LLC vs. Sole Proprietorship Taxes

Sole proprietorships and limited liability companies (LLCs) are legal entities recognized by the Internal Revenue Service (IRS) for tax purposes. They are appealing to anyone looking to own and operate their own business.

Sole proprietorships cost no money to start. However, choosing the LLC structure and paying the filing fee to their secretary of state affords business owners personal asset protection and tax options that are unavailable to sole proprietorships.

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Key Takeaways

• Sole proprietorships are the default single-owner business entity according to the IRS.
• LLCs are business entities that protect an owner's personal assets from a company's debts and obligations.
• Both entities are taxed at the individual income level by default, but LLCs have additional tax options.
• LLCs can choose to be taxed as either a C-corp or an S-corp, both of which provide tax-saving opportunities.

Understanding Sole Proprietorships and LLCs

Sole proprietorships are the default business entity and do not require owners to file paperwork with their state to form. Alternatively, self-employed individuals who elect a single-member LLC business structure must file paperwork with the state in a process called "organization" Sole proprietorships require little effort or money to establish, which makes them attractive to startups and new business owners.

Single-member LLCs are an excellent option for owners who want to protect their personal assets from the start. That's because LLCs safeguard the owner's personal assets if the business suffers a loss or gets sued.

Significantly, sole proprietors and single-member LLCs are taxed similarly at the outset. Under both structures, profits will automatically pass through the corporate income level and only be taxed at the personal level on the owners' annual income tax returns.

Despite this, single-member LLC owners have more tax options and flexibility than sole proprietors. That's because LLC owners can also choose to be taxed as either a C corporation (C-corp) or S corporation (S-corp).

Tax Structures of Sole Proprietorships and LLCs

Sole proprietorships are viewed as the same legal entity as their owner. Profits from the business bypass the corporate tax level but need to be reported on the owner's personal tax return. Sole proprietors must report their earnings and losses on what is called the IRS Schedule C form. Sole proprietorships can also deduct 20% of what the IRS calls Qualified Business Income (QBI). The IRS provides a list of income streams that do not qualify as QBI.

LLCs are viewed as separate legal entities from their owners but are automatically taxed similarly to sole proprietorships. They have access to the same QBI deduction benefit as sole proprietorships as well.

Sole proprietors and single-member LLCs are also both subject to self-employment taxation (for Medicare and Social Security). This tax is typically split between employees and their employers, but self-employed individuals must pay this tax in full.

Still, LLC owners have the additional options of being taxed as either a C-corp or S-corp. These options have more requirements but provide added flexibility and tax-saving options unavailable to sole proprietors.

Additional Tax Structure Options with LLCs

While your LLC can be taxed like a sole proprietorship, it can also choose to be taxed as one of the below options:

• C-corp: This legal entity can also be a tax designation for LLCs. C-corps are a terrific option for owners who want to invest as much of their gains back into the business as possible. Single-member LLC owners can pay themselves a salary and then reinvest these retained earnings into their business as tax-exempt money. This is an attractive designation to investors because it indicates a company is seeking to grow.
• S-corp: This tax designation is helpful because it limits that pesky self-employment tax described above. Suppose your business makes a profit at the end of the year. Under an S-corp, owners can lower their tax amount by taking out any money left over after paying themselves a "reasonable" salary. The withheld amount, or dividend, will not be included in an owner's taxable income even though it's technically still personal gain.

No matter how you choose to structure your business, solid bookkeeping is of the utmost importance. Learn the nuances of your business' tax structure and track your gains accordingly. This will make tax time run smoothly at the end of the year.

Choosing the Right Structure for Your Business

While the minimal cost of sole proprietorships is attractive to some, small business owners seeking long-term sustainability would be wise to incorporate as an LLC. Both can be taxed the same way, but LLCs provide protections and flexibility unattainable with a sole proprietorship.

Even those who started as sole proprietors would be wise to consider shifting their structure early on. The self-employment tax rate can rise alongside a business's growth. So, while sole proprietorships can be low-cost at the start, there is a risk that yours will become costlier over time. For this reason, it is best to keep your options open and meet the changes in your business head-on.

Seek Assistance

Taxation is a complicated subject on the best days. The added challenges that come with self-employment can make incorporating a laborious process. When you have questions that require dedicated answers, it's always best to contact a small business lawyer for guidance.

Related Topics

• LLC Member Tax FAQs
• Sole Proprietorship Taxes
• Incorporation and Legal Structures
• Business Tax Basics