How to Avoid Self-Employment Tax for an LLC

Limited Liability Companies (LLCs) are popular business structures, providing owners with liability protection from business debts and obligations. While this offers significant advantages, the default tax treatment for LLCs can expose owners to substantial self-employment taxes. This article explores self-employment tax as it applies to LLCs and details a common strategy to potentially reduce this tax liability.

Self-Employment Tax and LLCs

Self-employment tax represents the Social Security and Medicare taxes for individuals who work for themselves. For 2024, the self-employment tax rate is 15.3% on net earnings, consisting of a 12.4% Social Security tax and a 2.9% Medicare tax. The Social Security portion applies to net earnings up to $168,600 for 2024, while the Medicare portion applies to all net earnings. An additional Medicare tax of 0.9% may apply to net earnings exceeding $200,000 for single filers or $250,000 for those married filing jointly.

By default, the IRS classifies a single-member LLC as a disregarded entity, taxed as a sole proprietorship. The LLC’s net income flows through directly to the owner’s personal tax return, reported on Schedule C (Form 1040). A multi-member LLC is typically taxed by default as a partnership, filing Form 1065. Each member receives a Schedule K-1 detailing their share of profits.

Under both default classifications, the entire net income of the LLC is subject to self-employment tax. Unlike traditional employment where an employer pays half of Social Security and Medicare taxes, self-employed individuals pay both portions, resulting in the full 15.3% rate on their net earnings. This creates a tax burden, as self-employment tax applies to all business profits, not just a salary.

Electing S Corporation Status for Your LLC

A common strategy for LLC owners to reduce their self-employment tax burden involves electing to have their LLC taxed as an S corporation. This election changes the tax classification of the entity without altering its legal structure. The primary benefit arises from differentiating between salary and distributions, with only the salary being subject to Social Security and Medicare taxes.

To qualify for S corporation status, an LLC must meet specific IRS eligibility requirements. The entity must be a domestic corporation with no more than 100 shareholders. Shareholders must generally be individuals, certain trusts, or estates, excluding partnerships, corporations, or non-resident aliens. The S corporation can only have one class of stock, though differences in voting rights are permitted.

The election process begins by obtaining an Employer Identification Number (EIN) for the LLC. This unique nine-digit federal tax ID is acquired by filing Form SS-4, Application for Employer Identification Number, with the IRS. Form SS-4 requires information such as the entity’s legal name, address, and type. EIN applications can be submitted online for immediate assignment, by fax, or by mail.

Once an EIN is obtained, the LLC makes the S corporation election by filing IRS Form 2553. This form notifies the IRS of the desire to be taxed as an S corporation. Completing Form 2553 requires providing the entity’s name, EIN, effective date, and accurately listing all shareholders, including their names and ownership.

Form 2553 must be signed by an authorized officer and all shareholders. The timing of the filing is critical; generally, it must be filed by the 15th day of the third month of the tax year for which the election is to take effect. For a new entity, the election must be made within two months and 15 days after the beginning of the tax year. Timely filing is advisable. After submission, the IRS typically sends a confirmation letter, usually within 60 days, indicating acceptance or rejection of the election.

Compensating Owners as an S Corporation

Upon successful S corporation election, LLC owners who provide services to the business are treated as employees for tax purposes. This introduces a dual compensation structure: a reasonable salary and distributions. This structure is the mechanism for reducing self-employment tax.

Owners who perform services for the S corporation must pay themselves a “reasonable salary.” This is defined by the IRS as compensation paid to a non-owner for comparable services in a similar industry and geographic location. The IRS scrutinizes reasonable salary amounts to prevent owners from minimizing their salary to avoid payroll taxes, and may reclassify distributions as wages if the salary is deemed too low. Factors include the owner’s training, experience, duties, responsibilities, time and effort devoted to the business, and compensation paid to non-shareholder employees.

The reasonable salary paid to the S corporation owner is subject to federal income tax withholding, Social Security, and Medicare taxes, similar to a traditional employee’s wages. The S corporation is responsible for withholding these taxes from the owner’s paychecks and remitting both the employee’s and employer’s share of these taxes to the IRS. Any profits remaining after the reasonable salary can then be taken as distributions.

A significant advantage of the S corporation structure is that distributions are not subject to self-employment tax. While distributions are generally taxed at the individual’s ordinary income tax rates or qualified dividend rates, the absence of the 15.3% self-employment tax on this income portion can lead to substantial tax savings. For example, if an LLC taxed as a sole proprietorship has $100,000 in net income, the entire amount is subject to self-employment tax. If the same LLC, now taxed as an S corporation, pays its owner a $60,000 reasonable salary and takes $40,000 as a distribution, only the $60,000 salary is subject to self-employment taxes, reducing the overall self-employment tax burden.

Maintaining compliance with payroll and tax obligations is an ongoing requirement for S corporations. This includes processing payroll for the owner’s salary, filing Form 941 quarterly, and issuing a Form W-2 to the owner for their salary. Additionally, a Schedule K-1 is issued for their share of the S corporation’s income and distributions.