How Are LLC Distributions Taxed? 2025 Guide

For small business owners and solo entrepreneurs, also called solopreneurs, forming a Limited Liability Company (LLC) offers excellent personal asset protection and tax flexibility. Understanding how to take money out of your LLC without triggering unexpected tax liabilities can be nerve-racking and complex.

This excellent guide demystifies LLC distributions taxes, explaining their taxation based on your LLC's classification and providing actionable insights for tax-smart planning throughout the year. 

Key Highlights

• LLC Tax Classification Matters: How your LLC distributions are taxed depends entirely on its federal income tax classification: disregarded entity (sole proprietorship), partnership, S corporation, or C corporation.

• Basis is Key: Are LLC distributions taxable? Distributions are generally tax-free up to your basis in the LLC. Exceeding your basis can trigger taxable capital gains.

• Owner's Draws vs. Payroll: For single-member LLCs (SMLLCs) and partnerships, owner's draws are not taxable income themselves; the LLC's net profit is taxed. S corporations require a reasonable salary for owner-employees, with distributions being separate and generally not subject to the 15.3% self-employment tax.

• Self-Employment Tax: Sole proprietors and partners typically pay self-employment tax on their distributive share of active income, not on distributions. S corp distributions are generally exempt from self-employment tax if a reasonable salary is paid.

• Professional Guidance is Crucial: Consulting with a tax professional, like those at 1-800Accountant, America's leading virtual accounting firm, can help navigate distribution planning, avoid surprises, and optimize your tax strategy.

What Is An LLC Distribution?

An LLC distribution is the withdrawal of money or property from the LLC by its owners. Its tax treatment depends on the LLC's tax classification and differs from owner's draws or guaranteed payments.

Owner's Draws Vs. Distributions Vs. Guaranteed Payments LLC

While often used interchangeably, these terms have distinct tax meanings:

• Distributions: Non-taxable returns of capital to owners, reducing their basis. Common in multi-member LLCs taxed as partnerships or S corporations. Generally, they are tax-free until they exceed an owner's basis.

• Owner's Draws: Money taken by owners of SMLLCs or partnerships for personal use, and aren't subject to payroll taxes. The owner is taxed on the LLC's net profit, not the draw itself.

• Guaranteed Payments: Payments to a partner for services or capital, regardless of income. Treated as ordinary income to the recipient, deductible by the partnership, and subject to self-employment tax. The IRS states that "Guaranteed payments to partners are ordinary income to the recipient."

LLC As A Legal Entity: Tax Treatment Depends On Election

An LLC's tax treatment is determined by its IRS election:

How LLC Distributions Are Taxed Depends On Your Tax Classification

The tax treatment of LLC distributions hinges entirely on how your LLC is classified for federal income tax purposes.

Single-Member LLC (Default Sole Proprietorship)

If your SMLLC has not elected to be taxed as a corporation, it is treated as a disregarded entity by default by the IRS. The owner is considered a sole proprietor for tax purposes. 

For an SMLLC, the owner's draw is simply a transfer of funds from the business to the owner's personal account. Draws themselves are not considered taxable income when taken. Instead, the LLC's net profit or loss is passed through directly to the owner's personal tax return (Schedule C, Form 1040). The owner is taxed on this net profit, regardless of whether they take any money out.

Example: If your SMLLC earns $100,000 in net profit, you will be taxed on that $100,000, even if you only took out $50,000.

As a sole proprietor, you pay self-employment taxes (Social Security and Medicare) on your net profit from the business, not on your draws. You will likely need to make estimated tax payments quarterly to the IRS to cover these obligations.

An S corp or C corp election will alter some of the obligations you've addressed as an SMLLC. 

Multi-Member LLC Taxed As A Partnership

Multi-member LLCs are, by default, taxed as partnerships. They are pass-through entities, meaning the business itself does not pay income tax. Profits and losses pass through to individual partners, who report their share on their personal tax returns.

Distributions to partners are generally tax-free up to their outside basis in the partnership. Outside basis represents their investment, adjusted for contributions, income, liabilities, distributions, and losses. If a cash distribution exceeds their outside basis, the excess is typically a taxable capital gain.

Carryover basis, holding period, and special “marketable securities treated as cash” note are considered property distributions. As mentioned above, guaranteed payments are treated as ordinary income to the recipient.

Partners receive Schedule K-1 (Form 1065), reporting their share of income, losses, deductions, credits, and distributions. The K-1 reports the amount of distributions, but taxability depends on the partner's individual outside basis.

