Sole Proprietorship: Structure and Taxation
Sole Proprietorship Structure
A sole proprietorship is an unregistered business that is operated by a single person.
Sole proprietors don't need to register with their state, pay formation fees, or follow any formal business practices. For legal purposes, a sole proprietorship is indistinguishable from its owner.
Sole proprietors don't have liability protection and will be personally liable for any debts and lawsuits.
Sole Proprietorship Taxes
When it comes to paying federal income taxes, sole proprietorships are considered “pass-through” entities. This means profits pass-through to the owner of the business who then reports these earnings as personal income.
Tax rates vary depending on the owner’s personal tax bracket. In addition to federal income tax, owners of sole proprietorships must pay self-employment tax to cover both the employer and employee share of Social Security and Medicare tax. The current self-employment tax rate is 15.3% (12.4% for Social Security and 2.9% for Medicare).
LLC: Structure and Taxation
A limited liability company (LLC) is a registered business entity that is considered separate from its owners, or members, for legal purposes.
Unlike a sole proprietorship, LLCs provide limited liability protection, which is designed to keep the owner's personal assets safe from creditors and lawsuits.
Although an LLC and its owner are separate legal entities, they're viewed as the same for tax purposes by the Internal Revenue Service (IRS).
A single-member LLC is considered a disregarded entity by the IRS and treated like a sole proprietorship at tax time. That is to say, income passes-through to the owner's tax return must like in a sole proprietorship.
Sole Proprietorship vs LLC
Most business owners choose to form an LLC vs. a sole proprietorship because an LLC legally separates the owner's personal assets from the business. This is called personal liability protection.
What is personal liability protection? When a business owner has personal liability protection, they can’t be held personally responsible if the business suffers a loss. This means personal assets (car, house, and bank account) are protected.
LLC vs. Sole Proprietorship Comparison
There are four main factors to compare between a sole proprietorship and LLC:
- Liability Protection
- Pass-Through Taxation
- Cost to Register and Maintain
A sole proprietorship doesn't offer liability protection, but an LLC does. This value usually outweighs all other factors.
An LLC owner can use the business's legal name as its brand name. A sole proprietor must use their surname as the business name or register a DBA (doing business as) name when available.
Both sole proprietors and LLCs are taxed as pass-through entities by the US Internal Revenue Service (IRS). This means that the business's profits will pass through to its members to be reported on their personal tax returns. All profits are only taxed once, at each member's individual income tax rate.
Cost to Register and Maintain
An LLC is a low-cost and low maintenance business structure. A sole proprietorship with a DBA is comparably priced.
Single-Member and Multi-Member LLC Taxes
While many LLCs pay taxes in the same way as a sole proprietorship, an important difference is the flexibility afforded to LLCs when it comes to selecting its tax status. Because the IRS does not recognize an LLC as a taxable entity with its own tax structure, it allows LLCs to choose how they would like to be taxed. An LLC can choose to be taxed as a disregarded entity vs. partnership, or elect C corporation vs. S corporation status.
If you own a single-member LLC and would like to retain the pass-through taxation of a sole proprietorship, you can choose to keep that tax structure for your business. With this structure, your LLC will not pay any federal income tax at the corporate level, and profits will simply be reported as business income on your personal tax return, along with your self-employment tax obligation.
A partnership’s tax structure is essentially the same as a sole proprietorship’s, except the business’s profits are split among the partners. This is the default tax structure for a multi-member LLC. Owners in a partnership must also pay employment taxes.
An S corporation is a pass-through tax classification and is not subject to corporate taxation. Unlike sole proprietorships and partnerships, S corp owners can save money on employment taxes by distributing their earnings to members and passive shareholders.
Owners of an S corp that play an active role must become employees and be paid a “reasonable” salary (earned income) based on their position and industry. This earned income is subject to both personal income tax and employment tax, while the remaining business profits are only subject to personal income tax. After all, distributions are allocated and properly taxed, these remaining business profits are then known as “retained earnings.”
C corporation tax status differs considerably from other business structures. C corps are the only business structure subject to corporate taxation. Following the Tax Cuts and Jobs Act of 2017, the corporate tax rate dropped to a flat rate of 21%. In addition to this amount, shareholders must pay taxes on dividends they receive, resulting in double taxation of at least a portion of your business income. When electing C corp status, business owners are not subject to self-employment tax.
There is no federal sales tax, but both LLCs and sole proprietorships need to be aware of any relevant sales taxes in their home state or municipality. These will vary depending on your location, your type of business, and the specifics of your business transactions.
Learn more about Sales Tax by reading our comprehensive guide.
Annual Report Filing Fee
As unregistered business entities, sole proprietorships are not responsible for filing annual reports with their state. LLCs, however, typically need to file either an annual or biennial report to their state of formation. Annual report filings usually come with a fee that can range anywhere from $10 to $800. In most states, the fee is under $100.
Know the Tax Requirements of Your State
Whether your business is an LLC or a sole proprietorship, different states have different tax requirements. While federal tax law will apply to businesses across the country, it is critical that you familiarize yourself with the particular tax obligations in your state. Keep in mind that states may use different names for similar taxes. Also be aware of any county, city, or other local taxes that may apply to your business.