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Operating Your Business: LLC vs Sole Proprietorship

Operating Your Business: LLC vs Sole Proprietorship

You may have workers on the payroll. But you’re the owner, not the employee. All of the business decisions come down to you. You control. Complications are part of ownership and creating profits.  

Your funds may be from the bank or family member loans. But you’re a small business owner, not General Motors. You’ve heard big companies often have limited liability. Is that available to the small business owner? Yes.

One route to limited liability is to form an LLC to own and manage business assets. Our topic is commerce, not your investment assets. How important is limited liability in avoiding high taxes in your particular business?

Sole Proprietors Can Operate as an LLC

An LLC is formed under state law. Your LLC needs a unique name.

It is usually formed in the state of operation where the small business owner resides. If your LLC functions outside your home state, it will also register in that state.  

Special rules may apply when certain professionals, such as doctors or lawyers, want to operate their professions as an LLC. These rules may apply when a corporation or partnership chooses to form an LLC. Our focus is the individual business owner’s limited liability company, rather than simply a sole proprietorship.

An LLC arises from registration with a particular state and is usually run by the member or members. You may also appoint a manager.

The ongoing administrative work to maintain an LLC is generally less than with a corporation. Both the limited liability company and a corporation can shelter the owner(s) from certain liabilities. In today’s litigious business environment, it is important to assess your liability risk.

Plan For Personal Asset Protection

Corporations are known for their ability to limit liability. This is important considering the growth in lawsuits. LLCs can also limit the owner’s liability in the event of a lawsuit.

Business loans to an LLC may also have limited liability. However, lenders may require the individual’s guarantee, similar to a direct loan to a sole proprietor.

The general rule is LLCs have their own assets. For example, the entity has a bank account in its name, and pays its liabilities. The goodwill of your business may lodge in the LLC.

Sole proprietors are generally subject to higher risks.  See your lawyer for details.

Budget for State Charges

States can charge for your business to operate through an LLC. California has an $800 annual tax. It may also charge a separate fee on bigger LLCs – those that make more than $250,000. See ftb.ca.gov/file/business/types/limited-liability-company.  

Check the tax rules in your state. A single-member LLC may be required to pay the state, even though disregarded for income tax purposes. The state charge can be small in relation to the potential personal liabilities of a sole proprietorship without an LLC.

Annual filings may be necessary.

LLC Is Taxed as Partnership

LLCs are owned by their members. With two or twenty owners, it is possible for an LLC to be classified as a partnership.  Partnerships are flow-through entities for tax purposes.

Our focus is single-member LLCs, not subject to partnership tax rules. Partnership tax rules allow flexible profit and loss allocations. Special income and deduction allocations are also permitted. Partnership agreements are particularly important as they reflect economic substance and broad scenarios.

LLC Is Taxed as Corporation

A limited liability company can elect to be taxed as a C corporation, even if owned by a single member. See Form 8832. As a C corporation, the entity files Form 1120 as its annual tax return.

A C-corporation pays income tax separately. Current corporate tax rate is 21%. Individuals who own LLCs that elect to be C corporations can have taxable dividends. This is the double taxation effect of distributions from profitable corporations.

LLCs can elect to be classified as flow-through types of corporations called S corporations. If you want S corporation status, skip Form 8832 and file Form 2553. See IRS instructions in Publication 3402. Income will be reported in Form 1040 by way of the Subchapter S return, Form 1120-S.

LLC Is a Disregarded Entity

If one-member LLCs do not elect treatment as C corporations or S corporations, they are disregarded for income tax purposes. Single-member LLCs vs sole proprietorship taxes are the same. Tax deductions for single-member LLCs and sole proprietorships are generally identical.

The business of the LLC is reported in the individual’s income tax return, Form 1040 Schedule C. Individual income tax rates are 10% to 37%. Business profits will flow through to Form 1040 Schedule SE to calculate self-employment tax.

You may ask, what about payroll reporting?  If the LLC has employees, it is treated as separate from the owner for payroll tax purposes. LLCs withhold income and payroll taxes from employee salaries — and file payroll reports under its name and employer identification number (EIN).

LLCs with employees or excise tax reporting need EINs. If the single-member LLC, a disregarded entity, adds a member, what happens? The LLC becomes a partnership under the tax rules when it takes on a new member.

Tax results and benefits can vary when the new member pays the individual owner or makes a contribution to the LLC. See Publication 3042

Structure for Success: Sole Proprietorship vs LLC

So which is better — sole proprietorship, LLC, C corporation or S-corporation? Top tax advisors and attorneys like LLCs as a vehicle to limit your liability — but focus too on your need for the simplicity and unlimited control of a sole proprietorship. Bottom line, seek out professional tax advice for the best entity structure that will meet both your business and tax planning needs!

Ines Zemelman, EA
Founder of TFX