How to Avoid Self-Employment Tax With an LLC

Self-employment tax is a tax consisting of Social Security and Medicare taxes, primarily for individuals who work for themselves. Many entrepreneurs form a Limited Liability Company (LLC) for its liability protection, which separates personal assets from business debts. This article explores how an LLC’s tax classification can influence or reduce self-employment tax liabilities.

Understanding Self-Employment Tax

Self-employment tax is the self-employed equivalent of the Federal Insurance Contributions Act (FICA) taxes that employees and employers typically share. The self-employment tax rate is 15.3%, comprising a 12.4% portion for Social Security and a 2.9% portion for Medicare. This tax is calculated on net earnings from self-employment. For 2025, the 12.4% Social Security portion applies to the first $176,100 of net earnings, while the 2.9% Medicare portion applies to all net earnings without a wage limit.

Self-employed individuals are responsible for both the employee and employer shares of these taxes. A deduction of one-half of the self-employment tax paid is allowed when calculating adjusted gross income for income tax purposes.

Default LLC Taxation and Self-Employment Tax

A Limited Liability Company (LLC) offers flexibility in its tax treatment, but it has default classifications based on the number of owners. For federal income tax purposes, a single-member LLC is automatically treated as a “disregarded entity,” meaning it is taxed as a sole proprietorship. In this scenario, the LLC’s profits and losses are reported directly on the owner’s personal income tax return, typically on Schedule C.

When an LLC has two or more members, the Internal Revenue Service (IRS) generally classifies it as a partnership by default. Under this classification, the LLC files an informational return (Form 1065), and each member receives a Schedule K-1 detailing their share of the business’s income or losses. In both the sole proprietorship and partnership default structures, the owner’s or partners’ entire share of the LLC’s net earnings is subject to self-employment tax.

Electing S Corporation Status

An LLC can elect to be taxed as an S corporation, which can change how self-employment tax applies to its owners. This election is made by filing Form 2553 with the IRS. After election, the LLC operates as a pass-through entity for income tax purposes, similar to a partnership, but with distinct self-employment tax implications.

The primary mechanism for self-employment tax savings under S corporation status involves distinguishing between a “reasonable salary” and shareholder distributions. The owner, now considered an employee of the S corporation, must receive a reasonable salary for services rendered to the business. This salary is subject to regular payroll taxes (Social Security and Medicare), which are withheld from wages and split between the employee and the S corporation.

Any remaining profits after paying the reasonable salary can be distributed to the owner as shareholder distributions. These distributions are generally not subject to self-employment tax, offering a tax advantage compared to a default LLC where all net earnings are subject to this tax. Determining a “reasonable salary” is an important aspect, as the IRS scrutinizes this to prevent tax avoidance. Factors such as the owner’s training, experience, duties, responsibilities, and comparable salaries in the industry are considered.

The S corporation files Form 1120-S annually to report its income, deductions, and credits. Each shareholder then receives a Schedule K-1, which details their share of the corporation’s income, losses, and distributions to be reported on their individual tax returns.

Electing C Corporation Status

An LLC also has the option to elect to be taxed as a C corporation. This election is made by filing Form 8832 with the IRS. When an LLC elects C corporation status, the entity becomes a separate taxable entity, distinct from its owners.

The owner, as an employee of the C corporation, receives a salary for their services. This salary is subject to payroll taxes, including Social Security and Medicare taxes, similar to any other employee. The C corporation itself pays corporate income tax on its net profits, which is a primary difference from pass-through entities. Any remaining profits distributed to shareholders as dividends are then taxed again at the individual shareholder level, a concept known as “double taxation.”

Unlike S corporations, C corporations do not offer the same direct self-employment tax savings mechanism on distributions because profits are taxed at the corporate level first. While the owner’s salary is subject to FICA taxes, the corporate profits are taxed independently. This double taxation of profits, first at the corporate level and then again at the shareholder level when dividends are paid, makes the C corporation structure less common for the main purpose of reducing self-employment tax on business profits. The C corporation reports its income and tax liability using Form 1120.