Key Takeaways

  • Tax Implications: Self-employed individuals pay self-employment taxes on net earnings, whereas LLCs can reduce tax liability by electing to be taxed as an S corporation.
  • Liability Protection: LLCs protect personal assets, unlike sole proprietorships or partnerships, which don't separate personal and business liabilities.
  • Costs and Administrative Burdens: Forming an LLC incurs state-specific fees and ongoing compliance requirements, whereas being self-employed has minimal administrative costs.
  • Flexibility and Scalability: LLCs provide a flexible structure, allowing for single or multiple members, making them scalable as the business grows.
  • Industry and Operational Suitability: Certain industries or client preferences might necessitate forming an LLC for legitimacy or contractual reasons.

Being treated as an LLC vs. self-employed person can make a world of a difference in the amount of taxes you pay. If you're an employee, the employer will pay 50 percent of your Medicare and Social Security taxes. If you're self-employed, you have to take care of all your taxes yourself. The tax you pay as self-employed is called the self-employment tax, and you might be able to reduce its amount by forming a limited liability company or a corporation. 

Self-Employment Tax Rates

Self-employment tax rates are:

  • 12.9 to 15.3 percent for Social Security paid on the portion of your income up to $117,000
  • 2.9 percent for Medicare plus an additional 0.9 percent on yearly wages over $200,000

Sole proprietors, partners in a general partnership, and members of an LLC that's taxed as a disregarded entity must pay self-employment taxes. Many businesses make estimated quarterly payments to the IRS to avoid being surprised with a large yearly bill and costly fines or penalties. You can estimate your taxes with an online tax calculator.

Taxes for Corporations and LLCs 

Unlike partnerships and individuals, the IRS treats all corporations like C corporations automatically. The corporation pays income tax on earnings, and its owners, also called shareholders, pay some personal income tax on the amounts they receive as well. Many small businesses choose to pay taxes as S corporations instead. An S corporation doesn't pay corporate income tax, and its shareholders report the company's income on their personal returns.

An LLC can be taxed as a disregarded entity, which means that it is taxed as a sole proprietorship or a partnership. It can also be taxed as an S corporation. Partners in a limited partnership or a partnership that's taxed as a corporation are not self-employed. The owners or shareholders of corporations receive income from dividends. Because this income isn't from self-employment, it's not subject to the self-employment tax. Compensation from your corporation is employment income, so employees pay the employee tax rate rather than the self-employment rate. 

Comparison of Tax Benefits for Self-Employed vs. LLC

An LLC can offer significant tax advantages over being self-employed, particularly with the option to elect taxation as an S corporation. For self-employed individuals, all net earnings are subject to self-employment taxes. However, LLC owners taxed as an S corporation only pay self-employment taxes on salaries, not on profits distributed as dividends.

Additionally, LLCs can deduct various business expenses more effectively, potentially lowering overall taxable income. By contrast, self-employed individuals must ensure all personal and business finances are clearly separated to claim similar deductions.

Avoiding the Self-Employment Tax

If you're a sole proprietor, a partner, or an LLC that's a disregarded entity, you'll pay Medicare and Social Security taxes on your percentage of your company's net income or profits. If your business is an S corporation or an LLC that's considered an S corporation, you'll pay Medicare and Social Security taxes only on the salary you receive, not on your company's other profits. You can't avoid self-employment taxes entirely, but forming a corporation or an LLC could save you thousands of dollars every year.

If you form an LLC, people can only sue you for its assets, while your personal assets stay protected. You can have your LLC taxed as an S Corporation to avoid self-employment taxes. However, you may not need an LLC if you have a good professional liability and property insurance coverage and do not have many assets.

Understanding Personal Liability in Self-Employed vs. LLC

One of the most notable distinctions between self-employment and operating an LLC is personal liability. As a self-employed individual or sole proprietor, personal and business assets are not separated. This means creditors can pursue your personal assets to settle business debts.

An LLC provides a protective barrier, shielding personal assets from business liabilities. This makes LLCs a preferred choice for businesses with higher risk exposure, such as construction or consultancy. However, this liability protection requires that LLC members maintain compliance with corporate formalities, such as separate bank accounts and accurate record-keeping.

How To Be Taxed as an S Corporation

To form a corporation or an LLC, you must file the correct documents with the secretary of state or another designated agency in the state where your company is located. The IRS automatically taxes all corporations as C corporations that pay corporate income tax. It taxes LLCs as disregarded entities whose owners pay self-employment tax on all their earnings. To be considered an S corporation by the IRS, you must file form 2553. If your company is an LLC, file form 8832.

Costs and Administrative Requirements

Forming and maintaining an LLC comes with additional costs compared to remaining self-employed. State-specific formation fees, annual filing requirements, and registered agent fees are common. For example, LLC annual maintenance costs range from $50 to over $500, depending on the state.

In contrast, self-employment involves minimal setup costs. However, LLC owners must adhere to more rigorous administrative tasks, such as maintaining minutes of meetings and submitting periodic reports. Self-employed individuals can bypass these requirements, but they may miss out on the benefits of a formal business structure.

What Is an LLC?

Owners of an LLC can take advantage of limited liability, like the owners of a corporation. LLCs can also pass through profits to the owners, so they're taxed at the lower individual rate. There are no limits on the number of owners an LLC can have. LLCs can file taxes as sole proprietors, also called single-member LLCs. They can also file taxes as S corporations or partnerships. The costs of creating an LLC depends on the state you want to do business in.

A single-member LLC protects your personal assets from the creditors. Setting up an LLC also lets you avoid paying personal and business taxes on your freelance income. As a pass-through entity, all the income and expenses of an LLC get reported on your personal income tax return.

Choosing the Right Business Structure for Your Industry

The choice between self-employment and an LLC can depend significantly on your industry and goals. For example:

  • Freelancers or Gig Workers: Often prefer self-employment for simplicity.
  • Consultants or Agencies: May choose LLCs for liability protection and client credibility.
  • Retail or E-commerce Businesses: Benefit from an LLC structure to scale and protect assets.

Assessing your long-term goals and industry norms can guide this decision. Certain clients or industries may only work with businesses structured as LLCs for contract purposes.

FAQ Section

  • What is the main difference between self-employed and LLC?
    The primary difference lies in liability and taxation. Self-employed individuals are personally liable for business debts, whereas an LLC provides personal liability protection.
  • Can self-employed individuals reduce their tax burden?
    Yes, they can deduct business expenses, but forming an LLC and electing S corporation taxation often provides more tax-saving opportunities.
  • How much does it cost to form an LLC?
    Costs vary by state, typically ranging from $50 to $500 for formation, with annual fees for maintenance.
  • What industries benefit most from forming an LLC?
    Industries with higher liability risks, such as construction, consulting, or e-commerce, often benefit from LLC structures.
  • Is forming an LLC worth it for freelancers?
    It depends on the freelancer’s income level, liability risk, and client preferences. Those earning consistently or dealing with high-risk projects might find it advantageous.

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