QUESTION:

We are considering changing our business from a corporation to a limited liability company. Are LLC members who actively participate in a business considered employees who are subject to withholding taxes and self-employment taxes?

ANSWER:

Generally, LLC members are treated the same as partners (or, in a one-owner LLC, as a sole proprietor). In other words, unless compensation is in the form of guaranteed payments, an LLC member's share of profits is not considered wages and is not subject to withholding. Each LLC member simply reports his or her share of LLC profits as income on the member's individual income tax return and pays estimated taxes in quarterly installments.

But note that an LLC member who is active in the business -- like a partner in a partnership -- does have to pay self-employment taxes on any share of LLC profits (except that the member doesn't owe these taxes if the LLC lost money or made less than $400 profit in that business year). If you discover that you have to pay self-employment taxes, know that at least you can deduct half of them as a business expense.

The self-employed tax situation for LLC members has been a subject of controversy and temporary regulations, and the dust has not yet settled around many of the issues. To protect yourself, especially if you are an inactive member of an LLC and don't plan on paying self-employment taxes, you might get an opinion from a local tax expert -- preferably one who is willing to argue his or her opinion to IRS officials, if it comes to that.