Does the Owner of an LLC Need to Pay Self-Employment Tax?
Operating under an LLC business structure provides numerous benefits. In addition to limiting personal liability, LLC’s receive pass through treatment, allowing owners to avoid double taxation.
Depending on the number of members, the IRS treats an LLC like a sole proprietorship or partnership. For single-owner LLCs, the sole owner reports all profits of the LLC on a Schedule C. This is then submitted with their 1040 individual tax return. This isn’t much different than multi-owner LLCs, which are treated like partnerships for tax purposes. Each member or co-owner of the multi-owner LLC pays taxes on their share of the profits through a Schedule E, which is then filed with their personal income tax return.
While most LLC owners understand their income tax liability, many struggle to understand whether or not they need to pay self-employment tax. In fact, this is one of the most common tax-related questions.
What is Self-Employment Tax?
When you work for an employer, Medicare and Social Security taxes get automatically deducted from each paycheck. This doesn’t happen when you’re self-employed. Instead, the owners of pass-through entities must pay self-employment tax themselves.
Self-employment tax is calculated at 15.3% of net business income. 12.4% of this amount goes to Social Security and 2.9% goes to Medicare. However, if business income exceeds a certain amount, taxpayers must pay an additional Medicare tax of 0.9%. The IRS income limit for the reduced amount varies from $125,000 to $250,000 depending on filing status.
Pass-through business types subject to self-employment tax include sole proprietors, independent contractors and freelancers, individual partners of partnerships, S corporation owners, and most limited liability company (LLC) owners.
What Type of Income is Exempt from Self-Employment Tax?
LLC owners must pay self-employment tax on most, if not all, business income. However, passive income is not subject to self-employment tax. Passive income includes income earned from rental properties, real estate investments, limited partnerships, or other business activities in which the owner of the LLC is not actively involved.
Can An LLC Reduce Self-Employment Tax Liability?
Making an S Corp election with the IRS cannot eliminate self-employment tax liability completely, but it may allow you to reduce the amount you owe. With an S Corp, the owner(s) pay themselves a salary out of all business earnings. They then distribute the remaining profits to other shareholders or partners. One benefit of this model, only the salary of the owner(s) is subject to self-employment tax. While owners must still pay income taxes on distributions received outside of their wages, they may not have to pay self-employment tax on these earnings.
Another option, LLCs can elect classification as a C Corporation. While C Corps pay income tax on all profits, these profits do not flow through the owners’ tax return. Much like an S Corp, each shareholder pays a portion of the FICA taxes on their wages. However, it’s important to note that not all LLCs will benefit from this election. The IRS imposes double taxation on C Corps. C Corps pay taxes on business profits on both a corporate level and individually on each shareholder’s personal tax statement. An experienced tax professional can help you determine if your organization could benefit from a C Corp election.
It’s important to remember that different tax rules apply to different types of businesses and state tax laws governing LLCs may vary. Always contact an experienced tax advisor if you are unsure of your tax liability.
TMDL provides tax planning and preparation for both individuals and businesses. Our team has years of experience and strives to keep our clients informed of the ever-changing tax environment. Please contact us for more information about our services.