How a Sole Proprietorship Is Structured and Taxed
A sole proprietorship is an unregistered business that is operated by a single person. Sole proprietors do not 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. This means that the owner does not enjoy any liability protection, and will be personally liable for all debts and other business obligations.
A sole proprietorship is also indistinguishable from its owner for tax purposes. When it comes to paying federal income taxes, sole proprietorships are considered “pass-through” entities. This means that the business pays no taxes at the corporate level. Instead, profits pass through to the owner of the business who then reports these earnings as personal income.
Tax rates will 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).
How an LLC is Structured and Taxed
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, this provides LLC members with limited liability protection, designed to keep their personal assets safe if the company accumulates a lot of debt or is hit with an expensive lawsuit.
Although an LLC and its owner are legally considered separate entities, they are viewed as the same for taxation purposes by the IRS; this is known as pass-through taxation, which means that all profits are distributed among LLC members who then report them as income on their personal tax returns. In fact, a single-member LLC is considered a disregarded entity by the IRS and treated like a sole proprietorship at tax time.
LLC Income Tax Flexibility
While many LLCs pay taxes in the same way as sole proprietorships, 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.
At its simplest, an LLC can be taxed in the same way as a sole proprietorship. However, the many options available to LLC owners when it comes to taxation can create very different outcomes. Ultimately, each business must decide what business and tax structure will work best in terms of operating costs, responsibilities, and tax liabilities. An attorney or tax professional can help you determine what structure is right for you and your business.