TAX BREAK

Comparison of LLCs and Sub-S Corporations for Self-Employment Tax by Michael D. Matejka

 

We have had previous articles on the relative advantages of limited liability companies (LLCs) when compared to other types of entities, such as corporations.  There are numerous tax and organizational differences between LLCs and corporations which cannot be completely summarized here.  In selecting the proper entity, it is necessary to take into account the business of the entity, the assets owned by the entity, and the owners of the entity.  This article will focus on comparing an LLC to an S corporation for purposes of self-employment tax and Social Security tax. 

 

This is one area in which, in certain situations, an S corporation may be more favorable than a limited liability company. Self-employed persons have to pay self-employment tax on the net income they derive from their trade or business. Generally, rentals from real estate are not included in self-employment income unless the rentals are received in the course of a trade or business as a real estate dealer. Dividends, interest, and capital gains are generally excluded from self-employment income as well.  Therefore, this discussion focuses on the conducting of a trade or business in an LLC or S corporation, rather than the holding of investment assets.

 

Limited Liability Companies

 

The general rule of thumb is that an LLC is typically the preferable entity for holding investment assets.  However, as we shall see, when a small business is involved, additional analysis is needed to determine the preferable entity.

 

An LLC with one member is taxed as a sole proprietorship and  the trade or business income of a sole proprietor is subject to self-employment tax.   An LLC with more than one member is taxed as a partnership. A general partner’s share of the partnership’s trade or business income is also subject to self-employment tax.  However, limited partners are not subject to self-employment tax, except on guaranteed payments for certain services rendered.  Therefore, whether a member of an LLC has self-employment tax on the LLC’s trade or business income depends on whether the member is classified as a general partner or a limited partner.

 

In 1997, the IRS issued proposed regulations which address the treatment of members of an LLC as either limited or general partners for purposes of self-employment tax.  Due to concerns raised by Congress, these regulations have not been finalized.    However, it is not likely that the final resolution of this matter will be less taxpayer-friendly than the proposed regulations.

 

Under the proposed regulations, a member of an LLC is treated as a limited partner unless the member has the authority to contract on behalf of the LLC or participates in the LLC’s trade or business for more than 500 hours.  For example, if A, B, and C formed an LLC for the purpose of conducting an automobile dealership and A was the manager, B participated in the business more than 500 hours a year, and C was neither a manager nor participated in the business for more than 500 hours a year, then A and B’s share of the trade or business income would be subject to self-employment tax but C’s would not. 

 

In addition, there is an exception for holders of more than one class of interest.  An individual who holds more than one class of interest in the LLC and would otherwise be treated as a general partner may be treated as a limited partner with respect to a class of ownership if members who would otherwise be treated as limited partners own 20% or more of that class. 

 

 

 

Continued

 

 

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