W-2 vs. K-1: How Employee and Pass-Through Income Are Taxed Differently

A W-2 is a statement of wages paid to you as an employee. A K-1 is a statement of your share of income, deductions, and credits from a partnership, S-corporation, trust, or estate. They look similar - both land in your mailbox in late January, both flow to your Form 1040 - but they create very different tax obligations. The W-2 employer has already handled income tax withholding and FICA. The K-1 has done none of that. If you receive a K-1 and treat it like a W-2, you will owe a substantial underpayment penalty.

The Core Difference

W-2 (employee): Employer withholds federal income tax each paycheck and remits it to the IRS on your behalf. Employer also withholds and matches FICA - 7.65% from your pay, 7.65% from the employer. Box 1 is your taxable wages. The IRS already has your money by April 15.

K-1 (partner or S-corp shareholder): The entity does not withhold income tax on your behalf. You receive your share of the entity's income and are responsible for paying estimated taxes quarterly on that income. If you are a general partner or LLC member treated as self-employed, self-employment (SE) tax of 15.3% applies to net earnings - you pay both halves because there is no "employer."

K-1 from a Partnership or LLC

A partner's distributive share of partnership income - shown on Schedule K-1 (Form 1065) - flows to the partner's individual return regardless of whether any cash was actually distributed. If the partnership earned $500,000 and you own 20%, you have $100,000 of taxable income even if the partnership retained all cash and paid you nothing. This phantom income issue is one of the most common surprises for new partners.

For general partners and members of LLCs treated as partnerships: net earnings from self-employment (your share of ordinary business income plus guaranteed payments) are subject to self-employment tax under IRC §1402. SE tax is 15.3% on the first $184,500 (2026 - verify with IRS) and 2.9% above that. The SE tax deduction (one-half of SE tax) reduces AGI.

Limited partners and LLC members with purely passive roles may avoid SE tax on their K-1 ordinary income. Under IRC §1402(a)(13), a limited partner's distributive share (other than guaranteed payments) is excluded from self-employment income. The IRS has litigated the distinction between limited partners and active LLC members for decades. If you perform services for the partnership, your share of ordinary income is likely subject to SE tax regardless of your title.

K-1 from an S-Corporation

The S-corp K-1 (Schedule K-1, Form 1120-S) works differently. Ordinary income passed through on the K-1 is not subject to self-employment tax - this is the fundamental tax advantage of S-corp status over a sole proprietorship or partnership. However, a shareholder-employee who performs services must receive reasonable compensation as W-2 wages. The W-2 wages are subject to FICA; the K-1 distribution above wages is not. This creates the W-2 + K-1 structure that S-corp owners use and that the IRS scrutinizes in audits.

An S-corp owner who receives only K-1 distributions and no W-2 salary is not compliant. IRS Revenue Ruling 74-44 holds that shareholder-employees must receive reasonable compensation as wages. Characterizing all income as distributions to avoid FICA is the most commonly audited S-corp issue. The IRS can reclassify distributions as wages and assess back FICA plus penalties. Reasonable compensation should reflect what you would pay a third party to perform your services.

Estimated Tax: The K-1 Holder's Obligation

Because K-1 income has no withholding, the recipient must make quarterly estimated tax payments to avoid underpayment penalties under IRC §6654. The safe harbor is 100% of prior-year tax liability (110% if prior-year AGI exceeds $150,000). Payments are due April 15, June 15, September 15, and January 15. K-1 income is often unpredictable - partnership income can spike in the fourth quarter as year-end transactions close, creating underpayment exposure even when prior-year safe harbor is used.

Authority: IRC §3401 (wages defined for income tax withholding - wages paid to employee by employer; employer required to withhold income tax; W-2 reporting); IRC §3102 and §3111 (FICA - employee share withheld by employer; employer pays matching share; total 15.3% on wages up to Social Security wage base); IRC §1402 (self-employment income - partner's distributive share of partnership ordinary income is self-employment income; limited partner exception under §1402(a)(13); guaranteed payments subject to SE tax); IRC §1401 (SE tax - 15.3% on net earnings from self-employment up to Social Security wage base; 2.9% above; additional 0.9% Medicare surtax for high earners); IRC §702 (partner's distributive share - reported on Schedule K-1 Form 1065; taxable to partner whether or not distributed; "phantom income" issue for partners); IRC §1366 (S-corp shareholder income - passed through on Schedule K-1 Form 1120-S; ordinary income not subject to self-employment tax; requires reasonable W-2 compensation for shareholder-employees); Rev. Rul. 74-44 (S-corp shareholder-employees must receive reasonable compensation as wages; distributions without reasonable compensation subject to FICA reclassification); IRC §6654 (failure to pay estimated tax penalty; safe harbor at 100%/110% of prior-year tax liability; quarterly payment due dates); Schedule K-1 Form 1065 (partner's share of income, deductions, credits; Box 1 ordinary income; Box 14 self-employment earnings); Schedule K-1 Form 1120-S (S-corp shareholder's share; Box 1 ordinary income; not subject to SE tax).

W-2 vs. K-1: How Employee and Pass-Through Income Work

K-1 from a Partnership or LLC

K-1 from an S-Corporation

Estimated Tax: The K-1 Holder's Obligation