Sole Proprietorship vs. Single-Member LLC: Subtle but Powerful Differences

As a busy business owner, I crave simplicity. And for many small businesses, keeping things simple is so important because we already feel like we’re at capacity on all fronts. 

That's why Sole Proprietorships and Single-Member LLCs are some of the most popular choices for people just starting out. Both are easy to set up or get started, but they can get complicated when it comes to taxes. Each type has its own set of rules, benefits, and potential drawbacks, which makes it important to understand exactly what you're getting into.

In this article, we’ll examine the tax impacts of Sole Proprietorships and Single-Member LLCs. 

We'll discuss the pros and cons, and ways to save on taxes while protecting your personal assets. We'll also explore when it might make sense to switch from one type to the other as your business grows. 

Understanding these differences is crucial for making sure your business has the best start possible.

Sole Proprietorship: The Simplest Business Entity

A Sole Proprietorship is the easiest way to set up your business. You don’t need to register with the state or deal with lots of paperwork—if you're working by yourself, you're automatically a Sole Proprietor. You’re essentially doing business as yourself. You can use your Social Security Number as your Tax Identification Number (although we recommend you apply for an Employer Identification Number or EIN if you choose to remain a Sole Proprietor as this will help protect your identify.)

This is why it’s a common choice for freelancers, independent contractors, and anyone just getting started. 

However, this simplicity comes with some downsides, especially when it comes to taxes.

Tax Filing

As a Sole Proprietor, you report your business income and expenses on your personal tax return using a form called Schedule C (Form 1040). 

This makes tax filing pretty easy, but it also means there's no legal separation between you and your business. 

All profits are considered your personal income and are taxed as such, including paying self-employment taxes (aka Social Security and Medicare taxes paid by the self employed). 

In other words, you and your business are treated as the same entity for tax purposes, and that can make things more complicated.

• Self-employment tax: Sole Proprietors must pay 15.3% in self-employment taxes (12.4% for Social Security and 2.9% for Medicare) on all net earnings up to $168,600 (for 2024). If you earn more than this, you only pay 2.9% for Medicare plus an extra 0.9% on earnings over $200,000 if you're single, or $250,000 if you're married and filing jointly. Self-employment taxes are one of the biggest challenges for Sole Proprietors because they apply to everything you earn. 
• Estimated Taxes: As a Sole Proprietor, you are not allowed to pay yourself through payroll as a W-2 employee. This means that your “income” is in the form of owner draws or pulling money directly out of the business. Without the withholding for income taxes that normally is done through a W-2, there are no payments to the government for your taxes unless you make estimated payments on a quarterly basis. 

Pros and Cons of a Sole Proprietorship

Pros:

• Very easy to set up: There’s no formal registration required. You don’t need to file formation documents with the Secretary of State, which saves you money and hassle.
• Complete control: You make all the decisions about your business. Since there are no partners or board members, you don’t need to get approval for decisions.
• Simple tax filing: All business expenses are deductible on your personal tax return, and all income is combined with your personal earnings.

Cons:

• No liability protection: If your business faces legal problems, your personal assets are at risk. You’re responsible for all debts and legal actions which could put your savings, home, or other personal property at risk.
• High tax burden: You have to pay self-employment tax on all profits. There are no strategies to limit this without changing your business type.
• Limited ability to grow: Since Sole Proprietorships can’t take on equity investors, they are generally limited in growth potential. Banks and lenders can sometimes also be more hesitant to lend to Sole Proprietorships.

Real-World Example

Imagine you run a freelance graphic design business and make a net profit of $50,000. 

As a Sole Proprietor, you would owe self-employment taxes on this amount, which comes out to $7,650 (15.3%). 

Plus, you would have to pay income taxes based on your overall income tax bracket. This can really add up and can make tax filing time stressful if you haven’t been saving up to cover these costs.

