Key Takeaways

  • Both self-employment and forming an LLC have advantages, but the right choice depends on liability protection, tax structure, and business goals.
  • An LLC offers limited liability protection, which separates personal and business assets.
  • Self-employed individuals (sole proprietors) have simpler setups but bear full personal liability.
  • LLCs offer more credibility, potential tax savings through S corp elections, and flexible management.
  • Startup costs, ongoing compliance requirements, and formality differ significantly between the two.
  • Independent contractors can form LLCs to enhance professionalism and gain legal protection.
  • Choosing between self-employed and LLC status impacts taxes, personal liability, growth potential, and credibility.

Self Employed vs LLC

There are some differences between a self employed vs LLC business. However, someone who is in fact self employed can create his or her own LLC. There are many reasons why someone who is self employed might create an LLC, including the following reasons:

  • Limited liability coverage
  • Pass-through taxation
  • Ability to earn compensation and have taxes deducted throughout the year

Understanding the Structural Differences

When evaluating self employed vs LLC, one key consideration is the legal structure. A self-employed individual typically operates as a sole proprietorship, meaning the business is not legally separate from the owner. In contrast, an LLC (Limited Liability Company) is a distinct legal entity formed under state law.

Key differences include:

  • Formation Requirements: Sole proprietorships require no formal registration beyond local business licenses. LLCs must be registered with the state, including filing Articles of Organization and paying a filing fee.
  • Ongoing Compliance: LLCs often require annual reports, a registered agent, and periodic fees, while sole proprietors have minimal compliance obligations.
  • Business Name Protection: LLCs offer exclusive rights to the registered name in the state, whereas sole proprietors don’t receive automatic protection of their business name unless registered as a DBA ("doing business as").

Liability and Risk Management

One of the most critical differences in the self employed vs LLC comparison is liability exposure.

  • Self-Employed (Sole Proprietorship): The owner is personally liable for business debts, lawsuits, or obligations. Personal assets like homes or savings accounts can be at risk.
  • LLC: Offers limited liability protection. The owner's personal assets are generally shielded from the business’s liabilities, provided proper business formalities are observed (e.g., not commingling personal and business finances).

This protection is especially important for businesses exposed to higher risks or client disputes.

Limited Liability Coverage

If you want to operate your own business, forming a single-member LLC is a good idea to prevent personal liability for the businesses debts and obligations. So long as you separate your personal and business assets and not comingle funds, then your LLC will not be viewed as an extension of yourself.

Credibility and Professional Image

Forming an LLC can enhance your business's credibility with potential clients, partners, and lenders. Clients may perceive LLCs as more established or reliable compared to sole proprietorships. Additionally:

  • An LLC name can help convey professionalism and permanence.
  • Contracts and invoices under an LLC name may be viewed as more trustworthy.
  • Access to funding may be easier, as some banks and investors prefer working with formal business entities.

Pass-Through Taxation

If you operate a single-member LLC, then you can choose to be taxed as a sole proprietorship or S corporation. By choosing this type of taxation, the LLC will not have to pay corporate income tax. Instead, the profits and losses will flow through to you as an owner. Therefore, you will report such profits and losses on your own personal income tax return.

If you owned and operated a C corporation, however, you would be subject to double taxation – both at the corporate and personal level, especially if the corporation pays shareholders any dividends to the shareholders.

Tax Filing Complexity and Flexibility

While both LLCs and sole proprietors benefit from pass-through taxation, the LLC offers more flexibility in how it's taxed.

  • Sole Proprietorships: File taxes using Schedule C on the individual’s personal tax return (Form 1040). All profits are taxed as personal income.
  • LLCs: By default, single-member LLCs are taxed the same way. However, LLCs can elect to be taxed as an S corporation or even a C corporation, offering strategic tax planning opportunities.

Also, LLCs may allow splitting income into salary and distributions, which can help reduce self-employment tax burdens (if elected as an S corp).

