Can an LLC Really Withhold Tax on Distributions? – Avoid This Mistake + FAQs

Lana Dolyna, EA, CTC

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Confused about whether your LLC should withhold taxes on distributions?

You’re not alone. According to a National Small Business Association survey, 86% of small-business owners hire tax professionals due to complex tax rules – and issues like LLC distribution taxes are a big part of that.

Federal Tax Law and LLC Distributions: What You Need to Know

When it comes to federal tax law, understanding how an LLC is taxed is crucial. LLCs are flexible entities – for tax purposes, they can be treated as pass-through entities (like partnerships or S corporations) or as corporations. This classification determines how distributions are taxed and whether any tax withholding is required by the IRS.

Pass-Through LLCs (Partnerships and S Corps): No Routine Withholding for Domestic Members

Most LLCs are pass-through entities for federal tax. This means the LLC itself doesn’t pay income tax. Instead, profits “pass through” to the owners (called members in an LLC). Each member reports their share of the profits on their personal tax return and pays any tax due.

No automatic withholding: Unlike a paycheck from an employer (where income tax is withheld each pay period), an LLC generally does not withhold federal income tax on distributions to its U.S. citizen or resident members. The IRS doesn’t require it. Instead, members are responsible for paying their own taxes on the LLC’s profits. Often, members make quarterly estimated tax payments to cover this liability since there’s no withholding by the LLC.
Distributions vs. taxes: A key point – for pass-through LLCs, taxes are owed on the profit allocated to you, not on the cash distributed. Even if the LLC retains profits (doesn’t distribute cash), members still owe tax on their share of those profits. Conversely, if the LLC does make a distribution, that cash itself isn’t separately taxed as long as it’s a distribution of profits already taxed on the books. There’s no second tax at distribution time under the pass-through model. So, there’s no need for the LLC to hold back (withhold) federal income tax from a domestic member’s distribution. The member will handle the tax when they file their return (and through estimated taxes during the year).
S Corporation nuance: An LLC that elects to be taxed as an S corporation is also a pass-through entity. Similar rules apply: no federal income tax withholding on distributions to shareholders. However, S corp owners must take a salary for work they do for the business, and that salary is subject to normal payroll tax withholding (income tax, Social Security, Medicare). That’s a different context – salary is not a “distribution.” The distribution portion (the profits paid out beyond salaries) still has no federal tax withholding; the S corp shareholders pay tax on that profit via their own returns. So if you run an LLC taxed as an S corp, remember: withhold taxes on your paycheck, not on your profit distributions.
Single-member LLCs: If you’re the sole owner of an LLC (and you haven’t elected corporate taxation), the IRS treats your LLC as a disregarded entity – essentially the same as a sole proprietorship. That means all the business income goes directly on your personal tax return. No tax is withheld by the LLC on money you take out, because legally those withdrawals aren’t even “distributions” to a separate person – it’s just you taking your own money. You must still pay income tax and self-employment tax on the profits, but you do that via your personal estimated taxes and annual return, not through withholding.

Bottom line (for domestic owners): In general, federal law does not require an LLC to withhold income tax on distributions made to U.S. members. Each member is responsible for their own taxes. This often surprises new LLC owners who are used to the withholding-from-paycheck model – but LLC distributions work differently. The onus is on the owner to pay the tax, not on the LLC to withhold it.

Foreign Members: The Federal Withholding Trap

What if your LLC has a foreign owner (non-U.S. resident)? This is where federal law does step in and require tax withholding at the entity level. The U.S. government doesn’t want to lose out on tax from foreign investors, so special rules apply.