Now let’s imagine that, on top of the tax you owe, your business also faces a lawsuit due to a contract dispute. Since you’re a Sole Proprietor, all your personal assets, like your car and savings account, are at risk. This can be a contributing factor to why some business owners switch to a different type of entity as they grow.

Single-Member LLC: Flexibility with Some Extra Protection

A Single-Member LLC (Limited Liability Company) is similar to a Sole Proprietorship in many ways, but it can offer more protection by separating your personal assets from your business liabilities. 

(Please note, that at Make Taxes Fair we are not attorneys and this information is educational in nature. We encourage you to consult an attorney regarding the ins and outs of what legal protection an entity such as an LLC or Corporation may or may not afford you.)

The LLC structure can provide a layer of liability protection that helps keep your personal finances safe if the business runs into problems. This means that, unlike a Sole Proprietorship, your personal property may be protected from lawsuits or debts of the business.

Despite this potential layer of protection, it’s important to still manage your risk by obtaining and carrying appropriate amounts of insurance.

Tax Filing

By default, a Single-Member LLC is called a “disregarded entity” for tax purposes, which means the IRS treats it like a Sole Proprietorship. This means the owner still files taxes on Schedule C and pays self-employment tax on all profits. 

Recall that scenario above, the tax bill would be identical to a Schedule C or Sole Proprietorship tax filing.

However, unlike a Sole Proprietorship, the LLC is a separate legal entity, which can help if you face legal issues.

While the Federal tax return is a “simplified filing” on the Schedule C, some states require specific forms or filings as well as potentially a tax, fee, or other payment due to the State.

Other Legal Filings

In addition to the income tax filings, there may also be other State filings with the Secretary of State for the state in which you are registered and doing business in. 

Choosing The S-Corporation Election

Another plus side of a Single-Member LLC is that you have the choice to choose a different tax path. By filing the IRS Form 2553 to be taxed as an S-Corp or Form 8832 to be taxed as a C-Corp you can choose from options that allow you to explore other tax strategies, like reducing self-employment taxes (S-Corp) or benefiting from corporate tax rates (C-Corp). This flexibility can save you a lot of money, especially as your business starts earning more.

Pros and Cons of A Single Member LLC

Pros:

• Liability protection: Your personal assets can be safeguarded from business debts and legal actions. If your business gets sued, your home and personal savings can generally benefit from an extra layer of protection from the LLC.
• Tax flexibility: You can choose how to be taxed—either as a Sole Proprietorship, an S-Corp, or a C-Corp. This flexibility allows you to adapt your tax strategy as your business grows.

Cons:

• Self-employment tax: If you choose the default tax status (as a Sole Proprietor), you still have to pay self-employment tax on all profits, just like a Sole Proprietor.
• Extra paperwork and fees: There are additional state fees and paperwork required to create and maintain the LLC. This can be a hassle and may cost a few hundred dollars per year.

More complexity: Running an LLC is a bit more complex than running a Sole Proprietorship. If you elect S-Corp status, you will need to manage payroll and follow more rules.

Real-World Example

Say you run a Single-Member LLC and make the same $50,000 in net profit as in the Sole Proprietor example above. If you use the default tax setup, you’ll still owe $7,650 in self-employment taxes. But if you choose to be taxed as an S-Corp and pay yourself a reasonable salary of $35,000, you would only owe self-employment taxes on that salary, not the additional $15,000 profit. This could save you a lot of money.

NOTE: The example here of a “reasonable salary” does not use any rule of thumb assumptions. Reasonable salary should be determined by conducting a Reasonable Compensation Study.

Now, imagine your business faces a lawsuit. Unlike a Sole Proprietorship, the LLC can add a layer of protection for your personal assets, meaning that your home and car are made more safe from claims. This extra layer of protection can give you peace of mind and make running your business less stressful.

Tax Implications of Self-Employment Taxes

Both Sole Proprietorships and Single-Member LLCs (if taxed by default) have to pay self-employment taxes. This tax covers your contributions to Social Security and Medicare. For most small business owners, this tax rate—15.3%—is higher than what you would pay if you structured your business differently. This is one of the reasons many business owners look for ways to reduce their tax burden.

