Individuals whose businesses are incorporated typically do not have to worry about self-employment tax if they are paying themselves a reasonable salary. Any salary taken by owner-employees is subject to FICA taxes (Social Security and Medicare). FICA taxes are deducted from the shareholder’s paycheck and are remitted regularly through payroll tax payments to the IRS. Owners of sole proprietorships, partnerships, and limited liability companies (LLCs)—are not considered “employees” but “self-employed individuals”. Instead of paying FICA tax through wages, self-employed people pay self-employment tax. Partners, sole proprietors and LLC members do not take a regular salary through payroll, so there is no tax withheld from the payments they take which are called “draws”.
Self-employed individuals pay self-employment tax equal to the employer and employee share of FICA tax. In other words, they pay 15.3% (comprised of 12.5% for Social Security tax and 2.9% for Medicare tax) on the net earnings of their business. In basic terms, net earnings from self-employment is calculated by subtracting total expenses from total income. Oftentimes, self-employed clients get confused because they think they only pay tax on the draws they pay themselves from the business. This is not the case, however, because if the business is profitable and no draws are taken, the owner will still pay 15.3% self-employment tax on those profits. The draws that the owner takes do not decrease the net profits of the business and generally have no effect on self-employment tax. There are some “draws” called ‘guaranteed payments” taken by some partners in a partnership that do decrease the profits of the other partners, but those guaranteed payments are still subject to the 15.3% self-employment tax for the partner who has received such payments. An LLC can elect to be taxed as a corporation thereby allowing the owners to take a regular salary and have some control over the self-employment tax that they pay. This is a good option for LLCs that are profitable.