Nonresident aliens and pass-through LLCs: If your LLC is a partnership (or an S corp, though S corps generally can’t have foreign shareholders under federal rules), and one of the members is a nonresident alien or foreign business, the IRS requires the LLC to withhold tax on that foreign person’s share of the income. In other words, the LLC must act as a tax collector for the IRS for the foreign member’s portion of profits.
How much is withheld: Typically, the withholding rate on a foreign partner’s share of effectively connected income (ECI) – that’s income connected to a U.S. trade or business – is 37% for individual foreign partners (which is the highest individual tax rate) and 21% for foreign corporate partners (the corporate tax rate). This is under Internal Revenue Code §1446. It’s essentially as if the IRS says, “Assume the foreign partner will owe the top tax rate; withhold that percentage of their share and send it to us.” Later, the foreign partner can file a U.S. tax return to report actual tax and potentially get a refund if too much was withheld.
When and how: The LLC must remit these withheld taxes to the IRS periodically (at least quarterly) using special forms (Form 8804/8805). Importantly, the requirement isn’t contingent on actually distributing cash. Even if the LLC doesn’t distribute a dime, it still must pay the IRS the withholding tax on the foreign owner’s share of the profits. In practice, many LLCs with foreign members will distribute at least enough cash to cover that tax—otherwise the tax is coming out of the LLC’s coffers (reducing cash in the business). So if you have a foreign member, plan your cash flow accordingly.
FDAP income: Aside from business profits, if the LLC makes certain types of payments to foreign persons, those might require withholding too. The IRS calls things like interest, dividends, rents, or royalties FDAP (“fixed, determinable, annual, or periodical”) income. If your LLC (even as a partnership) pays a foreign person any FDAP income (say, a dividend or interest), it generally must withhold 30% of that payment and send it to the IRS, unless a tax treaty lowers the rate. This usually applies more to corporations, but if an LLC partnership has, for example, foreign investors and distributes U.S.-source interest income to them, that interest would be subject to 30% withholding under these rules (reported on Form 1042-S). The key is, any U.S.-source payment to foreign persons — be it distribution of profits or other income — triggers a withholding obligation for the LLC.
FIRPTA (real estate sales): If your LLC distributes proceeds from the sale of U.S. real estate that was owned by the LLC and one of the owners is foreign, there’s another twist. Under FIRPTA (Foreign Investment in Real Property Tax Act), when a foreign person disposes of U.S. real property, the buyer (or the partnership) must withhold 15% of the amount realized. In an LLC context, that means if the partnership sold property and is distributing the gain to a foreign member, the LLC might need to withhold a chunk for the IRS. This is a more specialized scenario, but it shows how layered the withholding requirements can be with foreign involvement.

Bottom line (for foreign owners): Yes, an LLC absolutely must withhold federal taxes on distributions (and allocated profits) to foreign members. The IRS makes the LLC the “withholding agent” in this case, responsible for capturing the tax before the money leaves the U.S. If you’re bringing in a non-U.S. partner/shareholder, be prepared to navigate these rules carefully – failure to withhold when required can lead to hefty IRS penalties for your LLC.

LLCs Taxed as Corporations: Distributions as Dividends

So far, we’ve focused on LLCs as pass-through entities. But what if an LLC elects to be taxed as a C corporation (or by default is classified as such, in the rare case this happens)? In that scenario, the LLC’s distributions are treated as corporate dividends to shareholders. How is withholding handled for those?

Domestic shareholders: If the LLC is taxed as a C corp, it pays corporate income tax on its profits. When it distributes after-tax profits to shareholders as dividends, there is no federal withholding on those dividends for U.S. shareholders. For example, if you own stock in a regular corporation like Apple and get a dividend, the corporation doesn’t withhold income tax from it; you simply report the dividend income and pay tax yourself. The same is true here: a dividend from your LLC-turned-corporation to a U.S. owner comes without withholding. (One exception: if a U.S. shareholder hasn’t provided a taxpayer ID or is subject to backup withholding for some IRS reason, then there could be a backup withholding at 24%. But that’s an uncommon scenario and not specific to LLCs.)
Foreign shareholders: If the LLC (as a C corp) has foreign shareholders receiving dividends, the corporation is required to withhold on those dividends. U.S.-source dividends to nonresident aliens or foreign entities have a default 30% withholding tax (again, tax treaties may reduce this). The LLC-corp would send that 30% to the IRS and the foreign owner gets a net 70%, along with a form (1042-S) at year-end detailing the tax withheld. In short, corporations do act as tax withholding agents when distributing profits to foreign owners, similar in spirit to the partnership case. The difference is that with a corporation, it’s specifically on the dividend distribution itself (since the corp already paid its own income tax on profits), whereas with a partnership it’s on the allocable profit.
Employee wages vs. dividends: Also note, if an LLC is taxed as a C corp and the owners work in the business, they might also be employees drawing salaries. Salaries, as always, are subject to normal payroll withholding. But the dividend portion is not subject to payroll or income tax withholding for U.S. owners.

Summary for federal law: Under federal tax law, an LLC usually does not withhold tax on distributions to U.S. owners. The owners pay the tax themselves. However, for foreign owners, the LLC must withhold and remit tax to the IRS on their behalf. And if an LLC is operating as a corporation, it follows corporate rules: no withholding on domestic dividends, but yes on foreign-held dividends.

Next, we’ll explore how things can change when state tax laws come into play – because each state has its own say in whether an LLC should withhold state income taxes on distributions.

State-Level Nuances: When States Demand Withholding on LLC Distributions

After navigating federal rules, you might be thinking, “Great, so usually no withholding… except for foreign situations.” But don’t relax just yet. State tax laws can introduce new twists. Many states require LLCs and other pass-through entities to withhold state income taxes on distributions or allocated income to nonresident owners. This is a mechanism for states to make sure they collect tax from out-of-state owners who might otherwise dodge filing a return.

