A sole proprietorship is a business owned by a single individual who faces unlimited liability for company debts. An LLC, or limited liability company, is either one owner or a partnership in which the owners enjoy limited liability for debts owed by the LLC. The IRS taxes sole proprietorships and LLCs -- two distinct forms of business organizations -- quite differently.
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Sole Proprietorship Tax
The IRS treats the income of a sole proprietor as the owner's personal income. As a sole proprietor, the owner of a business can write off many of his business expenses as itemized deductions on his tax return. A sole proprietor must report business income on Form 1040 and write off business expenses on Schedule C. He must pay self-employment taxes instead of the FICA taxes that employees pay. A one-person LLC is taxed exactly the same as a sole proprietorship.
LLC Pass-Through Taxation
Unless the LLC elects otherwise, the IRS automatically taxes an LLC as if it were a partnership. All LLC income "passes through" the company as if it didn't exist -- in other words, the LLC as an entity isn't taxed. Instead, the LLC income is attributed to each partner in proportion to that partner's ownership stake in the business. The LLC cannot shield its partners from taxation by retaining company earnings because, for tax purposes, income is apportioned among the partners whether it is actually distributed to them or simply re-invested in the business. LLC partners may write off their proportionate share of the company's business expenses.
LLC Filing Requirements
Even though it owes no taxes, an LLC must file a partnership tax return -- Form 1065 -- every year. It must also distribute Schedule K-1 to each partner for reporting that partner's attributed share of LLC income and deductible expenses. LLC partners use the information on Schedule K-1 to help them prepare their Form 1040 individual tax returns.
LLC Taxation Options
The LLC enjoys flexible federal income taxation options. By submitting Form 2553 to the IRS, it can elect to be taxed as a corporation. Two types of corporate taxation are possible -- "C corporation" taxation and "S corporation" taxation. An LLC electing to be taxed as a C corporation is taxed as an entity, but the partners are taxed only on LLC income that is actually distributed to them. An LLC taxed as an S corporation is not taxed as an entity. Partners must pay income tax on their proportionate share of LLC income, but do not have to pay self-employment tax.
References & Resources
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