LLCs AND THE SELF EMPLOYMENT TAX
An Article by WILLIAM A. TAYLOR (The Business Lawyer)
A number of businesspeople have decided to operate their businesses in the form of a limited liability company (LLC) instead of as a corporation.
Aside from the S corporation, which is treated like a partnership in many respects, LLCs have the advantage over corporations of reflecting the net profits and (more likely during the start-up period) net losses – directly on the tax returns of the owners. In start-ups, that advantage will allow each owner to pay income taxes on lower total household income figures as the LLC losses are subtracted from income from other sources.
Social Security Tax for Self-Employed People However, income taxes are not the only taxes for for owners of LLCs; there are self-employment taxes as well. That is because partnerships (as well as sole proprietorships) are owned by people who are not considered “employees” by the taxing authorities (a person can’t hire himself or herself). Therefore, no FICA (employee social security tax deductions) can be taken out of money owners receive because FICA is reserved for people receiving payrolls. Because public policy is worried about millions of aged 60+ “retired” ex-businesspeople having no money to support themselves and relying on the public dole instead, the law requires self-employed people to contribute to the Social Security system for old age, disability and hospitalization coverages.
Calculation of the Social Security Tax on Self-Employed People Imagine yourself to be a self-employed person who receives $100,000 as your share of income from the business. You will have a tax rate of 28% and might consider your calculations to be finished. You would be wrong – because of the Self-Employment (SE) tax requirement. Another 15.3% of most of the first $90,000 will also be due, not as an income tax but rather as an SE tax – amounting to another $14,600.
There might possibly be some relief. However, it depends on the facts.
Fact #1 – Management of the LLC For tax purposes, an LLC is treated like either a partnership (if it has two or more owners) or like a sole proprietorship (if it has one owner). Both partnerships and sole proprietorships could be managed by someone other than the owners. If so, the owners (called “members” in an LLC) hold the status of investor – and the law allows investors an exemption from paying SE tax – on the reasoning that income to an investor is like income to a limited partner in that it is not earned by that partner, because, being a limited partner, s/he is not participating in the management of the business, but rather is a return on investment.
Fact #2 – Retiree Partners of Service Partnerships Except for retiree-partners, owners (i.e., members) of Internal Revenue Service-defined “service partnerships” should not even try to exempt themselves from the SE tax. A service partnership is one in the fields of accounting, actuarial science, architecture, consulting, engineering, health or law. Retiree partners can receive payments for continuing use of their goodwill (name) by the active partners and exclude those payments from SE tax.
Fact #3 – Personal Liability for LLC Debts An owner of an LLC, who has guaranteed a debt of the LLC, has created an SE tax liability by that mere act. Signing-on for an LLC obligation flies in the face of the existence of the LLC in the first place; however, it may be necessary. By signing, that owner will have to pay SE tax on his/her LLC income – as well as income tax on his/her percent of the LLC income.
Fact #4 – Participation in LLC Management Having authority to sign contracts for the LLC will create an SE tax liability by that mere authority and that owner will have to pay SE tax on his/her LLC income – as well as income tax on his/her percent of the LLC income.
Fact #5 – Working in the Business for 500 Hours per Year Working in the business a little less than 10 hours a week is all that is required to create an SE tax liability; that owner will have to pay SE tax on his/her LLC income – as well as income tax on his/her percent of the LLC income.
Any one of Facts ##3, 4 or 5 will create an SE tax liability in an LLC member. An investor who doesn’t fit any of those categories will be exempt from the SE tax.
Fact #6 – One Owner/One Exempt Check/One Subject to SE Tax If an LLC is created to contain two (2) or more classes, where at least 20% of the ownership of one class is composed of investor-types (not in violation of Facts ##3, 4 or 5), a person can be in violation of Facts ##3, 4 or 5 yet still receive money from the LLC that is not subject to the SE tax – if s/he is also a member of that investor class. The payments from the LLC are merely apportioned between the amount considered to be return on investment (not subject to the SE tax) and the amount that is not (and is thereby subject to the SE tax).
Fact #7 – Member-Managed LLCs and the SE Tax There is no way to escape the SE tax for an owner in a single class Member-Managed LLC (i.e., one that has only one class and is run by the owners). The “fix” for that problem is to amend the LLC to call for a second class and rely on Internal Revenue Service Proposed Regulation § 1.1402(a)(h)(3) which allows a person to be both a general partner (SE taxable) and a limited partner (not SE taxable) at the same time, thereby allowing a reasonable percentage of the money received from the LLC to be classified as return on investment.
For partners running several businesses at the same time (or having several different locations of the same business, with each location run by a different partner), it is possible to set up several LLCs where only the managing partner (for a location) is considered to have received 100% SE taxable income from that location; all other partners could be treated as investors.
Fact #7 – Manager-Managed LLCs and the SE Tax By definition, a Manager-Managed LLC has at least two classes: one for the managers and one for the non-managers. However, not all LLC operating agreements are explicit in describing the classes. They should be, however, to provide the protection to the investor / non-manager class members in order to shield them from SE tax on their LLC distributions.
Summary Beware the SE tax, you who operate your businesses as LLCs.
ABOUT THE AUTHOR: William A. Taylor, attorney at law, does business as “THE BUSINESS LAWYERS.” He can be reached at (510) 893-9465