Nowadays, limited liability companies snap at the heels of sole proprietorships when it comes to the most popular business forms in the US, and for a good reason. Still retaining management and taxation simplicity, LLC companies bring valuable legal protection to the business owners in the form of limited liability. On the other hand, being independent legal entities, LLCs are very similar to sole proprietorships in many concerns, including taxation and employment, which are among the core factors to consider for any businessman. Hence, to enjoy a protective limited liability shield, many sole proprietors switch for LLC formation at some point while remaining single company owners. Initially, single-member LLC owners are not entitled to be employed in their companies, and the IRS sees them as self-employed for tax purposes. And actually, the question about employment or self-employment mostly arises in relation to taxation. So, let’s take a look.
How Is a Single-Member LLC Formation Taxed
An LLC company established by a single person, be it a physical or legal person, is automatically treated as a sole proprietorship by the IRS. Tax authorities consider this type of LLCs as disregarded entities, i.e. those that are not regarded independent from their owners. It means, when paying taxes, the LLC is directly associated with its owner, and the “pass-through” taxation method applies when all business revenues and losses pass on to a personal tax return of the LLC member and are taxed at the current individual rate of such member(find out more in the article by lawyer D.Kondratiev) . Likewise, the LLC company profit is its owner’s profit subject to self-employment tax in full even if you decide to leave all income in the company. In other words, all LLC taxes are actually paid at the personal level and no federal or state tax returns need to be filed. In the meantime, though, a single-member LLC owner will pay both income tax on the company income and a self-employment one on this amount as his or her self-employed profit.
To say a few words about individual rates the LLC formation income tax is paid at, they range from moderate 10% to hefty 37%. The rate escalates proportionally to the profit escalation. The higher the LLC owner’s profit, the higher the rate. Besides, though state taxes are payable at a personal level too, some states levy specific fees for operating on their territory that also depend on your company income and are to be paid on the annual basis. To add more, while being a disregarded entity for income tax payments, single-member LLCs remain independent entities exposed to excise taxes for certain types of activities. You need to check with your Department of Revenue to stay compliant with the state.
To continue, if you hire employees, your LLC company becomes an employment taxpayer responsible for FICA and unemployment taxes. Noteworthy, to report your employee taxes, your LLC needs to have an EIN you can get on your own or with the help of LLC formation services.
On the bright side, self-employment income is not only about taxes. As a business owner, you can extract a number of ongoing business expenses such as travel costs, office, and equipment rent from your taxable income. On top of that, pass-through entities can make use of an added 20% qualified income deduction. QBI or qualified business income is the net sum of your business profit. Though there are certain limitations on the QBI amount, this extra deduction can help you save quite a bit of money on your single-member LLC company taxes.
Single-Member LLC Formation: Self-Employment Tax
The net earnings of a single-member LLC company are the net profit of its owners, which is subject to self-employment tax at a rate of 15.3%, which comprises 12.4% Social Security payment and 2.9% Medicare payment. It’s worth noting that 15.3% is not charged over the whole amount of your taxable income. Following valid IRS regulations, the Social Security part of the tax is paid over only the first $137,700 of your profit while the Medicare part is applied to the total amount of net earnings. More than that, if your income exceeds some limit, the Medicare tax is increased by 0.9%. And those income limits depend on the taxpayer status:
- Spouses filing jointly – over $250,000;
- Spouses reporting separately – over $125,000;
- Head of household – over $200,000;
- A single person – $200,000;
- Widow or widower with a dependent child – $200,000.
While self-employment tax can noticeably bump up your payments when summed with the income one you’ll have to pay on your LLC company income, you are entitled to withdraw half of the self-employment tax amount as a deductible expense.
How to Avoid Self-Employment Tax for Single-Member LLC Formation
One of the most popular ways for LLC company members to avoid or cut down the self-employment tax amount is to switch for a corporation status. By choosing an S-Corp status, LLC members engaged in the business activity are considered the company employees and are paid salaries for their work. While they still pay self-employment tax on the wage or salary, the distributive company profits are not FICA taxable, and they only pay income one on that. C-Corp eliminates the company income transfer to the individual tax returns of LLC members and brings in federal tax returns for the business. In the meantime, employed business owners only pay self-employment taxes on their salaries. Here, however, you should remember about C-Corp’s dual taxation since distributed owners’ profits are still due for income tax payments. Yet, while pass-through entity incomes are taxed at individual rates of the LLC formation owners and those rates vary, C-Corp incomes are taxed at a 21% flat rate. As a result, the aggregate taxes of high-profit corporations might appear to be lower than those of high-revenue LLCs.
Yet another self-employment reduction is possible for the account of passive income, which is not subject to the self-employment tax. What the IRS treats as passive income is:
- Revenues obtained from commercial and business activities, in which you have no material participation during a tax year;
- Income from real estate activities, unless you are a real estate agent or expert and this is your major activity.
Both of these self-employment tax reduction methods are legal and quite feasible but we strongly recommend that you consult a professional before introducing any changes in practice.
Hands On Your LLC Taxes With LLC Services
Just as you are hands-on in operating and growing your business, it’s essential to always keep your hand on your LLC company taxes. And to maintain your business in good standing with the state, it’s crucial to get the hang of all these issues at the stage of business formation and choose proper tax classification to achieve the desired business results in the future and lessen the burden on your developing business. While many entrepreneurs often hire attorneys or tax specialists to help, LLC services are also a great alternative in this concern. Widely available on the modern legal market, LLC formation companies provide every kind of assistance in not only registering your business but also giving it the right start. Thus, the best LLC services such as Rocket Lawyer or LegalZoom come up with a wealth of maintenance services including consultations and filing annual tax reports. Still delivering professional service, they are much more affordable than private consultants working on hourly rates, which is especially important for startup projects when every cent counts.
Dmitriy Kondratiev, chief Editor of LLC.services, associate in Axon Partners.
Experienced lawyer (Intellectual Property, Patenting, Contract law, Labor Law, International Private Law).
Worked with IT-companies Webxloo (Delaware), Autoxloo (Florida), SCC (Delaware)