Sole Proprietorship vs. LLC: The Tax Differences You Need to Know

By Chelsea Baldwin, Contributor, on June 13, 2018

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After you’ve proven that you can do this whole freelancing thing on your own, it’s time to make it “official.”

But what works better for your business in the sole proprietorship vs. LLC debate? Unless you’re a freelance tax accountant, you probably have no idea what the best option is for you tax-wise. Establishing a sole proprietorship may sound more appropriate, since you’re operating as a business of one. But at the same time, you hear a lot of talk about the advantages of LLCs. While LLCs empower you to better protect your personal assets, sole proprietorships can be easier to set up.

There are a lot of factors in this decision-making process, but let’s take a look at one of the most important considerations: how each of these business entities affect your taxes.

Sole Proprietorship vs. LLC: The Similarities

In the most basic sense, sole proprietorships and LLCs do have some pretty important similarities when it comes to paying taxes as a business owner.

Quarterly Estimates

No matter what type of business structure you have in place, you still have to pay quarterly tax estimates to the state and the IRS based on how much you’re earning.

“Everyone who earns an income must pay taxes on that income whether it is from a job, self-employment, investments or other sources,” says CPA Alicia Sisk-Morris. People who are traditionally employed usually have these estimates withheld from their paychecks, but self-employed individuals need to pay in on their own every quarter. “Those estimates need to be made by April 15, June 15 and September 15 during the tax year, with the final payment made January 15 of the following year,” Sisk-Morris explains.

Business Expenses

With both LLCs and sole proprietorships, you can write off your business expenses — like office supplies, legal fees and internet payments — as tax deductions when you file your tax return every year.

These similarities might seem basic at first, but they’re important to consider before you set out on your own. No matter what business structure you choose, make sure you understand how to pay quarterly taxes and set up a system to track your business-related expenses.

Sole Proprietorship vs. LLC: The Differences

While the similarities of sole proprietorships and LLCs are pretty easy to comprehend, the differences can get confusing — which is why so many indys struggle with this decision-making process. Here’s an explanation of the main differences to clear the air.

Legal Separation

While this isn’t exactly tax-related, it’s worth mentioning.

According to Dan Royer, a seasonal tax preparer of almost 20 years for H&R Block, “An LLC may be classified for federal income tax purposes as a partnership, corporation or an entity disregarded as separate from its owner by applying the rules in Regulations section 301.77013. This is basically to protect your personal assets from the liabilities of the business.”

So, what’s the biggest difference here? If you have a sole proprietorship, you and your business are essentially one and the same. If your business gets sued, your personal assets are on the line. But if you have an LLC, you’re legally separated from your business, which means you won’t lose your car or house if your business struggles.

Taxpayer Identification

As you probably already know, the IRS uses a person’s Social Security number (SSN) as the most common form of taxpayer identification. But if you establish an LLC, you may need to obtain an Employer Identification Number (EIN) to provide to your clients and use with the IRS. It depends specifically on how your company is taxed, but EINs are favored by a lot of indys, since fewer people get access to your SSN — lowering the risk of identity fraud.

As a sole proprietor, you have the option to keep things simple and continue to use your SSN as your primary taxpayer identification. But, if you’d prefer, you can file for an EIN, instead. Keep in mind that EINs are not required for sole proprietors operating without employees.

Saving Money on Taxes

Here’s where things can get tricky in the sole proprietorship vs. LLC debate.

In a sole proprietorship, all of your business revenue is considered your personal income.

With an LLC, you can pay taxes along the same model as a sole proprietorship, or you can turn your LLC into an S Corporation and potentially save money on taxes. Remember: This depends on how much money you make each year, and only becomes a good idea after a certain revenue threshold. Be sure to talk to an accountant about this option before you take action.

When you establish your LLC as an S Corp, you become both an employee and a shareholder of your company. According to Investopedia, “Shareholders can be company employees, earn salaries and receive corporate dividends that are tax-free if the distribution does not exceed their stock basis.”

Basically, you’re still paying the same taxes as a sole proprietorship or standard LLC, but some of your business’s revenue can count as tax-free dividends or distributions, which saves you money.

The (Basic) Pros and Cons of Each

If you’re thinking of establishing a sole proprietorship for tax purposes, consider:

  • Pro: Your tax paperwork may be easier to manage, since you can treat yourself and your business as a single entity.
  • Con: More people get access to your SSN.

But if you’re leaning more toward an LLC, here are a couple of tax-based pros and cons to consider:

  • Pro: Fewer people get access to your SSN, and you may be able to save money on taxes.
  • Con: There are additional fees and paperwork involved to create an LLC, and if you don’t earn enough, it might not be worth it.

Making the Decision

Overall, you have two (simplified) options: Establish yourself as a sole proprietor and keep things simple, or turn your business into a more complex LLC, which could potentially allow you to save more money down the line. However, there are a few things to take into consideration before you make your decision, like the amount of paperwork, the annual fees and the associated accountant and payroll costs if you choose to turn your LLC into an S Corporation.

“This is such an important decision and is so complex that it should not be made without professional help,” emphasizes Royer. “Seek out a professional tax preparer, and if you are considering an LLC, I would recommend getting an opinion from an attorney, as well.”

Now that you have a better idea of what might be the best option for you and your finances, prepare some questions and talking points to go over when you do meet with an accountant. Doing so will ensure you’re well-equipped to make your final decision.

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