LLC Taxed As An S Corporation

Are you wondering about S corp distributions vs. salary? 

Electing S corporation status can be a powerful tax strategy for profitable businesses, allowing separation of owner compensation into a reasonable salary and tax-free distributions.

An S corp shareholder-employee must be paid a reasonable salary (W-2 wages) for services, subject to payroll taxes. The IRS can reclassify distributions as wages if a reasonable salary isn't paid.

After a reasonable salary, remaining profits can be distributed to the shareholder as shareholder distributions, which are generally not subject to self-employment taxes. This is a key S corp advantage.

S corp distributions are typically tax-free up to the shareholder's stock basis. Stock basis is adjusted annually for:

• Contributions

• Income

• Losses

• Distributions

If a distribution exceeds stock basis, the excess is generally a capital gain.

Accurate basis tracking is paramount. The IRS requires shareholders to use IRS Form 7203, S Corporation Shareholder Stock and Debt Basis Limitations, to compute basis limits and track basis year-to-year. For more information, refer to our helpful S corp Distributions guide.

LLC Taxed As A C Corporation

An LLC can elect to be taxed as a C corporation, introducing double taxation. A C corporation pays income tax on its profits at the corporate tax rate. Distributions of after-tax profits to shareholders are typically dividends, taxed again at the individual shareholder level. This is double taxation.

Due to double taxation, C corp status is generally not preferred for small businesses, unless retaining earnings for growth or seeking venture capital. If you elect this status, pay attention to: 

• Earnings & Profits (E&P). E&P represents a corporation's ability to distribute dividends without affecting its capital. 

• Dividends. This is a distribution from a C corp to its shareholders that is made out of the company's E&P.

• Return of Capital. This is the portion of a C corp distribution that exceeds the company's current and accumulated E&P.

Do I Pay Self-Employment Tax On LLC Distributions?

Self-employment tax covers Social Security and Medicare for self-employed individuals. Its applicability to LLC distributions depends on your LLC's tax classification.

Sole Proprietorship & Partnership

For SMLLCs taxed as sole proprietorships and multi-member LLCs taxed as partnerships, owners are subject to the self-employment tax on their distributive share of the LLC's active income, not on the actual cash distributions. The tax liability arises from earning the income, not distributing it.

Example: If a partnership earns $200,000 and a partner has a 50% share, they will be taxed on $100,000, and that $100,000 will generally be subject to self-employment tax, regardless of how much they took out in distributions.

S corp Election

S corporation election offers an advantage: the owner-employee must be paid a reasonable salary (W-2 wages) for services, subject to payroll taxes. Any distributions beyond this salary are generally not subject to self-employment taxes. The IRS scrutinizes salary reasonableness to prevent tax avoidance.

Unlike owner-employees, owners considered "passive" do not materially participate in the business. The Net Investment Income Tax (NIIT), often referred to as the "NIIT (3.8%)", is a surtax of 3.8% on certain investment income for high-income individuals, estates, and trusts, and may impact eligible passive owners. 

How Distributions Affect Your Basis (And Why Basis Tracking Matters)

Understanding and tracking your basis in an LLC is paramount. It determines the taxability of distributions, deductibility of losses, and gain/loss on the sale of ownership interest.

Outside Basis (Partnership) Vs. Stock/Debt Basis (S corp)

Taking cash distributions exceeding your basis results in a taxable capital gain. For partnerships, it's capital gain from selling a partnership interest. For S corporations, it's capital gain from selling stock.

State Tax Wrinkles: Nonresident Owner Withholding And Composite Returns

State tax laws can add complexities, especially for LLCs with owners in different states.

Several states require LLCs (especially partnerships) to withhold income tax on the distributive share of income for nonresident owners. This means the LLC remits a portion of the nonresident owner's income to the state, even if no cash distribution is made.

Example: California requires withholding for nonresident owners. The CA FTB mandates pass-through entities withhold a percentage of California-source income for nonresident members, reported via Form 592-PTE CA FTB: nonresident owner withholding (Form 592/592-PTE).

Some states offer composite returns – a single income tax return filed by the LLC on behalf of some or all nonresident owners, simplifying compliance. Check with state officials before making larger-than-normal distributions. 

What Counts As A Taxable Distribution? Quick Checkpoints

While distributions are generally tax-free up to your basis, several scenarios can trigger a taxable event:

• Cash > Basis: If cash (or marketable securities treated as cash) distributed exceeds your adjusted basis, the excess is a taxable capital gain, IRS Pub 541: partnership distributions & basis.