Here’s what you need to know about state-level tax withholding on LLC distributions:

States want their cut: If your LLC operates in State A but one of your members lives in State B (or is a foreign resident, for state purposes considered nonresident), State A may require you to withhold State A’s income tax on that member’s share of the income. The logic is, the income was earned in State A, so State A wants to ensure it gets the taxes due from the nonresident. The LLC acts as the middleman to capture that tax when distributions are made (or at least once a year even if not distributed).
Varied rules by state: Not all states have this requirement, but many do. The rules, rates, and thresholds differ from state to state, sometimes significantly. For example:
- California – Requires 7% withholding of California source income from payments (including distributions) to nonresident owners, if the total payments exceed $1,500 in a calendar year. So if your California LLC has a member living in Texas, and you distribute profits to them, you likely need to withhold 7% for California’s tax. California provides forms (like Form 592-B) to report this.
- New York – Takes a slightly different approach: NY requires partnerships and S-corps to remit estimated state tax on behalf of nonresident partners/shareholders throughout the year (via Form IT-2658). This is effectively withholding, although it’s done as quarterly estimated tax payments by the entity. A nonresident owner can file an exemption certificate if they promise to handle taxes themselves, but otherwise the entity must pay in. So a New York LLC with a nonresident member has to make those NY tax payments for that member during the year.
- Georgia – Requires a 4% withholding of Georgia-source income for nonresident members, unless a composite return is filed or certain exemptions apply.
- Illinois – Requires pass-through entities to withhold 4.95% (Illinois’ income tax rate) on distributions to nonresident individuals and 7% for nonresident corporations/partnerships.
- Massachusetts – Since 2009, MA mandates withholding on distributions to nonresident members unless the member files a specific exemption form (PTE-EX). Essentially, all pass-through entities in MA must either collect and remit tax on behalf of out-of-state owners or have an exemption certificate on file.
These are just a few examples. Many other states (such as Hawaii, Idaho, South Carolina, Wisconsin, and others) have their own versions of nonresident withholding for pass-through entity distributions.
Who is a nonresident? Generally, this means someone who does not reside in the state where the LLC’s income is sourced. Note that if your LLC does business in multiple states, you might have to consider withholding for owners for each state’s portion of the income. For instance, if a Colorado LLC has income from Colorado and California, and an owner lives in New York, you may have both Colorado and California nonresident withholding obligations for that owner’s respective income from each state.
Thresholds and exemptions: States often set a minimum threshold (like California’s $1,500) before withholding kicks in. Small distributions might be exempt. Also, many states allow an owner to “opt out” of withholding by filing a form promising to file a state return and pay the tax themselves. If they do that, the LLC can skip withholding for that owner. Another alternative in some states is composite returns, where the LLC files a single tax return on behalf of all its nonresident owners and pays the tax due for them (so individual owners don’t file separate returns in that state). If a composite return is filed, separate withholding on each distribution may not be required. The specifics vary, so it’s important to check each relevant state’s rules.
Does it apply to resident owners? No, state nonresident withholding rules only require withholding for owners who are not residents of that state. If all your LLC’s owners live in the same state where the business operates, you generally don’t have to worry about state withholding on distributions – those owners will just pay tax in their home state as usual. The rule is targeting out-of-state folks.
How the math works: Suppose your LLC in State X has $100,000 of taxable income sourced in State X, and a 50% owner who lives out of state. If State X’s nonresident withholding tax rate is 5%, the LLC might be required to withhold $100,000 * 50% * 5% = $2,500 for that owner’s state tax and remit it to State X’s tax agency. Then at year-end, the owner gets a credit of $2,500 on their State X tax return (since tax was prepaid for them).
Penalties for not withholding: Just like the IRS, states can impose penalties and interest if an LLC fails to withhold when required. The LLC itself can be on the hook for the taxes that should have been withheld. This can catch LLC managers off guard – you might distribute profits, not withhold anything, and then get a bill from the state months later for the tax plus penalties. So compliance is important.

In summary, at the state level, many states require LLCs to act as tax withholding agents for distributions to nonresident owners. The rules aren’t uniform, so you must check each state where your LLC earns income. If your LLC has only local owners, state withholding likely isn’t an issue. But if you have out-of-state investors or partners, be prepared to possibly withhold state income tax on their share of the earnings. It’s an extra layer of tax planning that LLC owners need to consider beyond federal law.

