Is owning an LLC a form of self employment? How does the IRS treat LLC income? Get a simple breakdown of your tax options as an LLC owner.
A limited liability company (LLC) is a popular business structure for small businesses. But is it considered self employment?
The short answer is usually. Which, of course, requires a bit of a longer answer.
There are a couple of ways of looking at self employment. The general sense is about control: owning your own business, being your own boss. That clearly applies to a sole proprietor. But it also applies to CEOs of startups who are drawing company paychecks. They might be signing their own checks, but they're not self-employed.
There is a clear line between self employment and being an employee, and it's all about taxes. Owners of LLCs are usually taxed as self-employed business owners, but they can elect to be taxed as company employees through special filings with the IRS.
Sounds complicated, but it's actually pretty simple. Let's take a walk through the options available to business owners who form an LLC.
Overview: What is an LLC?
An LLC is a legal business entity owned by one or more members. It is formed by filing articles of organization and other LLC documents with the state. The LLC's name reflects its major advantage over sole proprietorship: limited liability.
Sole proprietorships are not legal entities. They are inseparable from their owners legally and financially, which exposes the owners’ personal assets to major risk.
An LLC is a separate entity with its own assets and liabilities. States introduced the LLC structure to let small business owners shield their personal assets. If an LLC goes bankrupt, creditors cannot come after its owners personally to pay the debts.
When it comes to LLC taxes, the picture is more complex.
This virtual workshop is one of many offered by the IRS on small business taxes. Image source: Author
The Internal Revenue Service (IRS) doesn't recognize LLCs as a distinct business form. Instead, LLCs may be taxed as one of three types of entities:
Disregarded entity: Single-owner LLCs are automatically taxed as sole proprietorships. The IRS calls these LLCs disregarded entities because they are not regarded as separate from their owners for tax purposes. The owners report profits from the business on Schedule C of their personal tax returns.
Basically, the IRS is saying yes, you formed a business to protect yourself, but for tax purposes, you can disregard that and file as a sole proprietor.
If you own a single-member LLC, you are taxed as a disregarded entity unless you file IRS Form 8832 to elect a different business classification.
Partnership: Multiple-member LLCs are automatically taxed as partnerships. They must file IRS Form 1065, an information return that partnerships use to report total income, taxes, and expenses. In addition, individual members must report their income on Schedule K-1. Profits from the business, however, continue to pass through as personal income to be reported on the members' individual tax returns.
Multiple-member LLCs can change their default classification by filing Form 8832.
Corporation: Form 8832 also allows LLCs to choose to be taxed as a corporation. Corporations are not pass-through entities. They are owned by stockholders, who are not self-employed.
A corporation's profits are subject to corporate income tax, and profits distributed to owners as dividends are subject to personal income tax. This means two layers of taxation instead of one, but it also provides flexibility in how and when profits are distributed. Depending on the corporate income tax rate and the owners’ personal income tax brackets, a corporate tax election may be advantageous for some LLCs.
Corporations are far more complex to set up and run than LLCs, however, with extensive documents to manage.
An LLC that elects to be taxed as a corporation can file IRS Form 2553 to be further classified as an S corporation.
An S corporation is a corporation that elects to pass corporate income through to its shareholders for federal tax purposes. Shareholders report their income on their personal tax returns. This gives its owners the advantage of pass-through taxation without the usual downside of paying self-employment tax on those earnings.
A member of an LLC that elects S corporation status may become an employee of the business and take a reasonable salary. This provides further flexibility in distributing the profits of the corporation and avoiding self-employed taxes.
S corporations may be owned only by individuals or certain trusts or estates. They may have no more than 100 shareholders and only one class of stock, among other restrictions. S corporation is a complicated election that requires extensive documentation. Get advice from a tax expert before pursuing this option.
LLC owners can choose their federal tax classification using IRS Form 8832. If you don't make an election, your LLC is automatically taxed as a pass-through entity. Image source: Author
Self-employed vs. LLC: What's the difference?
The bright line between employment and self-employment really lies in whether you're paying self-employment tax on your earnings. The current self-employment tax rate is 15.3% on 92.35% of your business income up to a threshold, currently $132,900. Income above the threshold is taxed at 2.9%.
That's a hefty rate, but self-employment income has its upsides. First, there's the 20% qualified business income (QBI) deduction. Second, as a business owner, you can deduct a host of expenses such as business-related travel, office space, and tools of your trade.
Unless a corporate tax structure is elected, business income from an LLC is subject to self-employment tax. So for the majority of LLCs, the owners are self-employed.
Owners of LLCs who elect to be taxed as corporations, on the other hand, are not self-employed. They pay income tax on dividends, but not self-employment taxes. This includes shareholders of S corporations.
It's possible for the owner of an LLC to have employment income as well as self-employment income. For example, a basketball coach might be building a personal fitness business as an LLC while working a regular job.
Or a web developer might have a full plate of independent work through an LLC, then take a contract for five months as a temporary employee. In both cases, employers will send them W-2s the following spring reflecting their wages, and clients will send 1099s reflecting their business income.
Both owners are self-employed. They’re also employed. Each will have to report 1099 business income and expenses on Schedule C, Profit or Loss From Business, and W-2 wages under personal income on Form 1040.
As always, the optimal tax setup for your small business depends on a variety of factors best sorted out by a tax expert. The IRS also offers virtual workshops on small business taxes that cover the basics for you.
Is owning an LLC considered self employment?
Unless the owner elects corporate tax status, owning an LLC is self-employment. Since pass-through taxation is generally beneficial, most LLCs retain their default tax status as disregarded entities or partnerships.
Bottom line: Even if you're signing your own paycheck, you're not self-employed if you're deducting payroll taxes from it. And even if you're a tiny cog in a global enterprise, if your income is reported on Form 1099, you're self-employed.
Meet the boss
If you've made the jump to LLC ownership, you've taken huge strides to establish your business and protect your personal assets. And as a business owner, you qualify for some sweet perks.
Many of them are financial, but the biggest benefit of all might just be running your own show. That's an accomplishment. Be sure to give yourself a gift certificate now and then, or at least take yourself out to lunch on your birthday.
