Key Takeaways

  • Sole proprietors pay self-employment tax (Social Security and Medicare) on all net profits, while LLC owners may reduce this liability by choosing an S corporation tax status.
  • LLCs offer more tax flexibility, allowing owners to elect to be taxed as a sole proprietorship, partnership, or corporation.
  • Sole proprietorships are simpler and cheaper to start but provide no liability protection, unlike LLCs.
  • An LLC can lower self-employment taxes by separating owner salaries (subject to payroll tax) from dividends or distributions.
  • LLC owners may also qualify for the Qualified Business Income (QBI) deduction, potentially reducing taxable income by up to 20%.

When considering LLCs vs sole proprietorship self employment tax, you'll need to look at how your business is structured with an eye to how your tax liability will change. The self employment tax, a charge levied by the government on people who work for themselves to make up for the lack of payroll tax deductions, can take the unaware by surprise, leading to unpleasant situations on tax day. But a well-prepared company should have no problems.

Payroll Taxes

Most people have worked for someone else at some point in their lives. If you ever look at your pay stub, you'll notice deductions made for Social Security and Medicare, programs designed primarily to help elderly Americans who have retired. These deductions are called payroll taxes, taken out of your earnings before you ever see them. Your employer pays half of your payroll taxes, and you pay the other half.

It's important to understand that there is a cap on Social Security liability; past $117,000, you pay no more into the system on your excess earnings. Medicare, instead, covers your entire paycheck. If you make over $200,000, the Medicare rate goes up.

LLC and Sole Proprietorship Payroll Responsibilities

Both LLCs and sole proprietors are responsible for paying federal payroll taxes if they have employees. For sole proprietors, payroll taxes apply to employee wages, while the owner pays self-employment tax on their net earnings.

In contrast, LLC payroll taxes depend on the tax classification:

  • Single-member LLCs taxed as sole proprietorships must pay self-employment taxes on net profits.
  • Multi-member LLCs taxed as partnerships share these taxes among members.
  • LLCs taxed as S corporations treat owners as employees, meaning the LLC must withhold Social Security and Medicare taxes from their paychecks and pay the employer’s portion as well. This setup can significantly reduce total payroll tax liability, since only salaries—not total profits—are taxed as employment income.

Self-Employment Tax

The self-employment tax is how you make up for payroll and income taxes on income that isn't from working directly for someone else. This is the tax you pay if you work for yourself, either because you own the company, or because you work freelance. If you are a business, however, you need to make quarterly payments to the IRS, or they will start to look at auditing you.

How Self-Employment Tax Differs Between LLCs and Sole Proprietorships

The self-employment tax rate is currently 15.3%, which includes 12.4% for Social Security and 2.9% for Medicare. Sole proprietors must pay this tax on all net business income, even if they reinvest their earnings.

By contrast, LLC owners have more flexibility:

  • Default LLC classification: Members pay self-employment tax on their share of profits.
  • S corporation election: Only the salary paid to the owner is subject to self-employment tax, while the remaining profits are treated as distributions, which are not subject to payroll tax.
  • Example: If an LLC owner earns $100,000 and pays themselves a reasonable salary of $60,000, they pay self-employment taxes only on that $60,000—potentially saving thousands in taxes each year.

This flexibility makes an LLC appealing for small businesses seeking both liability protection and potential tax savings.

Taxation and Business Type

The simplest form of business is the sole proprietorship, followed by the partnership. In both forms, the business is largely indistinguishable from its owners. At tax time, the income made by such a business is treated as “pass through” income made by the owners, who report it on their individual income taxes. These companies also have to pay payroll taxes, including Social Security and Medicare, on the entire income of the company.

A corporation, on the other hand, is usually subject to a special tax called the corporate tax. This is a percentage of the money earned by the company. This money is taken out before any profits of the business can be split among its shareholders; the shareholders then pay taxes again on their share of the proceeds. Corporations pay half of the payroll tax of their employees; the employees only have to pay Social Security and Medicare on their salaries. These kinds of corporations are called C Corporations.

S Corporations, set up under special laws designed to foster small American-owned businesses, don't pay the corporate income tax. Instead, they let money “pass through” to shareholders like a partnership or sole proprietorship would. In exchange for this favorable taxation, S Corporations agree to follow strict rules on how their stock works and who it can be sold to. These rules include:

  • Only one form of stock can be issued
  • Only American citizens or legal non-citizen long-term residents can own the stock. This means that investment funds and other financial instruments cannot invest in S Corporations.
  • Only a fixed number of certificates can be issued, usually to at most 100 investors, though family members and spouses count collectively as one investor.
  • The business must be based out of the United States.
  • Certain kinds of businesses cannot be S Corporations.

