Choosing the right business structure is a critical part of entity selection and restructuring for any small business owner. Here, we’ll go over some vital information to better understand the tax implications and benefits of an LLC and a sole proprietorship, so you can make smarter decisions, protect your assets, and optimize your business finances.
What is a Sole Proprietorship?
A sole proprietorship is the simplest and least expensive form of business ownership. It’s a structure where one individual owns and operates the business, thus making them the sole proprietor. Those who run an online business, operate as a freelancer, or sell goods and services automatically operate as a sole proprietor, unless another business entity has been registered.
The most significant distinction between sole proprietorships and LLCs is that there’s no legal separation between the business and the business owner. Therefore, the sole owner of the business is personally responsible for the finances, including any debt incurred. Any profits and losses are consequently reported on personal income tax returns.
In many situations, individuals form a sole proprietorship using their legal name as the business name, but you can register a brand or trade name if preferred. Aside from this, there’s virtually no paperwork and minimal startup costs, making them an attractive option.
What is an LLC (Limited Liability Company)?
Starting an LLC requires a little more than a sole proprietorship, as it’s considered a separate business entity that needs to be created and registered following state laws. LLC structure can vary based on the number of individuals involved (multi-member LLC), but businesses with one owner can form a single-member LLC.
In an LLC, there are separations between business and personal assets. An LLC is a legal entity on its own, so it distinguishes between personal and business debts and liability. This means if the company is sued or owes money, the owner’s personal assets are protected. It’s essentially a business structure that combines the simplicity of a sole proprietorship with the legal protection of a corporation.
Key Differences Between Sole Proprietorships and LLCs
There are a few primary differences between a sole proprietorship and a limited liability company that business owners should understand, as outlined in the following table.
| Feature | Sole Proprietorship | LLC |
|---|---|---|
| Legal Status | Not separate from the owner | Separate legal entity |
| Liability | The owner is personally liable | Limited personal liability |
| Taxes | Pass-through to personal return | Flexible: default pass-through or elect corporate |
| Setup | Simple, inexpensive | Requires registration and filing fees |
| Credibility | Lower | Higher (adds professionalism) |
| Ongoing Requirements | Minimal | Annual filings, maintenance fees |
Tax Pros and Cons of a Sole Proprietorship
Sole proprietorships and LLCs also differ slightly in how they’re taxed. If you’re a sole proprietor, you’ll need to report all business income and expenses on Schedule C of your personal tax return and attach it to Form 1040. There are no separate business tax filings because, legally, you and your business are considered the same entity. This is regarded as pass-through taxation, and the net income from your business will be taxed at your individual income tax rate.
Of course, there are some advantages and disadvantages to this. If you operate your business as a sole proprietorship, some of the most notable tax pros include:
Simple filing: You only file one personal tax return using Schedule C.
Pass-through taxation: Business income is taxed once on your personal return.
Deductible expenses: You can deduct business costs like supplies, travel, and insurance.
Loss deductions: Business losses can offset other personal income.
No separate business tax: There’s no corporate tax or extra filing required.
Some disadvantages to this business structure regarding taxes include:
High self-employment taxes: You pay the full 15.3% for Social Security and Medicare.
Limited tax planning: Fewer ways to reduce taxes or structure income strategically.
No income separation: Business and personal earnings are taxed together.
Quarterly tax payments: You must make estimated tax payments four times a year.
Fewer deductions: Some advanced deductions and benefits aren’t available.
Tax Pros and Cons of an LLC
A single-member LLC and a sole proprietorship can be similar in tax treatments, as they’re both pass-through entities. In multi-member LLCs, the tax obligations of the business income are shared among all owners. However, a multi-member LLC needs to file Form 1065, U.S. Return of Partnership Income (including Schedule K-1 for each LLC member), which is a business tax return.
An LLC may also choose to pay taxes as a corporation. This means that an LLC could be established as an S corporation, where each LLC owner is treated as an employee. Alternatively, setting up an LLC as a C corporation would require the LLC to pay corporate income tax at the federal level, thus opening up the potential for business entity tax savings. Due to the complexity of options when setting up your LLC, it’s best to work with a financial coach for businesses or a tax professional to determine which option is best for your situation.
In general, if you register your business as an LLC vs. a sole proprietorship, some of the most notable tax advantages include:
Limited liability: Your personal assets are protected from business debts and lawsuits.
Tax flexibility: You can choose to be taxed as a sole proprietorship, partnership, or corporation.
Pass-through taxation: Profits are typically taxed only once on your personal return to avoid double taxation.
Potential tax savings: Electing S-corp status can help reduce self-employment taxes.
More deductions: LLCs can claim additional business deductions and benefits, such as health insurance premiums, retirement contributions, etc.
It’s also important to understand that owners of an LLC also face some disadvantages regarding taxes. Some cons of LLC filing include:
State fees: Many states charge annual LLC fees or franchise taxes.
More paperwork: LLCs require more record-keeping and compliance than sole proprietorships.
Complex taxes: Filing can be more complicated depending on your chosen tax classification.
Extra costs: You may need to hire an accountant to handle filings properly.
Possible double taxation: If taxed as a C-corp, profits can be taxed at both the corporate and personal level.
How to Switch From a Sole Proprietorship to an LLC
Forming an LLC after you have already established a sole proprietorship is also possible. This is typically a good option if business owners decide they want to gain more protection over their personal assets, expand the business, or take advantage of tax flexibility.
- Choose a name. Pick a unique business name that meets your state’s rules.
- File articles of organization. Submit the official paperwork to your state to form the LLC.
- Create an operating agreement. Outline how your LLC will be run, even if you’re the only owner.
- Get a new EIN. Apply for a new tax ID from the IRS for your LLC.
- Open a business bank account. Keep your LLC’s finances separate from personal accounts.
- Update licenses and permits. Transfer any business licenses to your LLC.
- Notify clients and vendors. Update contracts, invoices, and suppliers with your LLC info.
- Transfer assets and contracts. Move all business assets and agreements under your LLC.
- Update accounting. Track income and expenses under the LLC and consult a tax professional if needed.
How to Choose the Right Business Structure for Your SMB
Many small business owners struggle to determine the best type of business license to procure when first starting. You may want to choose an LLC if your business idea may carry a high degree of risk and requires liability protection, or requires multiple owners. On the other hand, sole proprietorships are ideal for freelancers or those beginning a smaller, less complex company.
Regardless of whether you choose an LLC or sole proprietorship, it’s important to make sure you stay proactive about your tax liability from the start. To learn more about LLCs and sole proprietorships and how to remain proactive about your taxes, book a free consultation with Del Real Tax today.
