A Limited Liability Company (LLC) is a flexible business structure offering owners liability protection while allowing them to choose how the business is taxed. The Internal Revenue Service (IRS) does not recognize an LLC as a distinct entity for federal tax purposes, so it must select an existing classification, such as a sole proprietorship, partnership, or corporation. The way an LLC member receives money is different from a traditional employee and depends on this tax classification. Understanding this relationship is key to managing associated tax obligations effectively.
The Role of the Operating Agreement
The company’s internal rules for financial management are established in the Operating Agreement (OA), which functions as a legal contract among the members. This document dictates the economic relationship between the owners and the business, including the process for distributing profits and losses. The OA specifies the method and frequency for paying members, ensuring transparency and providing a framework for dispute resolution.
The agreement defines the ownership percentages and the corresponding profit-sharing ratios, which do not necessarily have to be equal to the members’ capital contributions. It establishes whether distributions are based strictly on ownership percentage or allocated through a different method, such as a “waterfall” distribution model or a special allocation for members who provide specific services. For multi-member LLCs, a written Operating Agreement is important because it sets the rules for capital accounts, buy-ins, and the distribution of available cash.
Owner’s Draws and Distributions
The most common way for members of an LLC taxed as a partnership or sole proprietorship to receive funds is through an owner’s draw or a distribution. The terms “draw” and “distribution” are often used interchangeably in this context, representing a withdrawal of company funds for the owner’s personal use. This mechanism allows the owner to take cash out of the business’s bank account, whether by writing a check or making an electronic transfer to a personal account.
An owner’s draw is considered a removal of profits from the member’s capital account and is not a deductible business expense for the LLC. The LLC does not withhold federal income tax or payroll taxes (FICA taxes) from the amount withdrawn.
The withdrawal itself does not create a taxable event. For tax purposes, the member is taxed on their share of the LLC’s total profit for the year, not just the amount they withdrew. The draw simply reduces the member’s capital account balance, which tracks their investment and accumulated profits in the company. Since the business is not handling the withholding, members must proactively manage their personal tax obligations throughout the year.
Handling Self-Employment Tax and Estimated Payments
LLC members are considered self-employed, making them responsible for paying self-employment taxes on their share of the business’s net earnings. This tax covers contributions to Social Security and Medicare, which are normally split between an employee and an employer. Because LLCs are pass-through entities, profits and losses flow directly to the owners’ personal tax returns.
The self-employment tax rate is 15.3%, consisting of 12.4% for Social Security and 2.9% for Medicare. The Social Security portion applies only to net earnings up to a certain annual limit, while the Medicare portion applies to all net earnings. Members calculate this obligation using Schedule SE, which is filed along with their personal income tax return, Form 1040.
Since no income tax or FICA tax is withheld from draws or distributions, members are required to make quarterly estimated tax payments to the IRS using Form 1040-ES. These payments cover both the federal income tax and the self-employment tax liabilities. Failing to pay enough tax through these quarterly installments can result in penalties from the IRS, making accurate estimation based on the company’s projected income a necessity.
Using Guaranteed Payments for Service Compensation
In a multi-member LLC taxed as a partnership, a member may receive a “Guaranteed Payment” for services provided beyond their typical ownership duties. Governed by Internal Revenue Code Section 707(c), this payment is fixed regardless of the LLC’s profitability. This is used to compensate a managing member for their labor, often referred to as a “partner salary,” even though the member is not an employee.
Guaranteed Payments are treated as a deductible business expense for the LLC, which can reduce the company’s overall taxable income. For the receiving member, the payment is treated as ordinary income and is fully subject to self-employment tax, just like the rest of their distributive share of the profits. The payment is reported separately from standard distributions on the member’s tax documents.
This payment mechanism differs from a standard distribution because it is compensation for services rendered, not merely a share of the profits. Unlike a distribution, a Guaranteed Payment does not affect the member’s capital account or tax basis in the company. It ensures a working member receives compensation for labor before the remaining profits are allocated, providing a predictable income stream.
When Can an LLC Member Be Paid as an Employee?
An LLC member cannot be classified as an employee or receive a W-2 salary if the LLC is taxed as a sole proprietorship or a partnership. This rule stems from the IRS view that an owner of a non-corporate pass-through entity cannot be an employee of their own business. An exception exists when the LLC elects to be taxed as an S-Corporation (S-Corp).
If the LLC files Form 2553 to elect S-Corp tax status, any member who actively works for the business must be paid a “reasonable salary” via a W-2 payroll system. This salary is subject to FICA tax withholding, which the S-Corp pays as the employer. The concept of reasonable compensation is an IRS requirement designed to prevent owners from classifying all earnings as distributions to avoid payroll taxes.
The IRS requires the salary to be comparable to what other businesses would pay for similar services, considering the member’s training, experience, and duties. After the member receives this salary, any remaining profit in the S-Corp can be paid out as distributions, which are not subject to self-employment tax. This dual payment structure is why many LLCs elect S-Corp status, as it can reduce the self-employment tax burden.
Year-End Reporting with Schedule K-1
At the end of the tax year, an LLC taxed as a partnership must file an informational return with the IRS using Form 1065, U.S. Return of Partnership Income. This form reports the company’s total income, expenses, and net profit or loss for the year. The LLC itself does not pay income tax on Form 1065, as the tax liability passes through to the members.
The LLC then prepares a Schedule K-1 for each member, which details their specific share of the business’s income, deductions, credits, and any Guaranteed Payments. This Schedule K-1 is the document that informs the member how to report their income on their personal tax return, Form 1040. The total of all individual Schedule K-1s must reconcile with the overall amounts reported on the LLC’s Form 1065.
For a single-member LLC, which the IRS treats as a disregarded entity, Form 1065 and Schedule K-1 are not used. Instead, the owner reports the business’s income and expenses directly on Schedule C, Profit or Loss From Business, attached to their personal Form 1040. The resulting net earnings amount is then used to calculate the member’s self-employment tax on Schedule SE.