Tax-Saving Strategies

• Health Insurance Deductions: If you are self-employed and buy health insurance, you can deduct the premiums for yourself, your spouse, and your dependents. This can help reduce your overall taxable income. Unfortunately, self employed health insurance deductions do not reduce your Self Employment Taxes.
• Business Expenses: Deduct all legitimate business expenses, like home office deductions, internet, and utilities used for work. These deductions can really add up and reduce how much tax you owe.
• Retirement Plans: Setting up a SEP-IRA or Solo 401(k) can give you significant tax deductions while helping you save for retirement. Contributions to these accounts are tax-deductible, which means you’ll pay less tax now while saving for your future. Similar to the health insurance deductions, retirement contributions also do not reduce the amount of Self Employment Taxes.

When to Consider Changing from Sole Proprietor to LLC

As your business grows, staying a Sole Proprietor might not give you enough protection or tax flexibility. Here are some situations where switching to an LLC could be a good idea:

• Liability Protection: If your business has employees, works with big clients, or involves activities that could lead to lawsuits, forming an LLC can help protect your personal assets. For example, if you’re running a construction business or providing professional advice, an LLC can keep your personal savings and property safe.
• Tax Flexibility: If your business income becomes high, electing S-Corp status could help you reduce self-employment taxes by splitting your income between salary and profit distributions. This way, you can keep more of what you earn.
• Growth Plans: If you want to expand, add partners, or bring in investors, an LLC makes it easier to add members without completely restructuring your business. Investors are often more comfortable with LLCs compared to Sole Proprietorships, which can make it easier to get funding.

Switching to an LLC doesn’t have to be complicated, but it does require planning. You’ll need to file formation documents with your state, get a new tax ID number, and ensure your business records are updated. Despite the extra steps, many business owners find the added protection and tax flexibility to be worth it.

Income Matters

As a general rule, as a business approaches the $70,000 to $80,000 net profit mark, the conversation of making the S-Corporation election becomes more relevant.

When a business hits the milestone of consistently generating net revenue (gross income minus all expenses) then that is the point where a business is better able to manage the financial responsibilities that come with making the S-Corporation election.

More of these responsibilities and requirements will be covered in the S-Corporation article in this series but some of those responsibilities include:

• Reasonable Compensation/Salary: The savings found by making the S-Corporation election mean that the IRS wants to see a “reasonable salary” for the efforts of the owner/operator of the business. At the $70,000 plus net profit milestone the business is able to begin to afford paying a salary and incurring the payroll taxes that come along with that. Below that mark, it can be a struggle to consistently pay that W-2 salary to the owner. 
• Corporate Compliance: Maintaining separate books and records is critical in maintaining the integrity of the S-Corporation and separating the business income and expenses from personal expenditures is an absolute non-negotiable. Being able to afford a bookkeeper to outsource this task is critical.

Tying it all together

Both Sole Proprietorships and Single-Member LLCs are simple options for small businesses, but they come with different tax responsibilities. 

While Sole Proprietorships are great for very small businesses or hobbies, forming an LLC can give you more protection and can save you money on taxes as your business grows. 

An LLC can be good choice if you want to reduce your personal risk or have plans to grow your business in the future.

If you’re just starting out and want to keep things simple until you get your foundation laidand are generating consistent revenue, a Sole Proprietorship might be all you need (but make sure to apply for an EIN to avoid using your Social Security Number). 

But if you’re planning to expand or want to protect your personal assets, a Single-Member LLC could be the better choice. 

The right decision depends on your business goals, your risk tolerance, and how much you want to save on taxes.

Next up in our series, we’ll look at Multi-Member LLCs and Partnerships, exploring how their tax structures work and how they can benefit businesses with multiple owners. Stay tuned for more insights into choosing the best business structure for your needs!