Key Concepts Explained: LLCs, Distributions, and Withholding Tax

Before we proceed to examples and pitfalls, let’s clarify some key terms and concepts to ensure we’re on the same page:

LLC (Limited Liability Company): A business structure that offers liability protection to owners (members) and flexible tax treatment. An LLC itself isn’t a tax type; it can be taxed as a sole proprietorship, partnership, S corporation, or C corporation, depending on elections and number of owners. Tax treatment of distributions depends on which of these forms the LLC takes for tax purposes.
Distribution: A payment of profits from the business to the owners. In an LLC, a distribution typically means taking cash (or other assets) out of the company’s accumulated earnings and giving it to members in proportion to their ownership (unless the operating agreement specifies otherwise). Distributions are not the same as salaries or wages. They represent profit that’s already been taxed (in the case of pass-throughs) or will be taxed to the owner (in case of corporations when they report dividends). For pass-through LLCs, you might receive a distribution and still owe tax on more than that if some profit was left in the company. Conversely, you might owe tax on profit even if you got no distribution (common in growth companies that reinvest earnings).
Withholding Tax: A system of collecting income tax at the source of the income. The payer of income withholds a portion and remits it to the tax authority on behalf of the recipient. The most familiar example is an employer withholding tax from an employee’s wages. But withholding can also apply to other payments – like interest, dividends, certain gambling winnings, and, relevant to us, distributions to nonresidents (state or foreign). The purpose of withholding is to ensure tax is collected in a timely manner, rather than waiting until a year-end tax return. It’s essentially a prepayment of tax.
Pass-Through Entity: A business entity (like a partnership, LLC, or S corp) that does not pay entity-level income tax. Instead, the income “passes through” to the owners’ personal tax returns. The owners then pay income tax on it. In pass-throughs, because the entity doesn’t pay tax itself, there’s usually no withholding at the entity level for domestic owners. The owners might need to pay estimated taxes individually to cover their tax liability.
C Corporation (as opposed to pass-through): A corporation (including an LLC electing to be treated as one) that pays its own corporate income tax. If it distributes profits to shareholders (as dividends), the shareholders pay tax again on those dividends. There’s no pass-through of profit; instead, it’s potentially double-taxed (once at corporate level, once at individual level on dividends). Withholding can come into play on those dividends if they go to foreign shareholders, as discussed.
Nonresident vs. Resident (State context): For state taxes, a nonresident owner is someone who does not reside in the state where the LLC’s income is earned. A resident owner lives in that state. States only care about withholding for nonresidents, since residents will file a normal return anyway.
Nonresident Alien (Federal context): A person who is not a U.S. citizen and not a resident for tax purposes (for example, someone living abroad who invests in a U.S. LLC). These persons are subject to special tax rules and withholding, as we covered under foreign members.
Withholding Agent: The person or entity responsible for withholding tax and remitting it. If your LLC has a withholding obligation (to the IRS for a foreign member, or to a state for a nonresident member), the LLC (or its managing member) is the withholding agent in the eyes of the law. That carries legal responsibility — if you don’t do it correctly, the government can come after the LLC for the money.
Form K-1: A tax form given to owners of pass-through entities (partnerships, S corps) each year, showing their share of the entity’s income, deductions, and credits. The K-1 is how the LLC reports to you (and the IRS) what your taxable share of the profit is. Important point: K-1 income is what you pay tax on, not necessarily the cash you received. There is no withholding shown on a K-1 (except in some cases it might list any tax the partnership paid on your behalf, like foreign withholding or state composite taxes, which you then claim as a credit). If your LLC withheld tax for you (say, for state nonresident tax), you’d usually get a separate statement or form indicating that, so you can claim it.
Composite Tax Return: An optional filing in many states where a pass-through entity files a single tax return covering all (or many) of its nonresident owners. The entity pays the tax for those owners as a group. This often can satisfy the state’s requirement instead of withholding from distributions. Owners included in a composite return typically don’t file their own separate return in that state. It simplifies life for the owners, though the tax might be calculated at a flat or top rate. Composite returns are a way to handle multi-owner, multi-state situations efficiently.
Tax Distribution (in an operating agreement): Although not a legal requirement, many LLCs include a clause in their operating agreement for “tax distributions.” This means the LLC will distribute enough cash to cover the members’ estimated tax bill on the LLC’s profits, even if they wouldn’t otherwise distribute that much. For example, if the LLC earned a profit of $100,000 and an owner’s share is $50,000, the LLC might issue a tax distribution of $50,000 * 40% = $20,000 to that owner so they have cash to pay the taxes due (assuming roughly 40% combined tax rate). This is not tax withholding – the LLC isn’t paying the tax to the IRS directly – but it’s a way to help owners meet their tax obligations. It prevents situations where owners owe tax on profits that were never distributed (the classic “phantom income” problem). If you’re structuring an LLC with multiple owners, considering a tax distribution policy is wise to keep everyone happy at tax time.

Understanding these terms lays the groundwork. Now, let’s bring it all together with some concrete scenarios to illustrate when an LLC would or wouldn’t withhold taxes on distributions.

Examples and Scenarios: When Does an LLC Withhold Tax (and When Not)?

To make this very tangible, let’s walk through a few typical scenarios that cover the spectrum of LLC tax withholding situations. Below we break down three common scenarios and how tax withholding is handled in each.

