Payroll Taxes for a Single Member LLC

May 21, 2008

So you finally did the right thing.   You converted your sole proprietorship to a single member Limited Liability Company so that you and your personal assets are protected from the liabilities of the business. Now you can sleep more soundly at night because your LLC is busy keeping your house, bed and pillow safe from evil creditors, right? If your LLC has employees, the Internal Revenue Service would say "not so fast – what about payroll taxes?"

Employers are generally obligated to withhold FICA and income taxes, the "payroll taxes", from an employee’s wages and pass on those amounts to the federal government. Stiff penalties can result if those obligations are not met. Still, if your LLC is the employer, shouldn’t those penalties apply to the LLC and not you personally? The IRS disagrees.

When you created your LLC, you were required to file a form with the IRS to obtain a tax identification number. To complete the form, you had to "check-the-box" to choose if the LLC will be taxed as a corporation, partnership or as a disregarded entity. Because you didn’t want to be double-taxed on the business and personal level, you didn’t choose to be taxed as a corporation, and because you are a single member LLC, you couldn’t choose to be taxed as a partnership because there needs to be more than one partner. As a result, your single member LLC is categorized by the IRS as a disregarded entity for federal tax purposes.

This is where personal liability comes in. Through Notice 99-6, the IRS decided to hold owners of single member LLCs personally liable for payroll taxes. The rationale was that because single member LLCs are disregarded for federal tax purposes, they are ignored and the owner is the "employer" for federal tax purposes. While state law normally provides that LLC owners are not to be held personally responsible for their LLC’s liabilities, the IRS trumps those laws with the Supremacy Clause of Article VI of the United States Constitution.

However, there is some light at the end of the tunnel, but it’s a good-news/bad-news scenarios. The good news is that on August 16, 2007, the IRS finalized new regulations stating, among other things, that they will no longer ignore single members LLCs for employment tax purposes. As a result, owners of single member LLCs will not be treated as employers for federal tax purposes. The bad news comes in two parts. First, the new regulations only begin to apply to employment taxes effective for periods beginning on or after January 1, 2009, so relief is not immediate. Second, owners of single member LLCs are still personally liable for the "Responsible Person Penalty" under Section 6672 of the Internal Revenue Code.

The "Responsible Person Penalty", also known as "trust-fund recovery penalty" and the "100-percent penalty" generally penalizes anyone who willfully fails to collect and pay over employee income tax and the employee portion of FICA taxes. The specific penalty is equal to the amount of tax not withheld and paid over. The liability of the "responsible party" is independent of the LLC’s liability, and owners of single member LLCs are generally treated as "responsible parties." 

As a result, if you own a single member LLC with employees, it is very important for you to verify that your payroll taxes are being handled properly. If not, you could be putting yourself at risk.