Sole proprietorship vs. LLC: an overview
Sole proprietorship
- The default business structure for independent contractors, freelancers, and solo small business owners.
- Doesn’t require a business name, a separate business bank account, or any formal paperwork to create. (However, if you use a business name different from your legal name—also known as a DBA—your state may require a fictitious name filing.)
- Legally, there is no difference between the business entity and its owner.
- Sole proprietors have personal liability for all of the business’s debts and liabilities. Creditors can even go after a sole proprietor’s home, car, or other personal assets to satisfy business debts.
LLC
- To establish a limited liability company (LLC), you typically need to file formal documents with the secretary of state and pay a filing fee.
- Most states require LLCs to have an operating agreement or articles of organization. You also need to keep business and personal funds separate by opening a business bank account (and ideally credit card) for business expenses.
- Provides more legal liability protection because business owners, also called members, are usually not personally liable for the LLC’s debts or lawsuits.
- If an LLC files for bankruptcy or faces a lawsuit, the members aren’t required to use their personal assets to pay the company’s debts or cover a legal settlement.
Sole proprietorship vs. LLC: taxes
Sole proprietorships and LLCs are both “pass-through” entities, meaning they don’t pay federal taxes at the business level. Instead, profits and losses from the business pass through to the owner’s personal income tax return. That means, tax-wise, they’re really about the same. The real advantage of forming an LLC instead of a sole proprietorship is the legal liability protection.
Here’s how tax filing works for different types of legal entities.
Filing taxes as a sole proprietor
A sole proprietorship doesn’t have to file a separate business tax return. The business owner simply reports the business income and expenses on Schedule C attached to their personal income tax return, Form 1040. The sole proprietor pays income taxes at their individual tax rate.
Self-employment taxes must be paid based on business profits. These taxes cover the social security and Medicare payments typically included in payroll taxes.
Filing taxes as an LLC
With an LLC, tax filing depends on whether the LLC is a single-member LLC (just one person) or multi-member LLC.
- Single-member LLC. For tax purposes, single-member LLCs are the same as sole proprietorships. Both are “disregarded entities” because they report business income and expenses on Schedule C attached to the owner’s personal income tax return.
- Multi-member LLCs. These companies file the same tax form used by partnerships: Form 1065. After the LLC’s Form 1065 is filed, each LLC member receives a Schedule K-1 that includes their share of the business’s profit or loss. The member then uses that Schedule K-1 to report their business income or loss on their individual tax return.
Either way, sole proprietors and members of an LLC pay federal and state income taxes and self-employment taxes on the business income with their personal tax return. An LLC can also elect to file as an S corporation for potential tax benefits (more on that later).
Franchise taxes and fees as an LLC
States charge franchise taxes on some entity types, but not all. Because these laws vary state-by-state, your location will determine whether you have to pay franchise taxes and how much.
For example, LLCs based in California pay a yearly $800 franchise fee, in addition to an LLC fee based on your annual income. In Texas, your business’s profit margins determine your franchise taxes.
These franchise taxes and fees are paid in addition to the usual federal and state income taxes. Whether an LLC saves you money on taxes will depend on where your business is located.
How Bench can help
Regardless of your business structure, accurate and complete bookkeeping is the backbone of a stress-free tax season. With Bench, your bookkeeping is completed and reviewed every month, giving you access to up-to-date and accurate information on your business’s financial health. Come tax season, a CPA or tax professional uses your Bench-generated financial reports to get you filed. Don’t have a tax solution? Bench can file for you as part of your subscription package. Learn more.
Sole proprietorship vs. LLC: legal protection
The biggest advantage to choosing an LLC over a sole proprietorship is liability protection.
Since sole proprietorships aren’t separate entities from the business owner, what the business is liable for, so is the business owner. For example, if you got a loan to buy new equipment for your lawn care business, defaulting on the loan could mean the lender will come after your personal assets (e.g., house or car) as collateral.
An LLC is a separate legal entity from the business owners. The owners are granted liability protection, so their personal assets are protected.
Sole proprietorship vs LLC: paperwork and compliance
A sole proprietorship doesn’t need much in terms of paperwork. They’re unincorporated businesses that can be started as quickly as you get a business idea.
But an LLC requires certain legal documents to operate. This means you’ll need to do some footwork before getting your business started. For example, some states require a business license and an employer identification number.
Learn more: What is an EIN Number?
Each state will have its own filing fees, necessary documents, and reporting requirements. The amount of paperwork required depends on your LLC’s location.
LLC vs. sole proprietorship vs. corporation
Both sole proprietorships and limited liability companies are relatively simple to form and maintain. But some companies need a more formal structure than either of these entity types can provide. In that case, the business might consider incorporation.
When you incorporate your new business, you have the option of structuring your business as a C corporation or an S corporation. You may also elect to have your LLC taxed like a C corporation or an S corporation.
Further reading: C Corp vs. LLC: Which Is Better for Early-Stage Entrepreneurs?
C corporation
A C corporation (or C corp) is an entirely separate taxable entity. C corporations file a corporate tax return (Form 1120) and pay taxes at the corporate level. Being structured as a C corporation makes it easier for a company to raise substantial capital or go public. It’s also easier to transfer stock or ownership in a C corporation. However, a corporation’s profits are taxed twice—once when the company makes a profit and again when the company pays out dividends to its shareholders.
If you’re currently doing business as an LLC, you may be able to make an election to have your business taxed like a C corporation by filing Form 8832.
S corporation
An S corporation (or S corp) files its own tax return (Form 1120-S), but business profits and losses pass through to the owner’s personal tax return. This tax status allows them to avoid the double taxation drawback of C corporations.
However, S corporations have more limitations, as they can’t have more than 100 shareholders, and all shareholders must be U.S. citizens.
If you’re currently doing business as an LLC, you may be able to elect to be taxed as an S corporation by filing Form 2553.
However, before changing your LLC’s tax status, talk to an accountant or tax lawyer. There are a number of pros and cons to selecting either C corporation or S corporation status for your business—more than we can cover in this article. Make sure you consider the whole picture before filing an election with the IRS.