Tax Deductible Compensation

You can earn compensation and have taxes withheld throughout the year, i.e. Social Security and Medicare taxes. The problem with self employed individuals is that they are subject to self employment tax, in addition to regular income tax, on business profits. This means that their taxes can be much higher due to the fact that they have to pay Medicare, Social Security, and self employment taxes. However, if you operate a single-member LLC, you have the option of operating as a pass-through tax entity. When this happens, it allows tax season to be a lot easier since taxes are already being taken out of your paycheck throughout the year. Furthermore, the paycheck you take from the LLC is a deductible expense. This further reduces your flow-through profit thereby also reducing the amount of taxes you owe.  

You can also further reduce your taxes if you pay yourself less money. This will leave you with even greater business profits. Thereafter, you can pay yourself dividends tax-free that you would have ordinarily paid self employment tax on.

Startup Costs and Administrative Requirements

When considering self employed vs LLC, cost and paperwork are important factors:

  • Sole Proprietor: Minimal startup costs; often only requires local licenses or permits. No state filing fees or annual requirements.
  • LLC:
    • Startup Costs: Typically includes a state filing fee (ranging from $50 to $500).
    • Ongoing Requirements: May include annual reports, franchise taxes, and maintaining a registered agent.

For entrepreneurs seeking a low-cost, simple structure, sole proprietorships offer a quick setup. However, the tradeoff is limited liability protection and fewer formal benefits.

How Can An LLC Avoid Self Employment Tax?

If you operate an LLC that is a disregarded entity, then you will have to pay Social Security and Medicare taxes on your share of the company’s entire net profits. But if you operate an LLC that is taxed as an S corporation, you will have to pay such taxes only on the compensation you pay yourself and not on the rest of the business profits.

Therefore, it could be beneficial to operate an LLC that is taxed as an S corp. For example, let’s say that you operate a two-person LLC that is taxed as a partnership (50/50). Now let’s assume that you make $400,000 in profits in any given year. You will have to pay self employment tax on 50% of $400,000, or $200,000. Now let’s assume that you operate an LLC that is taxed as an S corp, and you are your partner both earn reasonable salaries of $80,000/year. You and your business will have to pay Social Security and Medicare taxes only on a portion of your compensation. Therefore, the remaining amount of your salary will be earned tax-free.

But keep in mind that you must pay yourself a reasonable compensation. You can’t pay yourself a salary of $100 and give yourself a significant compensation in the form of dividends (which are tax-free). If you fail to pay yourself what’s considered a reasonable compensation, you could risk being audited by the Internal Revenue Service (IRS). A reasonable compensation is determined by looking at several factors, including what others in the same industry get paid for the same services, the level of experience you have, your educational background, and how much of a salary other employees for the LLC are making.

Independent Contractor vs. LLC: When to Transition

Many independent contractors operate as sole proprietors but may benefit from forming an LLC. Transitioning to an LLC makes sense if:

  • You want to limit your personal liability.
  • You’re working with larger clients who prefer dealing with formal business entities.
  • You want to separate your personal and business finances more cleanly.
  • You anticipate business growth and need a structure that supports it.

An LLC can also simplify collaboration with partners or investors, as ownership shares and roles can be clearly defined in an Operating Agreement.

Frequently Asked Questions

1. Is it better to be self-employed or have an LLC?It depends on your business goals. An LLC offers liability protection and tax flexibility, while self-employment is simpler and cheaper to start.

2. Do I need an LLC if I am self-employed?No, but forming an LLC can help protect your personal assets and provide a more professional image.

3. Can a self-employed person get LLC tax benefits?Yes. By forming an LLC and electing S corp taxation, you may reduce self-employment taxes.

4. What is the main downside of an LLC?Higher startup and maintenance costs, plus more administrative tasks compared to a sole proprietorship.

5. Does an LLC pay more taxes than a sole proprietor?Not necessarily. In fact, LLCs can potentially save on taxes through pass-through taxation or S corp election.

If you need help learning about the tax implications for self employed people and LLC members, or if you are thinking about establishing a single-member LLC, 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.