Scenario 1: LLC with All U.S. Resident Members (No Withholding Required)

Example: Alice and Bob form AB Consulting LLC in their home state, and both are U.S. citizens living in that state. The LLC is a partnership for tax purposes. In 2024, the LLC earns $200,000 in profit. They decide to distribute $150,000 and leave $50,000 in the business for growth.

Tax outcome: For federal tax, AB Consulting LLC will issue K-1s to Alice and Bob splitting the $200,000 profit (say 50/50, so $100k each). Alice and Bob will each report $100k of income on their personal tax returns and pay tax on it. The LLC does not withhold any federal income tax from the $75k each it distributed to them. Alice and Bob are expected to pay their own estimated taxes to the IRS for that income during the year.

For state tax, since both owners live in the same state the business operates in, no state nonresident withholding is needed. They will each pay state tax on their share via their personal returns, just like federal.

Important: Even though the LLC only distributed $75k to each, Alice and Bob owe tax on $100k each (the full profit share). They need to have budgeted for the tax on that extra $25k retained in the business. This is where they might use the distribution they got to cover the tax bill, or perhaps the LLC made a tax distribution. But again, that was not a withholding – it’s just internal planning.

Scenario 2: LLC with a Foreign Member (Federal Withholding Required)

Example: Globalco LLC has two members: Charlie (a U.S. resident) and Delta Corp (a company based in Germany). They own 50/50. Globalco LLC operates in the U.S. and is treated as a partnership for U.S. tax. The LLC made $1,000,000 in effectively connected taxable income this year. They distribute half the profits to the owners and retain half for expansion.

Tax outcome: For Charlie (U.S. owner): $500k of income is allocated; he pays U.S. tax on that via his personal return (no federal withholding by the LLC, same as scenario 1). For Delta Corp (foreign owner): $500k of income is allocated to this German company. Here’s the big difference – the IRS requires Globalco LLC to withhold tax on Delta’s share. Because Delta is a foreign corporation, the LLC withholds at the corporate rate (21%) on the $500k. That’s $105,000 withheld and sent to the IRS. When Globalco actually distributes profits, say it distributed $250k to Delta (half of its share, since they distributed half the profits), the LLC would send the distribution net of withholding. In other words, out of Delta’s $250k cash distribution, $105k went to the IRS and $145k went to Delta. Even if Globalco didn’t distribute the cash, it would still owe that $105k to the IRS for Delta’s tax. At year-end, Globalco will give Delta a Form 8805 showing $500k of income allocated and $105k tax paid on its behalf. Delta can use that to claim credit if it files a U.S. tax return, or that might just be the final tax.

State considerations: Suppose Globalco LLC is in California. California treats foreign members as nonresidents for state tax and would require withholding at 7% of the California-sourced income for Delta as well. If the $500k was all CA source, that’s another $35,000 withheld for CA. So Delta ultimately gets less because both IRS and California took a cut via withholding.

Important: In this scenario, withholding was mandatory and significant. Charlie got his distribution without any tax withheld, but Delta’s distribution had substantial withholding. The LLC had to navigate complex forms and deposit schedules to comply. If Globalco LLC had failed to do this and paid Delta the full amount, the IRS could come after Globalco for that $105k (plus penalties). So, for any LLC owners reading this with foreign partners or investors: do not overlook your withholding obligations. The taxes involved can be large.

Scenario 3: LLC with Out-of-State Members (State Withholding Required)

Example: XYZ LLC is formed in Florida and does business in Florida and Georgia. It has two members: Erin (lives in Florida) and Farah (lives in Georgia). They split profits 50/50. In 2024, XYZ LLC’s Georgia-source income is $100,000, and Florida-source income is $100,000 (Florida has no state income tax, but Georgia does). They distribute all profits to the owners at year-end: $100k to Erin and $100k to Farah.

Tax outcome: Federal: Each gets $100k K-1 income, and each pays their federal tax. The LLC does no federal withholding (both are U.S. persons).

State:

For the Georgia-source $100k allocated to Farah (a Georgia resident) and Erin (a Florida resident): Georgia will tax both of them on that income (Georgia taxes nonresidents on GA-source income). Georgia’s rules require the LLC to withhold 4% of the Georgia-source income for any nonresident member. Erin is a nonresident of GA (she’s a Floridian), so the LLC must withhold Georgia tax on Erin’s share of GA income. Erin’s share of GA income is $50k (half of $100k), so at 4%, XYZ LLC withholds $2,000 for Georgia tax from what it pays Erin. Farah, on the other hand, is a Georgia resident, so no GA withholding is required on Farah’s portion – Farah will just pay GA tax on that $50k as part of her individual GA return.
For the Florida-source $100k: Florida has no income tax on individuals, so there’s no state tax to worry about for that portion at all. Neither Erin nor Farah owes state tax on the FL income (one of the perks of Florida).
Summing it up: Erin receives $100k profit distribution minus $2k Georgia tax withheld = $98k net to her, plus a credit in Georgia for $2k of tax paid on her behalf. Farah receives her full $100k distribution (no FL tax, and GA didn’t require withholding on her since she’s a resident, though she’ll pay GA tax when she files her return).

