Self Employment Tax LLC: Everything You Need to Know
Self-employment tax LLC is the Social Security and Medicare tax obligation placed on self-employed individuals.3 min read
Self-Employment Tax LLC
Self-employment tax LLC is the Social Security and Medicare tax obligation placed on self-employed individuals. The self-employment tax is designed to parallel the combined Social Security and Medicare tax liability assumed by employees and employers within a typical business structure.
In particular, the Social Security tax in 2018 is 12.4 percent of income up to $127,200. Employers and employees both contribute equally to fulfill this tax obligation. However, self-employed individuals are responsible for the entire Social Security tax obligation. Similarly, the Medicare tax is 2.9 percent of all income received, and self-employed individuals must pay this. In addition, higher earners pay an additional 0.9 percent tax on their income above a certain income threshold ($200,000 for single filers).
The combined 12.4 percent Social Security tax and the 2.9 percent Medicare tax is jointly known as the self-employment (SE) tax.
How Does Forming a Business Entity Affect my Self-Employment Tax Obligations?
As a self-employed individual, you typically must make quarterly payments to the Internal Revenue Service (IRS) of your estimated SE tax, as well as your income tax. Not doing so could expose you to punitive actions by the IRS, including fines and penalties. Importantly, there are several types of business entities that do not serve as a tax shelter from the SE tax. These include:
- Sole proprietorships
- General partnerships
- LLCs that file as disregarded entities
For example, a general partnership may pay the SE tax on behalf of each general partner, or each general partner may be responsible for paying the SE tax to the IRS individually.
Notably, there are three types of business structures that do offer a tax shelter to the SE tax. These include:
- Limited partnerships
- S corporations
- LLCs, when the LLC elects to be taxed as an S corporation
The Limited Partnership
The limited partnership is perhaps the simplest business structure to understand with respect to the SE tax. In particular, the limited partnership includes two levels of partners: general partners and limited partners.
General partners are legally liable for all aspects of a business, including the day-to-day operations and/or other managerial roles. Limited partners, however, are only liable for a particular aspect of a business. For example, a limited partner may not be associated with the general operations of a business, but may instead simply provide a capital investment into a business (i.e., be a shareholder in a business).
In instances where the limited partner does not have any direct involvement in the operations of the business, the shareholder profits (i.e., income that is received as an owner of a business) received by the limited partner are not subject to the SE tax. However, the compensation received by a general partner for his work performed in the business is subject to the SE tax. There is an ongoing discussion as to whether the shareholder profits received by general partners are subject to the SE tax. Current law suggests that all shareholder profits are exempted from the SE tax; however, it is recommended that you consult with a tax professional on this technically.
An S corporation is a type of business entity that is designed to provide a tax advantage status to small business owners. S corporations operate as a powerful tax shelter from the SE tax.
For example, in an S corporation, there are two types of income that a business owner may receive. The first type is compensation for work performed. This type of income parallels the income derived by an employee of a typical corporation (C corporation). Accordingly, this income is exposed to the SE tax.
However, as an owner of the S corporation, you are also entitled to shareholder profits. Importantly, these are not exposed to the SE tax. As the owner of the business, you get to decide your compensation package. As long as you pay yourself a reasonable compensation for work performed, you can increase your shareholder profits to significantly reduce your exposure to the SE tax.
An LLC is a limited liability company, where each business owner is considered a member of the LLC. Importantly, the members of an LLC may elect to be taxed as a disregarded entity or as an S corporation. Electing to be taxed as an S corporation provides similar tax advantages to the above described S corporation.
If you are a business owner, consider forming a limited partnership, an S corporation, or electing for your LLC to be treated as an S corporation to reduce your tax liabilities. As always, consulting with a qualified tax adviser is always recommended.
If you need help with forming a business structure to reduce your self-employment tax liabilities, you can post your legal needon UpCounsel's marketplace.