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.
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.
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.
Pros:
Cons:
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.
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.
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:
Cons:
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.
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.
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.
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:
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.
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:
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!