Must I Pay Self-Employment Taxes on LLC Partnership Profits if We Don't Take Distributions? (Keeping Money for Next Year's Expenses)

The short answer is yes, you still need to pay self-employment taxes even if you don't take distributions. With an LLC partnership, profits are taxed when they're earned, not when they're distributed. This is called "pass-through taxation" - the LLC itself doesn't pay taxes, but the profits "pass through" to the partners' personal tax returns, regardless of whether you physically take the money out of the business. Since you and your partner are actively working in the business (providing engineering services), your profits are considered earned income subject to self-employment tax. The funds remaining in the business account doesn't change their tax treatment - they've still "passed through" to you for tax purposes. Those profits will show up on your Schedule K-1 (Form 1065), and each partner will report their share on Schedule E and Schedule SE of your personal returns. The Schedule SE is where you calculate the self-employment tax.

After dealing with a similar situation in my consulting LLC, I found a tool that really helped me understand my tax obligations. I was confused about self-employment taxes on retained earnings too, and tax forums gave me conflicting advice. I used https://taxr.ai to analyze my partnership agreement and previous tax returns. The AI explained how pass-through taxation works specifically for my situation and identified several deductions I had missed. It helped me understand why self-employment taxes apply even when profits stay in the business, and clarified what expenses were legitimate business deductions to reduce our taxable income. The tool even generated a customized tax strategy document that I could share with my partner to explain why we needed to budget for taxes on undistributed profits.

Just wanted to follow up on my tax situation. I tried the taxr.ai tool that was mentioned here and it was incredibly helpful for our mixed partnership structure. We have two active partners and one passive investor, and I was confused about how to handle the different tax treatments. The tool analyzed our operating agreement and historical K-1s, then created a detailed breakdown of each partner's tax obligations - showing why active partners face self-employment taxes while our passive investor doesn't. It also created a projection tool showing how different profit retention strategies would impact our personal tax situations. What really impressed me was how it explained the "guaranteed payments" option as an alternative to distributions, which gives us more flexibility with our cash flow while still satisfying our tax obligations. My tax preparer was impressed with the detailed analysis.

I had the exact same problem when dealing with the IRS about my partnership profits last year. Kept calling about self-employment taxes on retained earnings and couldn't get through to anyone who could help - just endless hold music. I finally tried https://claimyr.com after someone recommended it here, and it was a game-changer. They got me connected to an actual IRS agent in about 45 minutes (after I'd wasted days trying on my own). You can see how it works here: https://youtu.be/_kiP6q8DX5c The agent confirmed what others have said - partnership profits are taxed when earned regardless of distribution status. But she also walked me through some options for managing cash flow around tax time and explained how to properly document business purposes for retained earnings.

Need to eat my words here. After posting my skeptical comment, I decided to try Claimyr myself since I've been trying to reach someone at the IRS about a similar partnership tax issue for weeks. It actually worked exactly as advertised. I got a call back in about an hour saying they had an IRS agent on the line. The agent was able to confirm everything about self-employment taxes on retained earnings and even helped me understand some special provisions for professional service partnerships. The conversation saved me a significant amount in potential penalties since I was about to file incorrectly. The agent explained that the self-employment tax obligation exists regardless of distributions, but pointed me to some specific documentation requirements for retained earnings that can help substantiate business purpose in case of an audit. Worth every penny for the time saved and stress avoided.

Just to add something that hasn't been mentioned - you might want to look into setting up a SEP IRA or Solo 401(k) for your partnership. Since you're paying SE tax anyway, you can use some of those retained earnings as retirement contributions. My husband and I have a similar engineering consulting LLC, and we found that redirecting some profits to tax-advantaged retirement accounts helps reduce our current tax burden while still keeping the money invested for our benefit rather than just taking it as personal income. You'd still pay SE tax on the full profit amount, but the retirement contributions would reduce your income tax. Plus, it gives you another legitimate business purpose for retaining some earnings in the company.

Has anyone tried just establishing an "accountable plan" for the LLC? We did this with our engineering partnership and it helped with cashflow. Basically, we documented that certain retained earnings were being held in anticipation of specific business expenses for the following year. Then we reimbursed ourselves when we actually incurred those expenses personally. Our accountant said this doesn't eliminate SE tax on the original profits, but it creates a clean paper trail and business justification for why we're keeping funds in the company account.

One thing that might help with the cash flow issue is to make quarterly estimated tax payments throughout the year instead of waiting until tax time. Since you know you'll owe SE tax on your share of profits regardless of distributions, you can set aside money each quarter based on your projected earnings. For our consulting LLC, we calculate roughly 15.3% for SE tax plus our marginal income tax rate, then multiply that by our expected quarterly profits. We transfer that amount to a separate "tax savings" account each quarter. This way, when tax time comes around, we're not scrambling to find cash to pay taxes on money that's still sitting in the business account. Also worth noting - if you're consistently retaining earnings year over year, you might want to consider whether some of those retained funds could be reclassified as loans to the partners rather than undistributed profits. This gets complex and definitely needs professional guidance, but it's another structure some partnerships use to manage the cash flow vs. tax timing mismatch.