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George Saenz, the Bankrate.com Tax Talk columnistLLC vs. S corporation

Dear Tax Talk,
Are LLCs treated as S corporations or partnerships from a self-employment tax perspective? Is income from a general partnership liable for self-employment tax? How are LLCs treated? Do we have to pay self-employment tax on income derived from an LLC? Thank you.
-- Avtar

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Dear Avtar,
A limited liability company, or LLC, with two or more members is treated as a partnership unless it elects to be treated differently. The trade or business income of a partnership is considered self-employment income to the managing members similarly, as in the case of a partnership's general partners. Rental income is not considered self-employment income to any member. This difference in treatment is generally why an LLC is used in real estate operations, whereas an S corporation is used for business operations.

Now, I know some people are going to say that you can't avoid Federal Insurance Contributions Act, or FICA, taxes by using an S corporation over an LLC. That's not true. The net income of the LLC is usually considered the self-employment income, which is subject to 15.3 percent tax. A company's net income does not truly reflect its ability to pay salary so that the partners end up paying self-employment tax on funds that are not available for distribution. In an S corp, there is no self-employment tax. Instead employment taxes, which are basically the same rate as self-employment tax, are due on declared salary. If these funds are tied up in assets, they're not available to declare as salary and, hence, employment taxes will be less.

For example, if a company accumulates assets through its income stream, the funds are tied up and not available to be paid to the partners. But in an LLC, the partners (members) do end up paying self-employment tax on assets, such as inventory and accounts receivable. This would not be the case by using an S corp. In addition, items such as health insurance, luxury auto limits, one-half of entertainment and other nondeductible items contribute to a partner's self-employment income, but not to S corp shareholders.

In summary, if it's not rental real estate, use an S corp.

To ask a question on Tax Talk, go to the "Ask the Experts" page and select "taxes" as the topic.

Bankrate.com's corrections policy -- Posted: Oct. 12, 2006
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