Self-Employment Tax Planning for Accumulated Earnings

April 13, 2006

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When comparing these two entity forms and their tax implications, the corporation might provide an advantage over the limited liability company (LLC), in terms of self-employment taxes, if you intend to retain earnings within the business for some special purpose.

In a corporation, owners pay no self-employment taxes if they do not receive salary from the corporation, even if the subchapter S election has been made. In contrast, in an LLC, all of the owners must pay self-employment taxes on their share of the business's earnings (whether or not distributed).

This may be a distinct disadvantage if you want to let earnings accumulate in the entity, free of self-employment taxes, which is not possible in an LLC at this time. In particular, owners of corporations primarily accumulate earnings in anticipation of an owner retiring. The owner's shares can be redeemed with the accumulated earnings. If done properly, the redemption qualifies for capital gains treatment, and thus lowers taxes for the owner. The LLC owner can do the same thing, except that he or she must pay self-employment taxes on the earnings as they are generated.

This also may be a disadvantage in the manager-managed LLC because in many cases the non-manager owners may not be paid any salary or distributions. Yet, unless careful steps were taken, all of the owners would have to pay the self-employment tax anyway, on their share of the entity's earnings, even though they receive no distributions. The way to avoid this problem is to be sure that the LLC operating agreement provides that income is shared on some basis other than the ratio of capital accounts, so that the non-manager owners will be allocated little or no income, and, thus, pay little or no self-employment taxes. This can be accomplished by having the LLC pay the manager-owner salary, lease and loan payments, etc.

Of course, this only shifts the payment of the self-employment taxes to the owner-manager. It does not solve the problem of the owner who wants to accumulate income in the holding LLC, free of these taxes.

Proposed Rule Change. The IRS has proposed regulations that would exempt LLC owners from paying self-employment taxes, provided they work less than 500 hours per year in the business. This would apply primarily to holding companies and non-manager owners in operating companies because of the 500-hour limitation. Note that the regulations have yet to be enacted. In addition, a proposed exception exists for personal service businesses, such as accounting firms. There, providing even minimal services would subject the owner to self-employment taxes.

The fate of these proposed regulations remains unclear because of their negative impact on limited partners in a limited partnership (LP). Currently, limited partners do not pay self-employment tax on their share of earnings, unless they receive "guaranteed payments" (i.e., salary) for services rendered. Then, they pay the self-employment tax only on the salary received. In short, currently, limited partners in an LP can avoid the self-employment tax if they do not receive any salary.

The proposed regulations, designed to produce relief for LLC owners, would also apply to LPs. This would mean that limited partners would end up paying self-employment taxes on their full share of earnings whenever they worked more than 500 hours, even if they did not receive any salary, or received only a small salary. For this reason, LP owners have generally opposed this proposed regulation.