Tax Differences Between an LLC and a Sole Proprietorship

By Tom Speranza, J.D.

Tax Differences Between an LLC and a Sole Proprietorship

By Tom Speranza, J.D.

If you have a small business you can own it in your individual capacity as a sole proprietorship or form a separate entity to own it. Once you decide to form an entity, there are various options—corporation, partnership, limited liability company—and within any of those structures you can sometimes determine how the entity's income is taxed by filing an Entity Classification Election (Form 8832) with the Internal Revenue Service.

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Basic Differences Between Sole Proprietorships and LLCs

Sole proprietorships have one major advantage—they are by far the simplest structure for a business. You own it yourself, you usually don't need to file any entity documents to get started, and you account for its income, expenses, and losses on your individual tax return.

But even though sole proprietorships are simple, there are two major reasons business owners choose to operate as a limited liability company (LLC):

Coowners and Investors

A sole proprietorship means a single person owns the business. If your business starts with more than one owner or investor, or you later decide to admit a new owner or investor, you need a legal structure that can accommodate multiple people or legal entities having an interest in the business.

Personal Liability

A sole proprietorship by definition has no legal separation between its owner and the business's activities. As a result, the owner has personal liability for the debts and other obligations the business has to suppliers, landlords, customers, employees, contractors, tax authorities, and anyone else who may have a legal claim against the business. A separate entity like an LLC can protect the owner's personal assets from the business's obligations.

LLC and Sole Proprietorship Taxation

So, when choosing between an LLC and a sole proprietorship for your business, how do federal income taxes work?

Sole Proprietorship

Sole proprietors report business income, losses, and expenses on their individual tax return using the schedules detailing Profit or Loss From Business (Sole Proprietorship) (Form 1040, Schedule C), Net Profit From Business (Sole Proprietorship) (Form 1040, Schedule C-EZ), Supplemental Income and Loss (From rental real estate, royalties, partnerships, S corporations, estates, trusts, REMICs, etc.) (Form 1040, Schedule E), and Profit or Loss From Farming (Form 1040, Schedule F). The owner is not considered an employee of the sole proprietorship, so the Self-Employment Tax (Form 1040, Schedule SE) schedule is filed with the annual return to report self-employment income.

LLC with One Member

An LLC with one member (owner) that has not elected corporation taxation is a "disregarded entity" for federal tax purposes and is taxed like a sole proprietorship, including for self-employment income.

A single-member LLC electing corporation taxation files the tax documents described below for multiple-member LLCs electing S corporation or C corporation taxation.

LLC with Two or More Members

An LLC with two or more members can choose to be taxed either as a partnership or corporation.

An LLC electing partnership taxation files a U.S. Return of Partnership Income (Form 1065) and reports income or loss to the members using Partner's Share of Income, Deductions, Credits, etc. (Form 1065, Schedule K-1). The members then use Schedule K-1 to include the income or loss in their individual tax returns.

An LLC electing S corporation taxation files a U.S. Income Tax Return for an S Corporation (Form 1120S) Because S corporations pass through their income to the owners like a partnership, LLCs making this election also report income or loss to the members using Schedule K-1.

An LLC electing C corporation taxation files a U.S. Corporation Income Tax Return (Form 1120) and does not pass through its income or loss to the members. An LLC with a C corp election is likely to employ its members as salaried employees.

State Income Taxes and Federal/State Employment Taxes

Sole proprietorships and LLCs have similar requirements for federal taxes withheld and paid for employees, but in many states, the two structures are subject to different tax obligations for business income and employee-related taxes. Be sure to use an accountant familiar with your state's rules.

Forming an LLC

An experienced corporate lawyer or online legal services provider is a valuable resource for a business owner considering an LLC. They can advise you on submitting the required state and federal filings and drafting an operating agreement that fits your particular situation.

This portion of the site is for informational purposes only. The content is not legal advice. The statements and opinions are the expression of author, not LegalZoom, and have not been evaluated by LegalZoom for accuracy, completeness, or changes in the law.