LLC vs Sole Proprietorship Self Employment Tax: Everything You Need to Know
When considering LLCs vs sole proprietorship self employment tax, you'll need to look at how your business is structured with an eye to how your tax liability will change. 3 min read updated on February 01, 2023
When considering LLCs vs sole proprietorship self employment tax, you'll need to look at how your business is structured with an eye to how your tax liability will change. The self employment tax, a charge levied by the government on people who work for themselves to make up for the lack of payroll tax deductions, can take the unaware by surprise, leading to unpleasant situations on tax day. But a well-prepared company should have no problems.
Most people have worked for someone else at some point in their lives. If you ever look at your pay stub, you'll notice deductions made for Social Security and Medicare, programs designed primarily to help elderly Americans who have retired. These deductions are called payroll taxes, taken out of your earnings before you ever see them. Your employer pays half of your payroll taxes, and you pay the other half.
It's important to understand that there is a cap on Social Security liability; past $117,000, you pay no more into the system on your excess earnings. Medicare, instead, covers your entire paycheck. If you make over $200,000, the Medicare rate goes up.
The self-employment tax is how you make up for payroll and income taxes on income that isn't from working directly for someone else. This is the tax you pay if you work for yourself, either because you own the company, or because you work freelance. If you are a business, however, you need to make quarterly payments to the IRS, or they will start to look at auditing you.
Taxation and Business Type
The simplest form of business is the sole proprietorship, followed by the partnership. In both forms, the business is largely indistinguishable from its owners. At tax time, the income made by such a business is treated as “pass through” income made by the owners, who report it on their individual income taxes. These companies also have to pay payroll taxes, including Social Security and Medicare, on the entire income of the company.
A corporation, on the other hand, is usually subject to a special tax called the corporate tax. This is a percentage of the money earned by the company. This money is taken out before any profits of the business can be split among its shareholders; the shareholders then pay taxes again on their share of the proceeds. Corporations pay half of the payroll tax of their employees; the employees only have to pay Social Security and Medicare on their salaries. These kinds of corporations are called C Corporations.
S Corporations, set up under special laws designed to foster small American-owned businesses, don't pay the corporate income tax. Instead, they let money “pass through” to shareholders like a partnership or sole proprietorship would. In exchange for this favorable taxation, S Corporations agree to follow strict rules on how their stock works and who it can be sold to. These rules include:
- Only one form of stock can be issued
- Only American citizens or legal non-citizen long-term residents can own the stock. This means that investment funds and other financial instruments cannot invest in S Corporations.
- Only a fixed number of certificates can be issued, usually to at most 100 investors, though family members and spouses count collectively as one investor.
- The business must be based out of the United States.
- Certain kinds of businesses cannot be S Corporations.
LLCs are a formation of local laws, though they exist in some form in all 50 states. As such, LLC status has nothing to do with federal income taxes, though it can affect local state taxes. An LLC can be a “disregarded entity,” letting it be taxed as a sole proprietorship or partnership. It can also count as an S Corporation, as long as it is filed and operates as a corporation. In either case, the LLC's owners have to pay the self employment tax, wherein they are responsible for not only the income tax due on their money, but also the payroll taxes they would have paid were the money coming from a salary.
If you need help with your LLC or sole proprietorship and the self employment tax, you can post your legal need on UpCounsel's marketplace. UpCounsel accepts only the top 5 percent of lawyers to its site. Lawyers on UpCounsel come from law schools such as Harvard Law and Yale Law and average 14 years of legal experience, including work with or on behalf of companies like Google, Menlo Ventures, and Airbnb.