Navigating Single-Member LLC Self-Employment Tax: A Guide
Should my business form an LLC? I hear this question from many business owners. Although there are non-tax reasons to form an LLC, the biggest consideration for taxes is self-employment tax.
Self-Employment Tax Defined
Self employment tax (SE) is levied on income generated by the tax payer for self employment activities. It is meant to replace the social security and medicare taxes an individual would pay if they were an employee of a company. The rate is 15.3%, subject to income limits. If you are a sole proprietor filing a schedule C on your individual tax return, the net income of the schedule C is subject to self-employment tax.
What is an LLC?
LLC’s are entities formed at the state level, and can have one or multiple members. When there is only one member, the Internal Revenue Service defaults to classifying it as a sole proprietor. When forming an LLC, you must elect to be taxed as a corporation in order to avoid this default.
When there are multiple members of the LLC, the IRS defaults to classifying it as a partnership. IRS rules on what income from a partnership SE tax are complicated, and the IRS aggressively classifies income as subject to SE tax.
What is a Single-Member LLC?
A Single-Member LLC is an LLC with only one member. By default an Single Member LLC is a disregarded entity for federal tax purposes, which means they don't file their own tax return. Single-Member LLCs are sole proprietorships and file on Schedule C of the individual form 1040.
State and local taxation vary by state.
Do LLCs pay self-employment taxes?
LLC's do not pay any federal income tax generally. They are pass through entities that show their income/loss on schedule K-1, which is them reported by the LLC members on their individual tax returns.
By default, if the LLC is taxed as a partnership, all of the operating income flowing through on the K-1 is considered self-employment income and is subject to SE tax.
Can filing as an S corporation reduce self-employment taxes?
Yes, but beware. If you elect S-Corporation status at the onset of the entity, you can potentially limit your income from self-employment. However, if you have already filed a return as a Partnership, there are tax consequences to electing S-Corporation status. Consult a tax professional before you make the change.
When forming a new entity, you can make an election on how they are taxed. You can do this using form 8832. Form 8832 does NOT make the s-corporation election. You will need to separately file form 2553 to accomplish this.
For more information on to use an S-Corporation to limit your SE tax, please read this article.
Conclusion
If you form an single member LLC and don’t elect an alternative tax treatment, your business will still be subject to self employment tax. Just forming an LLC and accepting the default IRS status will do NOTHING for your taxes.
If you form a multiple member LLC and don’t elect the alternative, you probably will still be subject to self employment tax.
In order to receive relief from self employment tax, consider an S-Corporation election. You can read more about that in this article.