What are the tax differences for sole proprietorships and LLCs?

When you start up a new business, you’ll have to choose a business entity. Most small business owners elect to form either a sole proprietorship or LLC. But what’s a more advantageous tax model for your small business: sole proprietorship or LLC taxes? There’s little difference between sole proprietorship taxes vs. LLC taxes. A single-member LLC is considered a sole proprietor, for tax purposes, while a multi-member LLC is considered a partnership. Both sole proprietorships and LLCs file tax returns that blend the business owner’s personal income with their business income. If you’re trying to choose between a sole proprietorship and LLC, you should do so by weighing your company’s liability risk, instead. Let’s dig a little deeper into this topic.

What’s a Business Entity?

When you form a new business, you need to choose a business entity. Your business entity type determines:
  • Which income tax you file
  • Your personal liability for company debt and lawsuits
  • How your business is able to raise money
  • Which legal paperwork you need to file with your state and with the IRS
You might be wondering why there are different kinds of business entities you can choose from. Business entities exist because there’s a wide variety of businesses in the United States, and they come in all different sizes and structures. Some companies are large; some companies are small; some companies are privately owned while others have thousands of shareholders. It would be unfair if a mom-and-pop restaurant had to operate by the same tax and liability rules that a massive corporation does. Business entities give you the freedom to run your business in a way that’s most financially lucrative to you. A sole proprietorship and an LLC are two of the most common business entities.

Sole Proprietorship vs LLC

Do you want to privately own and operate your business? Then you should consider forming either a sole proprietorship or an LLC. These business entities give you the greatest freedom to run your business how you see fit. In a sole proprietorship or LLC, you won’t have any shareholders who have voting powers or who can sway company decisions. There are, however, major differences between sole proprietorships and LLCs when it comes to taxes and liabilities. So far as taxes are concerned, your entity choice may determine how much tax savings you reap every year when you file your business tax return. But there’s even more at stake when it comes to liabilities. Let’s briefly review the differences between sole proprietorships and LLCs.

What’s a Sole Proprietorship?

When you form a sole proprietorship, you gain complete control over your business and you don’t need to consult anyone else to make changes. Sole proprietorships are not taxed separately from your personal taxes. When you file your annual tax return, you’ll report all your business income, expenses, and deductions all on the same tax filing as your personal finances. A sole proprietorship does not distinguish between the two. For that reason, it’s one of the easiest business entities to form because taxes are easier to report. The same goes for liabilities. When you form a sole proprietorship, your business assets and your personal assets are one and the same. If you choose not to register a business entity, then you’re automatically considered a sole proprietor by the IRS.

What’s an LLC?

Like a sole proprietorship, a limited liability company (LLC) gives you complete control over your business—so long as you’re the only owner. When you form an LLC, your personal assets won’t be at risk if your business faces bankruptcy or lawsuits. An LLC protects you from personal liability, as the name implies. The owner of an LLC is called a “member.” If you’re the only LLC member, then your business is considered a “single-member LLC.” Most states allow single-member LLCs, but not all states. If your business has additional members, then it’s considered a “multi-member LLC.” LLCs are similar to sole proprietorships in that profits (and losses) are easily passed on to your personal income, and you don’t have to pay corporate taxes. LLC members are considered self-employed, so you’d have to pay your own self-employment taxes toward Medicare and Social Security. Ownership is an area in which an LLC is significantly more complicated than a sole proprietorship. First, a member doesn’t have to be an individual person—a member can be a corporation, another LLC, or foreign entities. There’s no limit to the number of members that can own an LLC. But if a member leaves, then the LLC is usually required to dissolve and then re-form as a new LLC (unless there’s a prior agreement that stipulates how the LLC will transfer ownership). Second, each member is only liable for its share of the business. If you’re a single-member LLC, then you’ll be liable for 100% of your company’s debt. If you’re in a multi-member LLC, then you’re only liable for your share of the company—if you contribute 50%, then you’re liable for 50% of the debt. You might be thinking, “wait—I thought an LLC protects me from liability if the business goes bankrupt or if I have to pay out damages in a lawsuit.” An LLC only protects you from personal liability—your vehicle, your home, and your savings accounts will be safe and cannot be repossessed during bankruptcy or lawsuits. But as the business owner, you’ll still be responsible for paying your share of the business debt. Your debt doesn’t vanish into thin air.

