LLC Members – Ignoring Self-Employment Taxes When Choosing Your Business Entity Can Be A Costly Mistake

By: Tamara Pow

In addition to income tax considerations on forming a limited liability company (“LLC”) in California and making contributions to the LLC, potential LLC members should keep in mind that income they receive from their LLC may be subject to self-employment tax, and that self-employment tax treatment may be different if the LLC is taxed as a corporation or a partnership.

LLC Taxed as a Corporation

For an LLC taxed as a corporation , if a member is active in the business of the company, payments to the member may be taxed as compensation which is deductible by the corporation and subject to employment taxes. Other amounts, and possibly excessive compensation, will be characterized as a dividend.

LLC Taxed as a Partnership

For an LLC taxed as a partnership , if a member is active in the business of the company, payments to the member may be self-employment earnings, salary or wages, or simply a distribution based on the member’s percentage interest. A member’s distributive share of LLC income is self-employment income if the business of the company is a trade or business that the member is active in. A member is considered active in the business if she has personal liability for claims against the LLC, has authority to contract on behalf of the LLC, or participated in the LLC’s trade or business for more than 500 hours in a tax year. On the other hand, if the member is not active (like a limited partner) then the income is generally not treated as self-employment income.

For certain professions, including health, law, engineering, architecture, accounting and others, if a member is providing professional services, that member will be considered active and all income from a partnership will be subject to self-employment tax. In California, most professionals are not eligible to practice in a limited liability company, but this rule would apply to a limited liability partnership (“LLP”) as well.

One other California difference to note is that for California state tax withholding purposes, a member of an LLC that is taxed as a partnership cannot be an “employee.”

Self-Employment tax and other individual taxes are one of many tax and other considerations to be taken into account in determining the right form of entity for your business. If you are active in your business, or are planning to practice a profession in a partnership, make sure to discuss these implications with your tax advisor prior to forming a business entity to avoid the hassle and cost of an entity conversion later.

Tamara Pow is an LLC attorney who also has an MBA, a California real estate broker’s license and experience in public accounting. She understands the importance tax planning plays in choosing an LLC as the proper form of entity for business and real estate investments.

The information appearing in this blog does not constitute legal advice or opinion. Such advice and opinions are provided by the firm only upon engagement with respect to specific factual situations. Specific questions relating to this article should be addressed directly to Strategy Law, LLP.