Sole proprietorships and LLCs are two of the most common business structures for small businesses, freelancers, and startups. Here's an overview of each.
Sole proprietorships and LLCs are both "pass-through" entities, meaning they don't pay federal taxes at the business level. Instead, profits and losses from the business pass through to the owner's personal income tax return. That means, tax-wise, they're really about the same. The real advantage of forming an LLC instead of a sole proprietorship is the legal liability protection.
Here's how tax filing works for different types of legal entities.
A sole proprietorship doesn't have to file a separate business tax return. The business owner simply reports the business income and expenses on Schedule C attached to their personal income tax return, Form 1040. The sole proprietor pays income taxes at their individual tax rate.
Self-employment taxes must be paid based on business profits. These taxes cover the social security and Medicare payments typically included in payroll taxes.
With an LLC, tax filing depends on whether the LLC is a single-member LLC (just one person) or multi-member LLC.
Either way, sole proprietors and members of an LLC pay federal and state income taxes and self-employment taxes on the business income with their personal tax return. An LLC can also elect to file as an S corporation for potential tax benefits (more on that later).
States charge franchise taxes on some entity types, but not all. Because these laws vary state-by-state, your location will determine whether you have to pay franchise taxes and how much.
For example, LLCs based in California pay a yearly $800 franchise fee, in addition to an LLC fee based on your annual income. In Texas, your business's profit margins determine your franchise taxes.
These franchise taxes and fees are paid in addition to the usual federal and state income taxes. Whether an LLC saves you money on taxes will depend on where your business is located.
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The biggest advantage to choosing an LLC over a sole proprietorship is liability protection.
Since sole proprietorships aren't separate entities from the business owner, what the business is liable for, so is the business owner. For example, if you got a loan to buy new equipment for your lawn care business, defaulting on the loan could mean the lender will come after your personal assets (e.g., house or car) as collateral.
An LLC is a separate legal entity from the business owners. The owners are granted liability protection, so their personal assets are protected.
A sole proprietorship doesn't need much in terms of paperwork. They're unincorporated businesses that can be started as quickly as you get a business idea.
But an LLC requires certain legal documents to operate. This means you'll need to do some footwork before getting your business started. For example, some states require a business license and an employer identification number.
Learn more: What is an EIN Number?
Each state will have its own filing fees, necessary documents, and reporting requirements. The amount of paperwork required depends on your LLC's location.
Both sole proprietorships and limited liability companies are relatively simple to form and maintain. But some companies need a more formal structure than either of these entity types can provide. In that case, the business might consider incorporation.
When you incorporate your new business, you have the option of structuring your business as a C corporation or an S corporation. You may also elect to have your LLC taxed like a C corporation or an S corporation.
Further reading: C Corp vs. LLC: Which Is Better for Early-Stage Entrepreneurs?
A C corporation (or C corp) is an entirely separate taxable entity. C corporations file a corporate tax return (Form 1120) and pay taxes at the corporate level. Being structured as a C corporation makes it easier for a company to raise substantial capital or go public. It's also easier to transfer stock or ownership in a C corporation. However, a corporation's profits are taxed twice—once when the company makes a profit and again when the company pays out dividends to its shareholders.
If you're currently doing business as an LLC, you may be able to make an election to have your business taxed like a C corporation by filing Form 8832.
An S corporation (or S corp) files its own tax return (Form 1120-S), but business profits and losses pass through to the owner's personal tax return. This tax status allows them to avoid the double taxation drawback of C corporations.
However, S corporations have more limitations, as they can't have more than 100 shareholders, and all shareholders must be U.S. citizens.
If you're currently doing business as an LLC, you may be able to elect to be taxed as an S corporation by filing Form 2553.
However, before changing your LLC's tax status, talk to an accountant or tax lawyer. There are a number of pros and cons to selecting either C corporation or S corporation status for your business—more than we can cover in this article. Make sure you consider the whole picture before filing an election with the IRS.
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