Sole Proprietorship vs. LLC Taxes

Sole proprietorships and LLCs have one big thing in common: the IRS considers them “pass-through” entities. “Pass-through” refers to how the IRS treats your business finances and your personal finances as the same thing. In a sole proprietorship, there’s no difference between your personal income and your business income. In an LLC, there’s no difference between your personal income and your share of the company’s profits. Other business entities require that you file separate taxes for both your business and your personal finances. But under a sole proprietorship or LLC, you’ll only have to file a single return. But there are minor tax differences between the two entities that you should be aware of.

Sole Proprietorship Taxes

Under a sole proprietorship, all business profits and losses are reported on your personal tax return. You’ll report these on the Schedule C form, which you’ll submit to the IRS attached to Form 1040. Use this equation to find out how much of your business income is taxable:
  • Total Business Income – Business Expenses = Taxable Business Income
All your business income is taxable, even money that you’ve set aside into a business savings account or investment fund.

Sole Proprietor Self-Employment Taxes

As a sole proprietor, you’re required to pay self-employment taxes. These are basically the equivalent of the Social Security and Medicare taxes that traditional employers and workers pay—when you work for an employer, the worker pays for half their portion and the employer matches it. Under a sole proprietorship, you’re going to pay both the employer’s and the worker’s portions via the self-employment tax. But the nice thing is that you can deduct half of your self-employment taxes.

Estimated Taxes

You’ll also need to account for estimated taxes. When you’re a sole proprietor, you won’t have an employer to withhold taxes from your paychecks, so it’s up to you to set aside your tax obligations. You must pay your estimated taxes to the IRS quarterly, or else the IRS may penalize you for underpayment. To calculate your owed taxes:
  • Estimate how much tax you’ll owe at the end of the year
  • Divide that number into four quarterly payments
  • Divide the quarterly payment by 3, and that’s how much money you’ll need to put aside every month
If you need help with this, don’t hesitate to enlist a tax preparation service like Community Tax. If you miscalculate your estimated taxes, your business could be financially slugged—you might have to pay huge IRS penalties, or you’ll have a massive tax bill when you file your return. Do whatever you can to make sure you’re making the right quarterly tax payments.

IRS Audits

Know that the IRS closely scrutinizes returns filed by sole proprietors. There’s a very thin line between business expenses and personal expenses, and the IRS wants to make sure that you haven’t accidentally or knowingly claimed business expenses as personal expenses, and vice versa. If you do, then you could face tax penalties or you could even be charged with tax fraud. When you’re deducting business expenses, the IRS will make sure that you’ve only used those expenses for business purposes. The best way to avoid trouble is to keep separate checkbooks for your personal finances and for your business. Always buy business-related items with your business accounts, and only buy personal items with your personal accounts. Good bookkeeping and accounting is crucial.

Sole Proprietorship Tax Benefits

Sole proprietorship tax benefits include:
  • Easy tax filing
  • Lowest tax rate of all business entities
  • No corporate tax
  • Great tax deductions
One of the best tax advantages of a sole proprietorship is that you can deduct health insurance for yourself, your spouse, and your dependents—and you can claim this deduction even if you’re not itemizing on your tax return. It’s a larger deduction, too, because it’s deducted from your gross income and not your adjusted gross income. Bear in mind that this deduction is proportional to your taxable income, so you won’t be able to claim it if your business has taken a loss. If you run a business from your home, you might also be able to claim the home office deduction. This deduction allows you to deduct everyday home expenses, like rent and utilities.

