When forming a new company, you have a choice of business entities. For most small business owners, electing to be taxed under the Internal Revenue Code as a Subchapter “S” corporation or forming a limited liability company are the obvious choices for the reason that they are “pass-through” entities for income tax purposes, meaning that business profits are not taxed twice as they are in “C” Corporations—first at the company level and then also upon distribution to the shareholders. While this “pass-through” element is a definite advantage, income taxes are not the only tax issue for the small business owner to consider in selecting a business form. Self-employment tax costs and benefits are a significant factor for you to weigh in determining choice of entity.
The Background of Self-Employment Taxes
Self-employed individuals are required to pay a self-employment tax equivalent to the Federal Insurance Contributions Act (FICA) tax rate. While certain amounts are non-taxable (such as rental and dividend income), most earnings are taxable at a rate of 12.4% for the Social Security tax, and 2.9% for the Medicare tax. The Social Security portion caps at a statutory wage rate ($102,000 in 2008) while the Medicare tax has no cap. These taxes can add up: If Amy earns $115,000 from her business, she will pay 12.4% on the first $102,000 and 2.9% on the entire $115,000, making a total self-employment tax liability of $15,983. (One half of this tax liability is deductible, which will reduce the effective tax rate somewhat.) With proper planning and the appropriate choice of business entity, Amy may be able to reduce this tax amount significantly.
Subchapter “S” Corporations
Subchapter “S” corporations (S-corporations) are state law corporations that have elected under federal law to be treated under a different set of taxation rules than ordinary corporations. There are benefits and restrictions to this form, the most notable benefit being the pass-through taxation discussed above. However, S-corporations have a distinct advantage when it comes to self-employment taxes: neither the corporation nor the shareholder has to pay self-employment taxes. However, the shareholder is not off the hook—the corporation must withhold payroll taxes, including Federal Unemployment Tax Act (FUTA) from wages for any employee-shareholder based on the value of that employee’s services. However, the remainder of any distribution is not subject to self-employment or payroll taxes.
Let’s look at Amy’s business again if she had formed an S-corporation and still had profits of $115,000.00. Amy performs services for the corporation with a reasonable value of $75,000. She will pay payroll taxes on the $75,000 equal to $11,475 (75,000 x 15.3%) and may receive a distribution for the rest in the sum of $40,000 free of payroll or self-employment tax. The result: Amy saves $4,508 in payroll taxes!
Limited Liability Companies
Limited liability companies are entities that are a hybrid between corporations and partnerships under state law. In addition to the “pass-through” tax treatment, the limited liability company provides more organizational flexibility than corporations and better asset protection than the traditional partnership forms, such as limited partnerships or general partnerships, making them a strong candidate for some parties. The self-employment tax liabilities, however, are not as simple or advantageous as S-corporations.
Single Member LLCs
If you are the sole owner of a limited liability company, unless you elect to be taxed as a corporation, the company is treated as a “disregarded entity” for federal income tax purposes. This effectively means that for most federal tax purposes (but not other purposes, such as tort liability), the company’s separate existence is ignored and the individual owner is treated as the sole proprietor. For self-employment tax purposes, this means that the entire amount of profits of the LLC is subject to the self-employment tax (limited by the caps on the Social Security portion). If Amy had formed an LLC and earned $115,000 through it, she would owe $15,983, exactly the same amount as she would have owed in employment taxes if she had not formed an LLC.
The IRS has attempted to address self-employment taxes for multi-member LLC’s. Under proposed regulations (put into place in 1997, but which have neither been formally adopted nor cancelled), the IRS treats LLC members as partners in a limited partnership. Generally speaking, for purposes of the self-employment tax, only the income a limited partner receives for services rendered is taxable. This sounds a lot like the S-corporation description above where Amy was only taxed on the compensation she received for services provided. There is a distinct difference, however: this treatment only applies to “limited partners.”
Under traditional state law, limited partnerships were comprised of “limited partners” who were typically passive investors, and one or more “general partners” who ran the partnership and were liable for its debts. The IRS has adopted its own definition of limited partners for the purposes of self-employment taxation, and has applied the definition to LLCs. Although there are several exceptions, generally, a member of an LLC will be treated as a limited partner so long as the individual avoids personal liability for the company, works less than 500 hours for the LLC, and avoids general power to contract in the name of the LLC. This situation is much more likely to be available in a “manager-managed” LLC (which is structurally similar to a corporation with managers acting like a board of directors and members acting like shareholders), although it may be possible to structure a “member-managed” LLC (which is structurally similar to a partnership) to create “limited partners” for self-employment tax purposes.
If Amy and John form an LLC, and Amy manages and contracts on behalf of the company, she will have to pay self-employment tax on the entire amount, subject to the applicable cap for Social Security taxes. This means that if Amy’s share of the profits is $115,000, she will have to pay self-employment tax equal to the $15,983 she would have if she had earned the same profits as a sole proprietor. By contrast, if John invested money for his membership interests, but does not manage the company, and provides 500 or fewer hours of services for the company, then only the share of his distribution attributable to the reasonable value of such services is subject to the self-employment tax. Let’s say John’s share of the LLC profits are $115,000, and John has performed 250 hours of work, which have a value of $10,000. John will pay self-employment tax equal to $1,530 ($10,000 x 15.3%) but the remaining $105,000 of his distribution will not be subject to the self-employment tax. This is essentially the same treatment as he would receive if he were a shareholder in an s-corporation.
To put an interesting (and somewhat complicated) spin on the above scenario, the proposed regulations also provides an exception whereby a member with management authority (Amy) may still be able to limit her self-employment tax liability to a portion of the distribution if the LLC has limited partners (John) with a substantial interest in the company, and a class of the managing member’s (Amy’s) interests are identical to the limited partners’ (John’s) interests. Even without another independent investor, you may be able to make your spouse or children a limited partner, and bring your self-employment tax liability closer in line with an S-corporation.
The above scenarios are just some of the possibilities available to you when you choose your business form, and even more elaborate arrangements are available (you may even elect to treat an LLC as an S-corporation and receive some of the benefits of both!). Self-employment taxation is just one important aspect of many that should influence your choice of business entity, and our attorneys can help discuss these options with you.