Meet Cathy, the Cooperative Development Institute’s new answerwoman! She can take on any co-op questions you might have, big or small. Today we address the submitted question: “How does a co-op structured as an LLC affect members’ individual taxes?” See all of Cathy’s answers and ask your own on her home page.
This is Part 2 of our Ask Co-op Cathy Segment addressing the question – “How can a worker co-op structured as an LLC retain earnings?” Here, we examine how this structure impacts the co-op members’ individual taxes. The below is a guest piece by David Hammer of the ICA Group, with contributions by CDI’s own Andy Danforth:
Let’s examine the issue of self-employment tax in worker-owner co-ops structured as LLCs or as cooperative corporations. This can get complicated quickly, and there are lots of confusing elements, but we will try to break it down simply. It’s important to remember that in addition to personal income tax, LLC members who are not “employees” but worker-owners have to pay self-employment tax (which is around 15%) on all their earnings plus personal income tax on their earnings (although they do get to deduct an amount equal to half of the self-employment tax from their earnings, because it is a business expense). A co-op set up as a corporation, however, only has to pay employment tax on members’ wages and then individuals pay personal income tax on their wages and patronage dividend. Given that the self-employment tax is over 15% (although half of it is deductible for an LLC member), this can make a big difference. Let’s look at a couple of examples to see the implications.
Example 1 (LLC Cooperative): Imagine that an LLC member was paid a ‘wage’ (technically a draw on profits — see Part 1) of $15 an hour. Working a regular 40-hour work week, that’s 2,080 hours a year for a total of $31,200. Plus, at the end of the year she gets paid $10,000 as her share of profits. She’d pay self-employment tax (15%) on that total $41,200 – which is around $6,200 — plus personal income tax on about $38,000 (the $41,200 less about half the self-employment tax, considered the ‘employer’ portion). Assuming a personal income tax rate of around 20%, that’s a total of about $14,000 in taxes.
Example 2 (Cooperative Corporation): If the same member were working for a cooperative corporation, she would only pay employment tax on the wage income ($31,200) and then would pay personal income tax on the total of wages and dividends — let’s call that total $39,000. (To keep things equal, I’ve reduced the patronage dividend to account for the fact that the co-op has to pay the employer side of the employment tax and the profits would be less – the reality would be different, but this is close). That’s a total of about $10,000 in taxes for the member, plus $2,300 for the co-op, or about $1,400 less than in the LLC example.
Here’s where it gets (even more!) complicated: As an LLC member, the person in example 1 can deduct everyday expenses as business related. So if she could claim more than $7,000 in expenses that she could deduct, she’d come out (just barely) ahead. If she could claim more deductions, she’d do even better. Of course at the corporation, if the co-op lowered the hourly rate to $12 and paid out more in patronage, they can boost things as well. If, for instance, they reduced the wage to $13 but between the wage and patronage still had the same net payout, the corporate co-op member would be close to $2,000 ahead of the LLC member.
It’s dizzying and it’s possible (likely) that I’ve missed some element, but all-in-all, in a documented worker situation, for the LLC scenario to be beneficial, members likely have to be prepared to have a more complicated tax situation where they take business deductions. The corporate scenario allows for a simple tax situation, simple retained earnings, and so long as they’re keeping wages low and paying out profits in patronage, they can lower the tax obligation. (Of course if the IRS starts auditing folks and says patronage paid out before 3 years is actually wages, this all become moot, but if folks are paid a competitive wage and the patronage comes after the end of the fiscal year, this shouldn’t be a problem. It could be a problem, but it shouldn’t be).
One more point worth noting on a bureaucratic level, LLC members have to make quarterly estimated payments to the IRS, so if you’re used to just filing an annual tax return, you’ll have to remember to pay attention more frequently.
Ask Co-op Cathy a Question
This is very good information. You should take care to clarify when you are referring to an LLC in the absolute sense versus referring to an LLC that does not elect to be taxed as an association (i.e. an LLC taxed as a partnership or disregarded). Part 1 of this article made this point quite clearly, but it is less clear in Part 2, and a reader might think that the legal structure of the entity (rather than its Check the Box designation) was the driver of how it would be taxed.