Self-Employment Taxes

When comparing the limited liability company (LLC) and the corporation, the tax implications of paying Social Security and Medicare taxes actually turns out to be equal either way.

The LLC is not a taxpaying entity and, accordingly, does not pay Social Security or any other employment taxes on the "salary" of the owner. The LLC owner is really self-employed, and the "salary" is only an owner's withdrawal from the business. However, the LLC owner must, on his or her personal income tax return (Form 1040), pay a "self-employment" tax, which is in reality the Social Security tax and the Medicare tax that would ordinarily be paid by the employer and the employee.

In contrast, it is sometimes said that the owner of the corporation can avoid the payment of self-employment taxes by not taking a salary from the business. This idea may not prove out in practice, because paying out all earnings as salary is the principal way that owners of corporations avoid double taxation of dividends. However, it is true that the corporation can allow earnings to accumulate in the corporation (subject to the accumulated earnings tax limitations, in the case of a regular "C" corporation). To this extent, the corporation could provide an advantage over the LLC. (Remember, an S corporation is a pass-through entity, so all income will be passed through to the shareholders as it would in an LLC.

But one reason that there's no real advantage in either the LLC or corporation when it comes to self-employment taxes is that the owner ultimately bears the cost of the tax in any event, whether it is paid through the business, or directly by the owner, and this cost will be the same in both cases.

In 2011, the corporation pays Social Security tax of 6.20 percent on the first $106,800 of salary paid to the owner, and the owner has to make a matching contribution (through a payroll deduction) of 4.20 percent. (This is a special one-year reduction in the employer-portion of the social security tax--normally the employee portion is 6.20 percent.)

On the other hand, the LLC owner is self-employed. The LLC owner must pay a "self-employment tax" at the rate of 10.40 percent of the first $106,800 in 2011 of self-employment income. This tax is, in reality, a combination of the Social Security tax that would be paid by the employer (6.20 percent) and the employee (4.20 percent.).

Similarly, the corporation pays a Medicare tax on your salary at the rate of 1.45 percent, with no limit on the earnings to which the rate applies, while you must pay a matching 1.45 percent contribution through a payroll deduction. In the LLC, you would pay 2.9 percent on your self-employment income (equal to the contribution made by the corporation and the employee-owner combined).

In each case, you effectively pay the same total rate of 13.3 percent (in 2011; 15.3 in 2012) on the same base of earnings. (In the corporation, 6.2 percent + 4.2 percent + 1.45 percent + 1.45 percent = 13.3 percent; in the LLC, 10.4 percent + 2.9 percent = 13.3 percent).

You also should be aware of three specific topics that affect self-employment taxation:

• Tax planning if you want to accumulate earnings in the business entity
• Some self-employment tax exceptions that favor LLCs
• How to combine the LLC and the statutory close corporation to minimize self-employment taxes

(For more information on self-employment taxes and your small business, see our in-depth discussion.)