Key Takeaways

  • The main difference between an LLC and a sole proprietorship lies in liability protection and how taxes are filed and paid.
  • Sole proprietors report business income on Schedule C of their personal tax return and pay self-employment taxes on all profits.
  • LLCs offer limited liability protection and flexibility in taxation—single-member LLCs are taxed like sole proprietors, while multi-member LLCs file as partnerships or can elect S Corp or C Corp taxation.
  • LLC owners may reduce self-employment taxes by electing S Corp status if they pay themselves a reasonable salary and take additional profits as distributions.
  • State filing fees, ongoing compliance costs, and annual reporting requirements are generally higher for LLCs than for sole proprietorships.
  • Choosing between an LLC and a sole proprietorship depends on factors like risk exposure, business growth goals, tax savings opportunities, and administrative preferences.

LLC vs. Sole Proprietor

When comparing an LLC vs. sole proprietor business, it is worth noting that LLCs are more advantageous in the long-run. Overall, you have a variety of options at your disposal in the form of:

With that, the most common type of business entity out there is the Limited Liability Company (LLC) and sole proprietorships. A sole proprietorship is most common among startups, but it does not yield the same tax advantages and protections as an LLC.

Understanding the Tax Differences Between LLCs and Sole Proprietorships

When analyzing LLC vs sole proprietorship taxes, it’s important to understand how each entity reports income and what tax obligations apply.

A sole proprietorship reports business income on Schedule C of the owner’s personal Form 1040. Profits are taxed as personal income, and the owner must pay self-employment tax (covering Social Security and Medicare) on the entire net income. This often results in a higher tax burden, especially as profits increase.

An LLC, on the other hand, provides more flexibility.

  • A single-member LLC is taxed by default as a sole proprietorship but can elect to be taxed as an S Corporation or C Corporation to reduce overall taxes.
  • A multi-member LLC is typically treated as a partnership for tax purposes and must file an informational return using Form 1065.

LLCs taxed as S Corporations can save on self-employment taxes by paying the owner a “reasonable salary” and classifying the remaining profits as distributions, which are not subject to payroll taxes.

Sole Proprietorships

Sole proprietorships begin as a single person doing business under a company name, otherwise known as Doing Business As (DBA). It is the easiest entity to create, and it is the most popular entity path in the United States. Sole proprietorships allow you to report net incomes and losses from personal income taxes. The main attributes you see in SPs are:

  • An organization with no employees
  • Small or part time businesses

Starring a sole proprietorship is free, with no costs whatsoever. You only need to file a DBA document with your county clerk’s office to prevent others from using your business name. Filing with a county clerk allows you to:

  • Open a business bank account
  • Apply for credit cards
  • Apply for small business loans

However, you must pay self-employment taxes, which usually comes with a heftier tax burden. With that, it is the easier way to start your own business as a separate entity, and it can pave the way to transiting into an LLC at a later date.

Tax Filing and Deductions for Sole Proprietors

Sole proprietors must pay income tax and self-employment tax on their business earnings. The IRS treats the owner and the business as one entity, meaning all income passes directly to the owner’s personal return.

Common deductions include:

  • Business-related expenses such as supplies, rent, and utilities
  • Home office expenses (if applicable)
  • Mileage and vehicle costs
  • Health insurance premiums

Sole proprietors must make quarterly estimated tax payments and file Schedule SE for self-employment taxes. They cannot split income between salary and dividends, which limits their ability to reduce self-employment tax liability.

While a sole proprietorship is simpler to manage, the lack of separation between personal and business assets can expose the owner to greater financial risk in case of debt or legal action.

LLCs

Limited liability companies offer primary advantages over SPs in the form of:

  • Protections against debts and liabilities
  • Protection from creditors and lawsuits
  • Pass-through taxation

LLCs absorb any liabilities or debts, absolving all participants in the LLC. Under an LLC, creditors cannot lay claim to your personal possessions, such as a house or car, to satisfy any judgments against you. Separating your personal and business assets also requires extensive record-keeping to ensure your assets are properly divided.

Tax Flexibility and Advantages of LLCs

One of the major benefits of forming an LLC is tax flexibility. The IRS allows LLCs to choose how they are taxed, making them more adaptable than sole proprietorships. By default, a single-member LLC is treated as a disregarded entity, but owners can elect:

  • S Corporation taxation (Form 2553): Helps reduce self-employment taxes.
  • C Corporation taxation (Form 8832): Useful for businesses planning to retain profits or attract investors.

