Self-Employment Tax Exceptions in Favor of the LLC

When comparing the limited liability company (LLC) and the corporation and the numerous tax implications, keep this in mind: Despite the many drawbacks for the LLC form when it comes to self-employment taxes, there are some factors in favor of the LLC to consider.

If you are an LLC owner, you can deduct half of the self-employment taxes you pay on your personal income tax return, Form 1040. This can be done even if you don't itemize deductions. This fact may lower the effective cost of the taxes and, thus, shift the advantage to the LLC. While the corporation can deduct its half of these taxes on its own tax return, this does not yield a direct benefit to the owner because the corporation files a separate tax return and pays its own taxes.

Furthermore, in the LLC, federal and state unemployment taxes are avoided on the owner's income, including guaranteed payments received for salary. In contrast, the corporation must pay both federal and state unemployment tax. Before July 1, 2011, the FUTA tax rate is 6.2%. After June 30, 2011, the FUTA tax rate is scheduled to decrease to 6.0%. The tax applies to only the first $7,000 you pay to each employee as wages during the year. The $7,000 is the federal wage base, but your state wage base may be different.

In addition, the LLC owner can avoid the self-employment tax if payments are made by the LLC to the owner as lease payments and loan repayments.

The Internal Revenue Code imposes the self-employment tax on profits derived from ownership of the business, plus any guaranteed payments for salary. The owner will not be "in the business" of leasing real estate (or equipment, furniture, etc) or making loans. Thus, the tax will not apply to these receipts. (In addition, the Code also specifically exempts lease payments received from anyone except a real estate dealer).

Lease payments and loan repayments are paid to the LLC owner for a reason other than his or her capacity as an owner. Accordingly, they are deducted by the LLC in computing its distributable income. Because the LLC does not pay taxes itself, this really represents a way to allocate income to a particular owner, but avoid the self-employment tax.

"Guaranteed payments" made to an LLC owner, for services rendered (i.e., salary) are also deductible by the LLC. However, these payments are subject to the self-employment tax with respect to the partner who receives the payments. They are added to his or her distributable share of the LLC profits, and he or she pays the self-employment tax on the total.

Division of profits in the LLC is covered by the LLC's operating agreement. Different schemes exist that can involve payments made to owners for leases of assets, loan repayments, and salary. Whether or not salary is deemed a "guaranteed payment" can affect how much net income is left to be divided among the LLC owners. In addition, some allocation schemes can have adverse income tax consequences. See our discussion of withdrawing funds from the business and tax aspects of funding decisions before you undertake to create an allocation scheme in your operating agreement.