LLCs are perhaps the most commonly-used entity form for new business ventures. They are easy to form and operate; they 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.
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.
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.
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.
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. The shareholder is compensated for services performed in the operation of the business. FICA is collected on this amount. The shareholder is also entitled to his or her portion of the profits of the business, and this concept 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.
Small business owners should be aware of something called a “subchapter S corporation”. Sub-S corporations 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. In a subchapter S corporation, 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.
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.