Important: The LLC needed to register with Georgia’s Department of Revenue to remit that withholding for Erin, and provide her a statement of the amount. If XYZ LLC had failed to withhold for Erin, Georgia could later bill the LLC for that $2k (plus interest). Note that even though Erin lives in Florida, she is subject to Georgia tax on the Georgia income – paying through withholding simplifies her obligation. She will likely still file a GA nonresident return to reconcile the actual tax vs. withheld amount.

These scenarios highlight how the need for withholding depends on the mix of member residency and tax status. Here’s a quick reference table summarizing the three popular scenarios and whether tax withholding applies:

Scenario	Federal Withholding?	State Withholding?
All LLC members are U.S. residents (LLC taxed as partnership or S corp)	No. The LLC does not withhold federal income tax on distributions to domestic members. Each member pays their own tax on profits via quarterly estimates and annual returns.	No (if all members reside in the business’s home state). State tax is paid by members individually through their returns. No special withholding required since there are no out-of-state owners.
LLC has a foreign (non-U.S.) member (pass-through taxation)	Yes. The IRS requires withholding on a foreign member’s share of income. The LLC must typically withhold at the top applicable rate (e.g. 37% for individuals, 21% for corporations) on the foreign owner’s portion and remit it to the IRS.	Yes, likely. Most states treat foreign owners as nonresidents. If the LLC’s income is sourced in a state that has income tax, it usually must withhold state tax on the foreign member’s share (rate and rules vary by state).
LLC has out-of-state members (Nonresident for state purposes)	No. Federally, as long as members are U.S. persons, there’s no federal withholding, even if they live in different states. The IRS doesn’t withhold for interstate differences.	Yes, in many states. If an owner lives out of state, the state where the LLC operates often requires withholding on that owner’s share of income. For example, an LLC in CA must withhold 7% of California-sourced distributions for any member who is an out-of-state resident (over the annual threshold). Each state’s rates and rules differ.

Note: If an LLC is taxed as a C corporation, distributions are dividends. There’s no federal or state withholding on dividends to U.S. shareholders, but yes, 30% federal withholding on dividends to foreign shareholders (and state withholding might apply to nonresident shareholders in some cases). That scenario is less common for small LLCs, but worth remembering.

By examining these scenarios, you can identify which situation matches your LLC and know whether you need to worry about withholding taxes on distributions. Next, let’s look at some common mistakes LLC owners make in this area and how to avoid them.

Common Mistakes to Avoid with LLC Distribution Taxes

Navigating LLC taxes can be tricky. Here are some common mistakes and pitfalls related to distributions and withholding, and how you can avoid them:

