Owners of a limited liability company, also called an LLC, have different tax responsibilities compared to a corporation. While an LLC is less regulated and more flexible than a corporation, its tax status can be a cause for confusion. The Internal Revenue Service does not officially recognize an LLC as a unique tax entity. Instead, the agency classifies the LLC as one of a number of existing entities, often resulting in confusion by owners who are tax novices.
An LLC is a special type of entity that can choose how it wants the IRS to treat it for tax purposes. Unless the LLC makes a special request to be treated as a corporation, the IRS will treat it as a sole proprietorship or a partnership based on the number of owners involved in the company. Sole proprietorships and partnerships are pass-through entities, which means the owners record business profits on their individual tax returns, rather than on a tax return for the company. The IRS does not consider a pass-through entity to be an employer when dealing with distributions made to owners for work done on behalf of the company.
Owners of an LLC are not considered employees of the company, even if they work for the company on a regular basis, unless the company has elected to be taxed as a corporation. A corporation pays its own taxes on profits, before making distributions to shareholders as dividends. As an independent tax entity, it can pay its shareholders wages and withhold employment taxes if a shareholder actually works for the corporation. A pass-through LLC does not pay taxes and does not have an independent tax status to withhold employment taxes from owner-employees.
A pass-through LLC makes two types of distributions to its owners: draws against an owner's year-end portion of profits, and profit distributions. It does not pay salaries or wages to owner-employees like a corporation because of the way it is taxed. Draws are typically optional and randomly distributed, but for owners that work for the company, the draw can be guaranteed and made according to a schedule. In this way, the guaranteed draw can operate like a salary. However, the LLC does not deduct employment taxes from this amount.
Since the pass-through LLC does not take out employment taxes for owner-employees, an owner must pay estimated and self-employment taxes on expected distributions, including Social Security tax, on a quarterly basis. An owner who works as an employee of the company is responsible for paying the entire amount of the employment tax: the half that the employee pays and the half that the employer pays. An owner who does not materially participate in daily operations may be exempt from paying employment taxes, but must check with the IRS to make sure.