• S corp with C corp E&P: If an S corp previously operated as a C corporation and has accumulated E&P, distributions follow specific ordering rules, potentially taxing a portion as dividend income.

• Property Distributions: Partnerships generally follow carryover basis rules. S corporations may recognize gain if distributing appreciated property.

• Guaranteed Payments: These are taxable compensation to the partner, subject to self-employment tax, and deductible by the partnership. They are not distributions.

Examples: Common LLC Distribution Scenarios (With Numbers)

Here are examples to illustrate LLC distribution taxation:

How To Plan Tax-Smart Distributions

Strategic distribution planning impacts tax liability and financial health. Coordinate distributions with tax obligations and maintain diligent records.

Coordinate Quarterly Estimates And Payroll (If S corp)

• SMLLCs & Partnerships: Make estimated tax payments quarterly for income and self-employment tax on LLC profits. Set aside funds for these payments.

• S Corporations: Pay yourself a reasonable salary (W-2 wages, subject to payroll taxes). Distributions beyond salary are generally tax-free up to the stock basis. Balance salary and distributions to minimize tax while complying with IRS reasonable compensation rules.

Align Distributions With Basis And Cash Flow

Regularly track your basis. Distributions exceeding basis trigger a taxable capital gain. Ensure distribution plans align with LLC's cash flow to avoid liquidity problems. Avoid large, unplanned year-end distributions.

Keep Clean Books

Meticulous bookkeeping is essential:

• Bank Feeds: Reconcile accounts, categorize transactions.

• Equity Accounts: Properly maintain accounts (Owner's Equity, Partner Capital Accounts, Shareholder Distributions).

Information from your bookkeeping system feeds into Schedule K-1 (Form 1065) for partnerships and Form 7203, S Corporation Shareholder Stock and Debt Basis Limitations, for S corps.

FAQs on LLC Distributions

Are LLC Distributions Considered Income?

Generally, no. LLC distributions are typically a return of capital, tax-free up to your basis. Your taxable income is the LLC's net profit (sole proprietorships/partnerships) or your reasonable salary (S corps).

How Often Can I Take Distributions?

You can take distributions as often as cash flow allows for SMLLCs and partnerships. For S corporations, ensure a reasonable salary is paid regularly to avoid penalties and additional scrutiny. 

Do I Issue Myself A 1099 For Draws?

No. Form 1099-NEC is for independent contractors, 1099-DIV for corporate dividends. LLC distributions are reported differently (e.g., Schedule K-1 or Schedule C).

What If My LLC Has A Loss—Can I Still Take Money Out?

Yes, but it's not advisable. Taking distributions with a loss further reduces your basis. If distributions exceed basis, it could trigger a taxable capital gain, even if the business itself is unprofitable. Consult a tax professional.

What Happens If I Misclassify S Corp Distributions As Wages (Or Vice Versa)?

Misclassification leads to significant tax problems. Unreasonably low salary and excessive distributions can lead to IRS reclassification as wages (subject to payroll taxes, interest, penalties). Conversely, if you treat all your compensation as wages and forgo distributions, you might be paying more in payroll taxes than necessary, missing out on the S corp's tax advantages.

When To Bring In A Pro

Tax law rules and complexities can be overwhelming. Navigating them alone can lead to costly mistakes.

Red Flags That Signal The Need For Professional Help

• Mixed Tax Elections: Changes in LLC tax election.

• Multi-State Owners: Managing withholding and composite returns.

• New Investors: Changes in ownership, contributions, and distribution agreements.

• Debt Basis Complexity: Tracking shareholder loans for S corps.

• Prior C Corp E&P: Intricate ordering rules for distributions.

• Significant Growth or Changes: Major business changes impacting the tax situation.

Don't let tax complexities hold you back

1-800Accountant's expert CPAs, EAs, and tax professionals help small business owners navigate tax complexities. When you trust us with your sensitive financial work, you get:

• Personalized Guidance: Dedicated accountant or team with tailored advice.

• Proactive Tax Planning: Strategies to minimize your tax burden.

• Accurate Bookkeeping: Clean and compliant financial records.

• Year-Round Advisory: Unlimited access to experts when you need them.

Get year-round guidance and a distribution plan. All it takes is booking a free 30-minute consultation today to discuss your needs and develop a customized distribution plan. Let us handle the numbers so you can focus on what you do best—running your business.