decide you want to change them later on? How are you going to decide that you are at a point where you do want to change those salaries and make them bigger or whatever?
Issue #5 – Buyout Provisions
All right, the fifth thing you need to look at is buyout provisions. Typically, if somebody does decide to move away from the business and go on and do something else, you'll want to know, what are you going to do in terms of a buyout provision? Are you going to have something in place in terms of that person moving away? Is that going to be open-ended? That's something that you really need to think about because if it comes time where somebody does step away from the business, you can avoid a lot of, like I said, costly litigation by agreeing to something in advance so that you can make sure that doesn't become a problem later on.