Sole Proprietorship Tax Disadvantages

What you have to remember about sole proprietorships is that you’ll be taxed on all your business profits, even the money you’ve set aside in reserves. You could possibly boost your tax savings by incorporating because the corporate tax rate might yield less taxable income—it all depends, of course, on how much you profit and how much you’re able to deduct as a sole proprietor.

LLC Taxes

For tax purposes, the IRS treats LLCs as either a sole proprietor or a partnership, depending on whether it’s a single-member LLC or multi-member LLC:
  • Single-member LLCs are treated like a sole proprietorship
  • Multi-member LLCs are treated like a partnership

Single-Member LLCs

If you own a single-member LLC, you’ll file your taxes just like a sole proprietor. You’ll report your profits and losses on Schedule C and submit it to the IRS with Form 1040. Just like with a sole proprietorship, you don’t have to file a separate business tax return. All the sole proprietor tax rules we discussed before apply to a single-member LLC.

Multi-Member LLCs

The IRS treats multi-member LLCs as partnerships (a partnership is another type of business entity). Like a sole proprietorship, business profits are not taxed as a separate entity. Each LLC member pays taxes on their share of profits on their personal income taxes. Each member’s share of profits and losses should be stated on an LLC operating agreement. Most operating agreements stipulate that profits are proportional to percent interest in the business (so if you have a 50% share, you’ll pay taxes on 50% of the company’s profits). If your LLC is not sharing profits in this way, it’s called a “special allocation.” Special allocations warrant their own IRS tax rules. Like a sole proprietorship, each member must pay taxes on his or her entire share—even money that’s set aside in reserves or savings. Also, each member must pay taxes on their annual share of profits whether they’ve been distributed or not. So, if there’s $50,000 sitting in a company bank account that’s supposed to be distributed to a member, the member must still pay taxes on it even though they haven’t yet received a paycheck. The LLC doesn’t file a tax return, but it must file Form 1065 with the IRS. Form 1065 is an informational return that stipulates profit sharing among the LLC members. It helps the IRS determine whether or not LLC members are reporting their profits correctly.

Self-Employment and Estimated Taxes

LLC members pay self-employment taxes and estimated taxes in the same way that sole proprietors do, but they only pay on their own share of profits—if you’re a single-member LLC, then you’ll pay self-employment taxes on all business profits. If you’re in a multi-member LLC, it might be difficult to determine how much self-employment tax you owe on your share, and how much you need to set aside in estimated taxes—again, a seasoned tax professional could make your life a whole lot easier in this area. LLCs can have members who are considered “inactive.” Inactive members are members who have invested money in the business, but who don’t make any business management decisions. These members may be exempt from paying self-employment taxes. Each LLC member reports self-employment taxes on Schedule SE, which is submitted with their personal tax return.

LLC Tax Benefits

LLC taxes are very similar to sole proprietor taxes, so your LLC will reap all the same tax benefits. Most of these tax benefits are in the deductions you’re able to claim.

LLC Tax Disadvantages

LLC taxes may be more difficult to file than sole proprietorship taxes, and they also tend to be a little more costly. If you’re a member of a multi-member LLC, it can be difficult to estimate how much in taxes you’ll have to pay on your share of the business, although a tax professional will be able to help you.