LLCs can also deduct more business expenses, including startup costs, business insurance, and employer contributions to retirement plans. Additionally, LLC members may benefit from the Qualified Business Income (QBI) deduction, which allows eligible owners to deduct up to 20% of their business income.

This flexibility allows LLC owners to strategically minimize tax liability based on the business’s financial structure and future growth.

Disadvantages of LLCs

LLCs are more advantageous, but you must keep in mind a few key rules. First, you need to keep your business and personal accounts separate. Failure to do so not only results in messy finances, but creditors could lay claim to your personal assets if you mix business and personal assets using legal loopholes.

In addition, LLCs are subject to state governance, including annual fees. For instance, you are required to pay annual dues in most states to keep your LLC in good-standing. You must also go through the registration process, and although the filing process is fairly simple, a filing fee of $100 is necessary to complete registration.

Other states may charge fees in the hundreds of dollars. When registering, you file what is known as an articles or organization, which is the primary document that creates your LLC. Starting an LLC could amount to $1,000, but you’ll save more in the long-term when considering the high taxes levied on SPs.

If you are dealing with multiple members of an LLC, you may want to contact an attorney to get sound legal advice on how to best structure your LLC. With that, an LLC with multiple members increases your chances of getting a loan. Start-ups, especially LPs, face a tougher time getting business loans. You may also refer to the Small Business Administration to know if loans are the best route for your business.

Additionally, you must appoint a registered agent for your LLC. A registered agent is someone who accepts legal documents for your LLC and forwards them to your business. State laws vary, but a registered agent must be someone who resides in the state and has a physical address that operates during normal business hours. The good news is that almost anyone can be an agent, including yourself, in most states. Register agents are not required for SPs.

Comparing Costs and Administrative Requirements

Although LLCs offer significant legal and tax advantages, they involve more costs and administrative duties than sole proprietorships. Most states require:

  • Formation filing fees (typically $50–$500 depending on the state)
  • Annual report filings and franchise taxes to maintain good standing
  • Registered agent services, which may cost additional fees annually

In contrast, a sole proprietorship generally has no formal registration costs beyond a DBA filing. However, the trade-off for this simplicity is the absence of liability protection and fewer tax planning opportunities.

Entrepreneurs should weigh the long-term savings from tax flexibility and liability protection against the initial and ongoing costs of forming an LLC.

Pass-Through Taxation

Pass-through taxation is the process of passing profits and losses through the LLC to the personal tax returns of each member. The pass-through method prevents you from paying double taxes, as would be the case under a corporate structure.

With SPs, however, you are responsible for any debts and obligations incurred in your company name, and your creditors have access to any personal possessions you have to satisfy outstanding debts. In addition, pass-through taxation is not available to an SP.

Self-Employment Taxes Explained

Both LLC owners and sole proprietors must pay self-employment taxes to cover Social Security and Medicare contributions. The current self-employment tax rate is 15.3% on net earnings.

  • Sole Proprietors: Pay this rate on all business profits.
  • LLC Owners: Can limit this tax if they elect S Corporation taxation, paying self-employment taxes only on wages, not on profit distributions.

LLC owners also have more opportunities to reinvest profits and structure compensation to reduce taxable income. For small business owners with growing profits, this can lead to substantial long-term savings.

Choosing the right entity structure affects how much of your revenue remains after taxes and business expenses, making it essential to consider both current income and future growth goals when comparing LLC vs sole proprietorship taxes.

Frequently Asked Questions

  1. How do I decide between an LLC and a sole proprietorship for tax purposes?
    Consider your business’s income, growth potential, and risk exposure. Sole proprietorships are simpler, but LLCs offer liability protection and more tax planning flexibility.
  2. Can a sole proprietorship become an LLC later?
    Yes. Many business owners start as sole proprietors and later form an LLC to gain liability protection and tax advantages.
  3. Do LLCs pay more taxes than sole proprietorships?
    Not necessarily. While LLCs have more fees, they often pay less in self-employment taxes, especially if they elect S Corporation status.
  4. How do LLC owners pay themselves?
    LLC owners typically take an owner’s draw or, if taxed as an S Corp, receive a salary plus dividends. The method affects how self-employment taxes are calculated.
  5. Do both entities qualify for the Qualified Business Income (QBI) deduction?
    Yes, both LLCs and sole proprietorships may claim the 20% QBI deduction if they meet IRS requirements.

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