Self Employed vs LLC: Everything You Need to Know
There are some differences between a self employed vs LLC business.3 min read
2. Limited Liability Coverage
3. Pass-Through Taxation
4. Tax Deductible Compensation
5. How Can An LLC Avoid Self Employment Tax?
Updated June 25, 2020:
Self Employed vs LLC
There are some differences between a self employed vs LLC business. However, someone who is in fact self employed can create his or her own LLC. There are many reasons why someone who is self employed might create an LLC, including the following reasons:
- Limited liability coverage
- Pass-through taxation
- Ability to earn compensation and have taxes deducted throughout the year
Limited Liability Coverage
If you want to operate your own business, forming a single-member LLC is a good idea to prevent personal liability for the businesses debts and obligations. So long as you separate your personal and business assets and not comingle funds, then your LLC will not be viewed as an extension of yourself.
If you operate a single-member LLC, then you can choose to be taxed as a sole proprietorship or S corporation. By choosing this type of taxation, the LLC will not have to pay corporate income tax. Instead, the profits and losses will flow through to you as an owner. Therefore, you will report such profits and losses on your own personal income tax return.
If you owned and operated a C corporation, however, you would be subject to double taxation – both at the corporate and personal level, especially if the corporation pays shareholders any dividends to the shareholders.
Tax Deductible Compensation
You can earn compensation and have taxes withheld throughout the year, i.e. Social Security and Medicare taxes. The problem with self employed individuals is that they are subject to self employment tax, in addition to regular income tax, on business profits. This means that their taxes can be much higher due to the fact that they have to pay Medicare, Social Security, and self employment taxes. However, if you operate a single-member LLC, you have the option of operating as a pass-through tax entity. When this happens, it allows tax season to be a lot easier since taxes are already being taken out of your paycheck throughout the year. Furthermore, the paycheck you take from the LLC is a deductible expense. This further reduces your flow-through profit thereby also reducing the amount of taxes you owe.
You can also further reduce your taxes if you pay yourself less money. This will leave you with even greater business profits. Thereafter, you can pay yourself dividends tax-free that you would have ordinarily paid self employment tax on.
How Can An LLC Avoid Self Employment Tax?
If you operate an LLC that is a disregarded entity, then you will have to pay Social Security and Medicare taxes on your share of the company’s entire net profits. But if you operate an LLC that is taxed as an S corporation, you will have to pay such taxes only on the compensation you pay yourself and not on the rest of the business profits.
Therefore, it could be beneficial to operate an LLC that is taxed as an S corp. For example, let’s say that you operate a two-person LLC that is taxed as a partnership (50/50). Now let’s assume that you make $400,000 in profits in any given year. You will have to pay self employment tax on 50% of $400,000, or $200,000. Now let’s assume that you operate an LLC that is taxed as an S corp, and you are your partner both earn reasonable salaries of $80,000/year. You and your business will have to pay Social Security and Medicare taxes only on a portion of your compensation. Therefore, the remaining amount of your salary will be earned tax-free.
But keep in mind that you must pay yourself a reasonable compensation. You can’t pay yourself a salary of $100 and give yourself a significant compensation in the form of dividends (which are tax-free). If you fail to pay yourself what’s considered a reasonable compensation, you could risk being audited by the Internal Revenue Service (IRS). A reasonable compensation is determined by looking at several factors, including what others in the same industry get paid for the same services, the level of experience you have, your educational background, and how much of a salary other employees for the LLC are making.
If you need help learning about the tax implications for self employed people and LLC members, or if you are thinking about establishing a single-member LLC, 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.