Self-employment tax can be a significant financial burden for small business owners. However, there are ways to reduce or even eliminate this tax liability. One option is to form a limited liability company (LLC) and elect to be taxed as an S corporation.
What is Self-Employment Tax?
Self-employment tax is a combination of Social Security and Medicare taxes that self-employed individuals must pay. The tax rate is 15.3%, which is divided into two parts:
- 12.4% for Social Security
- 2.9% for Medicare
Self-employment tax is due on all net income from self-employment, up to a certain limit. For 2023, the limit is $147,000 for Social Security tax and $200,000 for Medicare tax.
How Can an LLC Avoid Self-Employment Tax?
By default, LLCs are taxed as pass-through entities. This means that the LLC’s profits and losses are passed through to the individual members, who then report them on their personal tax returns. As a result, LLC members are subject to self-employment tax on their share of the LLC’s profits.
However, LLCs can elect to be taxed as S corporations. S corporations are also pass-through entities, but they offer the following advantages:
- No self-employment tax: S corporation owners are not subject to self-employment tax on their share of the company’s profits.
- Lower tax rates: S corporations are taxed at the corporate tax rate, which is generally lower than the individual income tax rate.
How to Elect S Corporation Status
To elect S corporation status, an LLC must file Form 2553 with the IRS. The election must be made within 75 days of the LLC’s formation.
Other Ways to Reduce Self-Employment Tax
In addition to electing S corporation status, there are other ways to reduce self-employment tax liability, including:
- Deducting business expenses: Self-employed individuals can deduct ordinary and necessary business expenses from their net income. This can help to reduce their taxable income and, therefore, their self-employment tax liability.
- Maximizing retirement contributions: Self-employed individuals can make tax-deductible contributions to retirement accounts, such as IRAs and 401(k) plans. These contributions can help to reduce their taxable income and, therefore, their self-employment tax liability.
- Hiring employees: Self-employed individuals who hire employees can pay themselves a reasonable salary. The salary is subject to payroll taxes, but it is not subject to self-employment tax.
Self-employment tax can be a significant financial burden for small business owners. However, there are ways to reduce or even eliminate this tax liability. One option is to form an LLC and elect to be taxed as an S corporation. S corporations offer a number of advantages, including no self-employment tax and lower tax rates.
How The Self Employment Tax Works (And How You Can Avoid It!)
FAQ
How can LLC members minimize self-employment taxes?
Can LLC members avoid self-employment tax on LLC profits?
Are LLC owners considered self-employed?
How can an LLC avoid income tax?
Do I have to pay self-employment tax as an LLC?
Self-employment tax must be paid quarterly. If you set up an LLC, you have some options when it comes to LLC self-employment taxes: Disregarded LLC. If you create an LLC with one member and do not elect to be taxed as a corporation (see below), then you will still continue to pay self-employment tax as an LLC.
Are LLC members considered self-employed?
Yes. LLC members are considered self-employed individuals, and self-employed individuals do not have FICA taxes (e.g., Social Security, Medicare) withdrawn from their paychecks. Instead, self-employed people pay FICA taxes directly to the IRS—which is known as the self-employment tax.
Can the IRS stop LLC members from avoiding self-employment tax?
Indeed, recent Chief Counsel memorandums (see ILM 201436049 and ILM 201640014) suggest that the IRS is willing to use management control or participation, or both factors in combination, to stop LLC members who attempt to avoid self – employment tax on their distributive shares.
Can a limited liability company reduce self-employment taxes?
Depending on your specific situation, it may be possible to reduce or completely negate self-employment taxes if you form either a limited liability company or some other form of corporation. When you’re an employee on somebody else’s payroll, your employer actually pays half of the Social Security and Medicare taxes on your income.