Mistake 1: Assuming “No Withholding” Means “No Tax.” Some new LLC owners think that if the LLC isn’t required to withhold taxes on distributions, then those distributions aren’t taxed at all. Wrong! Whether or not tax is withheld, if you have profit, you owe tax on it. No withholding just means it’s on you (the owner) to pay the tax via estimates and your return. Always set aside money for taxes on your LLC profits, even if you don’t see anything withheld up front.
Mistake 2: Confusing Distributions with Salary. If you come from a corporate job, you’re used to income tax coming out of your paycheck. LLC distributions are not a paycheck. Do not attempt to put your member distributions on payroll or withhold income tax as if you were an employee (unless you really are paying yourself a salary in an S corp scenario, which is separate). Owners of an LLC (in a partnership or sole prop setup) generally aren’t employees, so you don’t send the IRS a W-2 or withhold federal income tax from their profit draws. Misclassifying an owner as an employee without proper setup can cause tax reporting nightmares.
Mistake 3: Forgetting Self-Employment Tax. Federal income tax might not be withheld on your distribution, but if you’re an active member in a partnership LLC, you likely owe self-employment tax (Social Security and Medicare) on your share of the income. This isn’t “withheld” by the LLC like a payroll tax, but you need to calculate it and pay it with your tax return (or estimated taxes). Ignoring this can lead to a big unexpected tax bill. Self-employment tax is roughly 15.3% on your net earnings from self-employment (with some adjustments). S corp owners avoid self-employment tax on distributions, but they have to run reasonable wages for themselves instead.
Mistake 4: Missing Foreign Withholding Obligations. We can’t emphasize this enough: if you have a foreign investor or partner in your LLC, do not overlook IRS Section 1446 withholding. A common error is a small partnership taking on a foreign partner and nobody realizing they had to file Forms 8804/8805 and pay taxes quarterly for that partner. The penalties for not doing required foreign withholding can be severe (the IRS can charge the tax you should have withheld, plus interest and penalties that can equal a large percentage of that tax). Always check owner citizenship/residency status. Have foreign partners fill out Form W-8BEN or W-8BEN-E to document their foreign status and any treaty claim, and consult a tax professional to set up the proper withholding routine from day one.
Mistake 5: Ignoring State Withholding Rules. It’s easy to focus on the IRS and forget state taxes. But states notice when money leaves their borders. A mistake is distributing all profits to out-of-state owners and not withholding state tax when required. States like California, New York, etc., will eventually notice from your K-1 filings or composite return absence that there were nonresidents with income. They may send a notice billing the LLC for back withholding. Avoid this by researching or asking a CPA about every state where your LLC does business. File any required state withholding forms or composite returns on time.
Mistake 6: Assuming “It’s Just a Small Amount, I Can Ignore It.” Maybe you have a foreign partner who only gets a few thousand dollars of profit, or an out-of-state partner who earned $500 from your LLC. You might think that’s too minor for the IRS or state to care. Be careful: legally, there’s often no de minimis exemption at the federal level for foreign withholding (tax is owed on any U.S. profit, though if it’s very small, practically it might slip through). States sometimes have small thresholds like $1,000 or $1,500. Know those rules – if you cross the threshold, even by $1, you must withhold. Don’t gamble by ignoring a requirement just because the amount seems small. Penalties can often far exceed the tax itself in those cases, ironically.
Mistake 7: Not Documenting Distributions and Withholdings Properly. Good record-keeping is essential. If you do withhold taxes for someone, make sure it’s documented and reported correctly (e.g., issuing the right forms like 1042-S for foreign payments or state equivalent forms to owners). Likewise, keep clear records of distributions to each member. This will help in preparing K-1s and ensuring basis calculations (each member’s investment basis in the LLC is affected by income and distributions, which matter for future tax events).
Mistake 8: Failing to Make Timely Tax Payments. If you are required to withhold taxes, those funds aren’t yours to keep until year-end – they often must be deposited quarterly or even monthly. Missing a deposit deadline for withheld taxes (federal or state) can trigger penalties. Put those due dates on your calendar and set aside withheld funds so you’re not caught short when it’s time to pay the tax authorities.

By being aware of these mistakes, you can take proactive steps to avoid them. Now, let’s discuss some best practices to handle LLC distributions and taxes correctly, ensuring you stay compliant and worry-free.

Best Practices for Handling LLC Distribution Taxes

To wrap up the main content, here are expert tips and best practices for managing tax on LLC distributions smoothly:

1. Know Your Tax Classification: Clearly identify how your LLC is taxed (partnership, S corp, C corp, or disregarded). This determines the rules for distributions. For example, if you have an LLC taxed as an S corp, remember that profits pass through and no withholding on distributions, but you should be running payroll for yourself with withholding on that portion. If you’re taxed as a partnership, no one should be on payroll just for being an owner (only for actual employment jobs), and no withholding on distributions for domestic members.
2. Identify Owner Residency and Status Early: Make a habit of collecting tax information from members when they join. For U.S. persons, that’s usually a Form W-9 (with their SSN/EIN and certification of U.S. status). For foreign persons, a Form W-8BEN or W-8BEN-E. This will tell you who is foreign vs. U.S., and where they claim residency. Also note states of residence for each member. Keep this info updated if people move or ownership changes. This groundwork will flag if you need to implement withholding for any owner.
3. Plan for Taxes (Don’t Wait Until April): Since LLCs often don’t withhold tax for domestic owners, it’s critical for owners to plan for their tax bill. A best practice is to calculate an estimated “tax bite” percentage for your profit and set aside that portion of each distribution (or have the LLC do it on behalf of members via tax distributions). For instance, if combined federal/state tax rate for owners is roughly 30%, and you distribute $10,000, set aside $3,000 for the eventual tax. This prevents nasty surprises and cash crunches at tax time. Encourage your co-members to do the same.
4. Use Tax Distributions in Multi-Member LLCs: If you’re drafting an operating agreement or just informally agreeing among owners, consider periodic tax distributions. These are distributions specifically earmarked to cover members’ tax liabilities on the LLC’s earnings. Usually, the amount is tied to a percentage of the profit allocated (e.g., distribute 35-40% of profit each quarter for taxes). This helps everyone meet their tax obligations and avoids situations where one member might be left owing taxes on profits that were never distributed as cash.
5. Consult Professionals for Foreign or Multi-State Situations: Once you have any complexity – a foreign owner, operations in several states, etc. – it pays to consult a tax professional (CPA or tax attorney). They can help set up the correct withholding accounts with the IRS or states, guide you on filing the right forms, and maybe find planning opportunities (like a treaty benefit for a foreign investor that reduces withholding, or a composite return that simplifies multi-state filings). International tax and state tax compliance can be tricky; don’t go it completely alone if you’re unsure.
6. Stay Compliant with Filings and Payments: If you are withholding taxes, treat those withheld funds as almost sacred. That money belongs to the tax authorities. Remit it on time as required (the IRS has schedules for depositing payroll and foreign withholding, and states have their own deadlines). File any annual reconciliation forms (like federal Form 1042 for foreign payments, or state annual summaries) on time. Also, provide the appropriate statements to your members so they know what was paid on their behalf (K-1s reflecting any credits, copies of any 1042-S or state forms sent to them). Good compliance builds trust with members and avoids penalties.
7. Reevaluate Annually: Laws change, tax rates change, and your LLC’s situation can change. Make it a habit each year to reevaluate: Did we add a new owner from a different state or country? Did a state law change requiring withholding (states occasionally adjust thresholds or rates)? Is the LLC electing a new tax status for next year? By reviewing these items, you can adjust your tax handling proactively. For example, more than 20 states in the last couple of years created an elective Pass-Through Entity Tax (PTET) as a workaround to the SALT deduction cap – if your state has this and you opt in, your LLC might pay state tax at the entity level (and then no withholding needed for that state, since the entity tax replaces it). This kind of election is something to discuss with your CPA to optimize taxes.
8. Keep Communication Open with Members: If you are the managing member handling finances, communicate with your co-owners about tax matters. Make sure they understand how taxes are being handled on LLC income, especially if they’re new to pass-through taxation. If you’re withholding state tax on their behalf or making a composite filing, let them know – they’ll need that information for their own tax prep (and it avoids them accidentally paying double or not claiming a credit). Transparency helps avoid confusion and conflict.