LLCs are a formation of local laws, though they exist in some form in all 50 states. As such, LLC status has nothing to do with federal income taxes, though it can affect local state taxes. An LLC can be a “disregarded entity,” letting it be taxed as a sole proprietorship or partnership. It can also count as an S Corporation, as long as it is filed and operates as a corporation. In either case, the LLC's owners have to pay the self employment tax, wherein they are responsible for not only the income tax due on their money, but also the payroll taxes they would have paid were the money coming from a salary.

Federal and State Tax Considerations

Both LLCs and sole proprietorships are considered pass-through entities for federal tax purposes, meaning income passes directly to the owners’ personal tax returns. However, LLCs can choose alternative tax structures, while sole proprietorships cannot.

Key federal differences include:

  • LLCs may elect to be taxed as a C corporation or S corporation, giving owners more control over how profits are distributed and taxed.
  • Sole proprietorships have no such election—they always report business income on Schedule C of their Form 1040.

State taxes vary significantly:

  • Some states, like California and Texas, impose annual franchise taxes or fees on LLCs regardless of income.
  • Many states charge a minimum annual LLC fee (e.g., $300–$800), which sole proprietors generally avoid.
  • Sole proprietors pay only state income tax on their earnings, without any state-level filing fees in most jurisdictions.

Deductions, Credits, and Filing Requirements

LLCs and sole proprietors can both claim business deductions for expenses such as supplies, rent, utilities, and mileage. However, LLCs have additional opportunities for deductions, especially when electing S corporation taxation.

Common deductions include:

  • Health insurance premiums for self-employed individuals.
  • Retirement plan contributions (e.g., SEP IRA or Solo 401(k)).
  • Home office and business equipment expenses.

LLC owners may also benefit from the Qualified Business Income (QBI) deduction, allowing a deduction of up to 20% of qualified business income. This deduction typically applies to most LLCs and sole proprietorships but may phase out at higher income levels depending on the type of business and total taxable income.

Filing differences:

  • Sole proprietors file Schedule C and Schedule SE along with their Form 1040.
  • LLCs may file Form 1065 (partnership), 1120-S (S corporation), or 1120 (C corporation), depending on their tax status.

Choosing the Best Structure for Tax Efficiency

When comparing LLC vs sole proprietorship taxes, your choice depends on how much you earn, how you want to grow, and how much liability protection you need.

  • Choose a sole proprietorship if you’re starting small, expect limited income, and prefer simple setup and reporting.
  • Choose an LLC if you expect higher profits, want flexibility to adjust tax classification later, or need liability protection.

LLCs often become more tax-efficient as profits grow. By electing S corporation taxation, business owners can lower their self-employment tax burden and take advantage of corporate-style benefits while maintaining pass-through income reporting.

If you’re unsure which structure best fits your goals, consulting a tax professional or small business attorney can help ensure compliance and maximize your savings. You can find a qualified business attorney on UpCounsel to guide you through LLC formation or tax elections.

Frequently Asked Questions

  1. Do LLCs pay less in taxes than sole proprietorships?
    Potentially, yes. An LLC taxed as an S corporation can reduce self-employment taxes by treating part of profits as distributions instead of salary.
  2. Is it better to start as a sole proprietor or LLC?
    If you’re testing a business idea, a sole proprietorship is simple and low-cost. For long-term growth or liability protection, forming an LLC is usually wiser.
  3. Do sole proprietors qualify for the Qualified Business Income deduction?
    Yes. Both sole proprietors and LLC owners may claim up to a 20% QBI deduction, depending on income level and business type.
  4. What taxes do LLCs pay annually?
    LLCs pay federal income tax through owners’ returns and may owe state-level fees such as annual franchise taxes or filing fees.
  5. Can I change from a sole proprietorship to an LLC later?
    Absolutely. Many entrepreneurs start as sole proprietors and later form an LLC as their business and income grow, gaining both tax and liability benefits.

If you need help with LLC vs sole proprietorship taxes, you can post your legal need on UpCounsel's marketplace. UpCounsel accepts only the top 5 percent of lawyers to its site. Lawyers on UpCounsel come from law schools such as Harvard Law and Yale Law and average 14 years of legal experience, including work with or on behalf of companies like Google, Menlo Ventures, and Airbnb.