LLC vs. Sole Proprietorship

One of the first hurdles you’ll face as a new business owner is identifying which  business entity is right for your future venture. As you begin your research, you might come across two options: a sole proprietorship and a limited liability company (LLC). You might wonder, “what is the difference between an LLC vs. sole proprietorship?”

Read on to better understand the difference between a sole proprietorship and LLC so you can decide what’s the best option for you as you start your business.  Each comes with its own nuances.

What is an LLC?

The Limited Liability Company (LLC) designation gives away one of its primary advantages—limited liability for its owners. This type of business entity is set up under state law, and is taxed as either a sole proprietorship, partnership, or corporation at the federal level. Read on to hear why this is the case and how to appropriately structure your business at a federal level.

With an LLC, your profits and losses are passed through. Members of an LLC taxed as a sole proprietorship or partnership pay self-employment tax, which goes toward Medicare and Social Security. Traditional employees don’t have to worry about paying self-employment tax, as their employers handle payment and withholding of employment taxes.

What is a sole proprietorship?

A sole proprietorship is arguably the simplest type of business to form and operate. You don’t need to do anything to set one up because this is the default tax entity for those engaging in business activities for themselves.  You only need to report your business income and expenses on your personal tax return.

Due to its simplicity, a sole proprietorship is often the entry point for businesses run by an individual with no contractors or employees. This is because it’s easy to set up. But in the long run, it might not be the best structure for your business as it grows and evolves.

What is the difference between an LLC and a sole proprietorship?

1 – Different incorporation requirements

As a sole proprietorship, you don’t have to fill out paperwork to form your business. Any single business owner or self-employed person who doesn’t elect another structure will default to a sole proprietorship.

By contrast, to form an LLC, you have to follow the process outlined by your state’s agency that handles LLC creation, most often the Secretary of State. Typically, to start an LLC, you should file an article of organization and pay a filing fee. Some states require you to file additional forms as you start your new business. From there, you should elect a specific federal tax structure, which we’ll outline in the next section.

2 – Different tax forms and filing

A sole proprietorship is a pass-through entity. This means income passes to its owner, who is then taxed on their personal income tax return. A sole proprietor is responsible for paying self-employment taxes. They should use Schedule C, which attaches to an individual federal tax return, Form 1040, to file taxes annually.

An LLC may be taxed under the default rules for LLCs, or the owner may elect a different type of federal tax structure. The options are:  

Single-member LLC

  • Default: Owners use Schedule C, which attaches to an individual federal tax return, Form 1040.
  • Elections: the business may elect to be taxed as a corporation (C or S corporation);
    • C corporation (Owners use Form 1120 to file your corporation’s federal taxes)
    • S corporation (Owners use Form 1120-S to file your corporation’s federal taxes and Schedule K-1 (Form 1120-S) is issued to shareholders; the passthrough to shareholders on their individual tax return, Form 1040, Schedule E)

Multi-member LLC

  • Default: Taxation as a partnership on Form 1065; passthrough to members on Schedule K-1 (Form 1065) to their individual federal tax return, Form 1040, Schedule E).
  • Elections: the business may elect to be taxed as a corporation (C or S corporation):
    • C corporation (Owners use Form 1120 to file your corporation’s federal taxes)
    • S corporation (Owners use Form 1120-S to file your corporation’s federal taxes and Schedule K-1 (Form 1120-S) is issued; passthrough to individual tax return, Form 1040, Schedule E)

Why consider using the single-member LLC structure

Many single-member LLCs keep the default taxation as a sole proprietorship to avoid double taxation, which is being taxed twice on the same source of income. The business income from a C corporation is taxed twice—we’ll explain how. With a C corporation, owners pay taxes on both business income and the dividends the corporation pays to them. The dividends are taxed on their individual tax returns.

Additionally, you won’t lose any of the limited liability protections an LLC provides by choosing to be taxed as a sole proprietorship by the IRS. But sole proprietors who haven’t chosen a business structure with liability protection are not legally separated from their business. So, if the sole proprietorship is sued or files for bankruptcy, their business and personal property are potentially at risk. In an LLC, the owner may be protected from personal liability for business debts and claims.

Want to form a new or different business entity?

Keep this in mind: it’s much easier to start off with the right business classification than to discover months or years down the road that you made a poor choice.

Is an LLC a sole proprietorship?

Here’s a related question we get from time to time: Is an LLC a sole proprietorship? An LLC is a business entity defined by state law, not federal law. In contrast, a sole proprietorship is an unincorporated business owned by one individual with no legal separation between the individual and the business. A single member LLC is taxed as a sole proprietorship by default. So, technically, you can be both—You can structure your single member business as an LLC and be taxed at the federal level as a sole proprietorship.

More help distinguishing the difference between sole proprietorship and LLC

Deciding on the best business structure for your small business shouldn’t be a decision you take lightly. It affects your tax obligation, ability to raise funds, share distributions, and more tax-related concerns. What we outline in this article are only some of the many factors to consider, and this is not intended to be legal advice or specific to any situation. We recommend you seek the advice of an attorney about the implications of entity selection.

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