Limited Liability Companies (LLCs) and Their Benefits
LLCs are perhaps the most commonly used entity form for new business ventures. They are easy to form and operate, provide the owners of the business protection against personal liability for obligations of the company, and unlike traditional corporations, LLCs themselves pay no income taxes.
The Drawback of LLCs for Owners
LLCs can, however, have a significant drawback for owners. LLCs are generally treated for tax purposes as either a proprietorship (if there is only one owner) or partnerships (if there is more than one owner). Neither of these entity forms is treated as being separate from its owner(s), and any company profit is taxed at the owners’ individual rates.
At first blush, this appears to be desirable, and it is – with respect to income taxes. Unfortunately, income taxes are not the whole story. Along with income taxes, owners of a business must pay employment taxes, primarily Social Security and Medicare taxes.
Understanding Employment Taxes for LLCs
Under the Federal Insurance Contributions Act (FICA), an employee of a business must pay 7.65% of the employee’s income to cover the employee’s Social Security and Medicare taxes. Employers match this contribution, meaning that the total amount payable under FICA is 15.3% of the employee’s income. FICA dips to 2.9% of income above $117,000.
FICA is not an income tax. It is an employment tax, collected only on income derived through work. It is not chargeable on dividend or rental income, for example.
The Impact of Self-Employment Tax
A person who is self-employed is, for tax purposes, considered both employer and employee. In other words, a self-employed person pays the full 15.3% due under FICA. This is called self-employment tax rather than FICA, but in all respects, the taxes are identical.
These concepts are critical to understand because the owners of an LLC are considered self-employed if they perform services for the business. Only if they are purely passive investors can they avoid paying self-employment tax on any earnings allocated to them through the LLC.
Comparing LLCs and Corporations for Tax Purposes
Contrast this with the possible treatment of shareholders in a corporation. Corporations are considered separate entities from their shareholders for all purposes, including taxation. A shareholder who works in the business is compensated in two separate ways:
- Compensation for services performed in the operation of the business – FICA is collected on this amount.
- Portion of the profits of the business – This applies whether the shareholder actually works in the business or not.
In other words, a corporation’s shareholders can divide their income from the company into two streams, only one of which is subject to the 15.3% burden of FICA. The other portion is not.
The Benefit of Subchapter S Corporations (S-Corps)
Small business owners should be aware of something called a subchapter S corporation (S-Corp). S-Corps are similar to LLCs in that they do not themselves pay tax; as with LLCs, the shareholders pay income taxes on the portion of the company’s profits allocated to them.
However, in an S-Corp, the owners, through skillful planning, can avoid at least some of the self-employment taxes on their earnings. Members of an LLC do not have this option if they work in the company’s business.
Choosing the Right Business Entity
Working through the question of which form of entity to choose when starting a business requires more thought than some might think. This article does not cover all of the variables that must be considered or even all of the available choices. The point, though, is plain: It’s not as simple as you might think.
Do some research, talk to a lawyer and an accountant, and choose wisely.
