by Christopher Weeg
Many factors go into choosing the type of entity in which to operate a business, including liability protection, governance structure, and, of course, taxes. This article focuses on how this decision affects the business owner’s self-employment tax burden.
What is Self-Employment Tax?
In addition to regular income tax, an employee’s wages are also subject to employment tax, which is paid one-half by the employer and one-half by the employee. In addition, business profits from an actively run business are generally subject to self-employment tax, which is paid by the business owner. The self-employment tax rate is currently 15.3 percent, plus an additional .9 percent on self-employment income in excess of $250,000 for married taxpayers and $200,000 for single taxpayers.
Overview of Pass-Through Entities
The most common entity types for small business owners are “pass-through” entities, such as S corporations, limited partnerships, and limited liability companies (LLCs). Pass-through entities do not pay income tax. Instead, their profits (or losses) pass-through to their owners, who report the income on their individual income tax returns and pay the applicable taxes. Not all pass-through entities, however, are treated the same from a self-employment tax perspective.
Unlike other pass-through entities, the profits of an S corporation are not subject to self-employment tax. S corporation owners who actively run the business are treated as shareholder-employees and must therefore be paid a reasonable salary, which is subject to employment tax as wages. What is “reasonable” has been extensively litigated over the years because S corporations are incentivized to pay insufficient compensation to avoid employment taxes. A conservative rule of thumb is the shareholder-employee’s salary should be similar to what the S corporation would have had to pay a non-shareholder employee.
A limited partnership has two types of partners: general partners, who manage the partnership and have unlimited liability, and limited partners, who are essentially passive investors lacking management authority but enjoying no personal liability for partnership debts. A general partner’s share of partnership profits is subject to self-employment tax, which is a stark difference from a similarly situated S corporation shareholder-employee who avoids this tax on corporate profits.
A limited partner’s share of partnership profits, on the other hand, is not subject to self-employment tax because, conceptually, his or her share of income is attributable to capital invested rather than compensation. The IRS, however, can treat a limited partner as a general partner if he or she actively participates in the partnership’s operations, regardless of such partner’s designation as a limited partner under state law or in the entity’s organizational documents. If this occurs, the partner will need to pay self-employment tax on his or her share of partnership profits for the years at issue, as well as interest and penalties.
Limited Liability Companies
By default, LLCs are taxed as partnerships for federal tax purposes. LLC members, therefore, are treated like partners in a partnership for determining whether their LLC profits are subject to self-employment tax. The IRS has generally taken the position that (1) LLC members who actively participate in the management of the LLC are subject to self-employment tax on their share of LLC profits and (2) those who merely invest in the LLC are akin to limited partners and thus not subject to self-employment tax.
Putting It All Together
Although the S corporation has a self-employment tax advantage over the LLC or limited partnership, it is not for everyone. The tax benefit comes at a cost of reduced flexibility due to the S corporation’s strict eligibility restrictions—i.e., all S corporation shareholders must generally be individuals and either U.S. citizens or residents, it must have no more than 100 shareholders, and it may only have one class of stock outstanding. Distributing profits to shareholders on an uneven, or disproportionate basis, also can be problematic. If, instead, an LLC or limited partnership is chosen, passive LLC members and limited partners must be cautious of becoming too active in the business, which could thereby trigger self-employment tax liability on their share of profits.
Christopher Weeg, J.D., LL.M., CPA, is an associate at Meadows, Collier, Reed, Cousins, Crouch & Ungerman, LLP, and can be reached at email@example.com.