By following these best practices, you’ll maintain compliance and your LLC’s distributions will be smooth and predictable from a tax standpoint. You’ll never have to ask in panic “Were we supposed to withhold something?!” because you’ll have it under control.

Now, to address some lingering questions you might have, let’s move to a quick FAQ section on LLCs and tax withholding on distributions.

FAQ: LLCs and Tax Withholding on Distributions

Q1: Do LLCs have to withhold taxes on distributions to their owners?
A: Not usually for U.S. owners. For domestic members, LLCs don’t withhold federal income tax on profit distributions. However, for foreign owners or nonresident state owners, withholding is often required.

Q2: How do foreign members of an LLC get taxed on distributions?
A: The LLC must withhold U.S. tax (generally 30% or the highest rate) on a foreign member’s share of income before distributing the remainder. The foreign member can then claim that withholding on their tax return.

Q3: What if my LLC didn’t distribute any cash – do I still need to withhold for a foreign partner?
A: Yes. The requirement to withhold for foreign partners is based on allocated profit, not actual cash distributed. The LLC must pay the tax to the IRS even if no distribution was made.

Q4: My LLC is just me (single-member). Do I need to withhold taxes from the money I take out?
A: No. In a single-member LLC (disregarded entity), any money you take out is just treated as your own income/draw. There’s no separate withholding. You should pay estimated taxes yourself on the profits.

Q5: Does an LLC taxed as an S corporation withhold taxes on distributions?
A: No for distributions, yes for salaries. S corp distributions to owners are not subject to tax withholding. But owner-employees must take a reasonable salary, and regular payroll tax withholding applies to that salary.

Q6: What forms does an LLC file if it withholds tax for someone?
A: For foreign persons, the LLC files Form 8804/8805 (and possibly 1042/1042-S for certain payments). For state withholding, it varies by state (e.g., California Form 592, Georgia G2-A, etc.), plus providing info to the owner for credit.

Q7: Are LLC profit distributions themselves taxable?
A: The distributions are not taxed separately. The tax is on the LLC’s profits (allocated to you via K-1). You pay tax on your share of profit, whether or not it’s distributed. Distributions are just withdrawing your after-tax profit (or in corporations, a taxable dividend of after-corporate-tax profit).

Q8: Can an LLC pay tax on behalf of its owners instead of them paying it?
A: By default, for pass-through taxation, owners pay their own tax. But LLCs can facilitate this by withholding (if required by law) or by electing things like composite returns or pass-through entity taxes at the state level. Those are essentially the LLC paying tax for the owners and the owners getting credit.

Q9: What happens if an LLC doesn’t withhold tax when it was supposed to?
A: The LLC can be held liable for the tax that should’ve been withheld, plus interest and penalties. For example, if you fail to withhold for a foreign partner, the IRS can bill the LLC for that partner’s tax. States can do the same for missed nonresident withholding.

Q10: If all LLC members live in different states from where the LLC operates, do we have to withhold for each state?
A: Potentially, yes. Each state where your LLC has taxable income may require withholding for members who are nonresidents of that state. You might end up withholding and remitting to multiple states. Alternatively, you might file composite returns or use other arrangements if allowed.