Tax Deductions

Both LLCs and sole proprietorships can claim many of the same tax deductions. If you’re filing sole proprietorship and LLC taxes in 2019, the most significant deduction you can claim is the Pass-Through Tax Deduction. This tax deduction was created by the 2017 Tax Cuts and Jobs Act. The Pass-Through Tax Deduction allows sole proprietors and partnerships (for multi-member LLCs) to deduct up to 20% of their net business income. If your income is over $315,000 (married filing jointly) or $157,000 (single), you must have employees or depreciable business property to claim this deduction. If you’re making more than $415,000 (married filing jointly) and $207,500 (single), you can’t claim this deduction if your pass-through business is a personal service firm. A personal service firm encompasses:
  • Law firms
  • Medical practices
  • Consulting work
  • Performing arts
  • Athletics
If you’re making:
  • Between $315,000 and $157,000 (married filing jointly)
  • Between $157,000 and $207,500 (single)
then there’s a phase-out calculation that will reduce the amount of money you’re able to deduct. Sole proprietorships and LLCs can also deduct business startup expenses, so long as the expenses are “ordinary and necessary.” These expenses include:
  • Operating expenses
  • Product costs
  • Advertising costs
  • Business travel expenses
  • Business-related meals
  • Cost of new equipment and assets
It’s important to know that these expenses must exclusively be used for business. If you use your own personal vehicle to travel for business, you’re only able to deduct the mileage you spent driving for business purposes. If you work from home and you spend money on new office equipment, that equipment must be used exclusively for your business and not personal use. The IRS may ask you for documentation (AKA: proof) that you’re only deducting business-related expenses. Again, it’s important that you keep separate checkbooks for business and personal use. Don’t be afraid to claim tax deductions, especially not ones that you’re rightfully entitled to. Just keep documentation of all purchases so you can prove to the IRS that the deduction is legitimate, and use an accounting service if you need help! Note: LLCs can claim the health insurance deduction, but not the home office deduction.

Liability Differences Between Sole Proprietorships and LLCs

As you’ve learned, there are only minor tax differences between sole proprietorships and LLCs. But there are major differences between the two business entities when it comes to liabilities.

Sole Proprietorship Liabilities

When you form a sole proprietorship, your business assets are considered your personal assets. That makes taxes a whole lot easier, but unfortunately, it also means that you can be held personally liable for any debts and obligations of your business. If your business goes bankrupt, the courts may seize your personal assets in order to settle your company’s debts. Your personal assets may include:
  • Your home
  • Your vehicle
  • Money in your savings accounts
  • Personal belongings
Your personal assets may also be at risk if you’re forced to pay damages in a lawsuit that you’re unable to afford. You’ll also be held liable for the actions of your employees—if you’re sued for something that one of your employees does, it’s your personal assets that may be at risk in a lawsuit, not your employee’s. Sole proprietors may protect themselves by buying liability insurance. It should be noted, though, that liability insurance may be expensive for small business owners. But remember that some lawsuit damages can bankrupt a small business, so it might be well worth the expense.

LLC Liabilities

LLC members have significantly more protection when it comes to bankruptcy and lawsuits. Under an LLC, your personal assets will be protected and cannot be seized by the courts. Only LLC assets can be sold to pay off debts.

Which Should I Choose: Sole Proprietorship or LLC?

At this point, we know there’s little difference between sole proprietorship taxes vs LLC taxes, but there are significant differences when it comes to liabilities. So which entity is better for your business? So far as taxes are concerned, there are very few differences between sole proprietorships and LLCs—in fact, if you’re a single-member LLC then you’ll be paying taxes in the exact same way as a sole proprietor would. For that reason, you shouldn’t need to take taxes into account when you’re choosing between these two business entities—unless you’re working from home. If you’re running a business out of your own home, you might be better off as a sole proprietor so you can claim the home office deduction. You’ll also want to be a sole proprietor if you’re testing out the feasibility of a new business. But you should base your decision most heavily upon liabilities. If you have a low risk business, you might want to be a sole proprietor. If you have a high-risk business, you might want to form an LLC. A low-risk business:
  • Sells products to customers
  • Is unlikely to have large debt
  • Doesn’t need insurance
A high-risk business:
  • Performance services for customers
  • Is more likely to incur large debts
  • Needs insurance because it’s more likely to face lawsuits
If you have significant personal assets that you want to protect, it might also be better for you to form an LLC. Remember that high-risk sole proprietors can purchase liability insurance to protect themselves. But if that insurance is too expensive, it’s better to form an LLC so you can protect yourself—anything can happen in the business world.