Sole Proprietorship vs. LLC: What small business owners should know

One of the first hurdles you’ll face as a new small business owner is identifying which business entity is right for your future venture. As you begin your research, you might encounter two options: a sole proprietorship and a limited liability company (LLC). You might wonder, “What is the difference between a sole proprietorship vs LLC?

Read on to understand the difference between a sole proprietorship and LLC so you can decide which is best for you as you start your business. Each comes with its own nuances. Want more help? Block Advisors’ Business Formation service can help you evaluate your options as you decide the best structure for your business.

What is an LLC?

The Limited Liability Company (LLC) designation gives away one of its primary advantages — limited liability protection for its owners. This type of business entity is set up under state law and is taxed as either a sole proprietorship, partnership, or corporation at the federal level. Read on to hear why this is the case and how to appropriately structure your business at a federal level.

With an LLC, your profits and losses are passed through. Members of an LLC taxed as a sole proprietorship or partnership pay self-employment tax, which goes toward Medicare and Social Security. Traditional employees don’t have to worry about paying self-employment tax, as their employers handle payment and withholding of employment taxes.

What is a sole proprietorship?

A sole proprietorship is arguably the simplest type of business to form and operate. You don’t need to do anything to set one up because this is the default tax entity for those engaging in business activities for themselves.  You only need to report your business income and expenses on your personal tax return.

A tan notebook that explains the difference between a sole proprietorship vs LLC

Due to its simplicity, a sole proprietorship is often the entry point for businesses run by businesses without contractors or employees. This is because it’s easy to set up. But in the long run, it might not be the most advantageous structure for your business for tax purposes as it grows and evolves.

What is the difference between a Sole Proprietorship vs LLC?

1 – Different incorporation requirements

As a sole proprietorship, you don’t have to complete any paperwork to form your business. Any single business owner or self-employed person who doesn’t elect another structure will default to a sole proprietorship.

By contrast, to form an LLC, you must follow the process outlined by your state’s agency that handles LLC creation, most often the Secretary of State. There are typically a couple of steps to start an LLC. In most cases, you should file Articles of Organization and pay a filing fee. Some states may require you to file additional forms as you start your new business.

You should select a specific federal tax structure after completing the necessary paperwork and paying fees. We’ll outline how in the next section.

2 – Different tax forms and filing

A sole proprietorship vs LLC also differs in its tax structure. A sole proprietorship is a pass-through entity. This means income passes to its owner, who is subsequently taxed on their personal income tax return. A sole proprietor is responsible for paying self-employment taxes. They file taxes annually using Schedule C, which attaches to an individual federal tax return, Form 1040.

An LLC may be taxed under the default rules for LLCs, or the LLC owner may elect a different type of federal tax structure. The options are:  

Single-member LLC

  • Default: Owners use Schedule C, which attaches to an individual federal tax return, Form 1040.
  • Elections: the business may elect to be taxed as a corporation (C or S corporation);
    • C corporation (Owners use IRS Form 1120 to file your corporation’s federal taxes)
    • S corporation (Owners use Form 1120-S to file your corporation’s federal taxes, and Schedule K-1 (Form 1120-S) is issued to shareholders; the passthrough to shareholders on their individual tax return, Form 1040, Schedule E)

Multi-member LLC

  • Default: Multi-member LLC taxes are reported on Form 1065; passthrough to members on Schedule K-1 (Form 1065) to their individual federal tax return, Form 1040, Schedule E).
  • Elections: the business may elect to be taxed as a corporation (C or S corporation):
    • C corporation (Owners use Form 1120 to file your corporation’s federal taxes)
    • S corporation (Owners use Form 1120-S to file your corporation’s federal taxes, and Schedule K-1 (Form 1120-S) is issued; passthrough to individual tax return, Form 1040, Schedule E)

Why consider using the single-member LLC structure

Many single-member LLCs keep the default taxation as a sole proprietorship to avoid double taxation, which is being taxed twice on the same source of income. The business income from a C corp is taxed twice—we’ll explain how. With a C corporation, owners pay taxes on both business income and the dividends the corporation pays to them. The dividends are taxed on their individual tax returns.

Additionally, you won’t lose the limited liability protections an LLC provides by choosing to be taxed as a sole proprietorship by the Internal Revenue Service (IRS). However, sole proprietors who haven’t chosen a business structure with liability protection are not legally separated from their business. So, if the sole proprietorship is sued or files for bankruptcy, their business and personal assets are potentially at risk. The owner may benefit from limited liability protection for any business debt and claims in an LLC.

Ready to form a new business entity or change your current business structure?

Keep this in mind: starting with the right business classification is much easier than discovering months or years later that another business structure better suits your needs. Luckily, we can help.

Block Advisors is here to help you make sense of the significant considerations for this important business decision.

Our Business Formation service empowers you to make an informed choice for you and your company. Let us help you reduce stress as you form or change the structure of your business entity.

Is an LLC a sole proprietorship?

Here’s a related question we get from time to time: Is an LLC a sole proprietorship? An LLC is a business entity defined by state law, not federal law. In contrast, a sole proprietorship is an unincorporated business owned by one individual with no legal separation between the individual and the business. A single-member LLC is taxed as a sole proprietorship by default. So, technically, the sole proprietorship vs LLC issue isn’t completely black and white. You can be both! You can structure your single-member business as an LLC and be taxed at the federal level as a sole proprietorship.

More help with the key differences between an LLC and a sole proprietorship

Deciding on the best business structure for your small business shouldn’t be a decision you take lightly. It affects your tax obligation, ability to raise funds, share distributions, and more tax-related concerns. What we outline in this article are only some of the many factors to consider, and this is not intended to be legal advice or specific to any situation. We recommend you seek the advice of an attorney about the implications of entity selection.

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