Tax Differences Between a Sole Proprietorships and an LLC

When you start a new business, you have to choose how the company will be taxed.  The majority of companies are set up as either a sole proprietorship or an LLC.  When requesting an EIN number for an LLC, the IRS will default the entity to a sole proprietorship for tax if you are a single member.  If the LLC has multiple members, the IRS will default it to a partnership for taxation purposes.  A true sole proprietorship (no entity created) provides you with no liability protection, and creating an LLC offers you some liability protection.  To understand what this means, we have to discuss topics like a business entity and the difference between a sole proprietorship and an LLC.

What's a Business Entity?

A business entity is an organization created by either an individual or group of individuals to conduct business. Individuals have many choices when setting up an entity, such as a sole proprietorship, partnership, LLC, corporation, etc.  The sole proprietorship and an LLC are two of the most common business entities, so we will focus on them.

Your choice in business entity type determines:

• How you will file
• Personal liability for company debts
• How easy it will be for the business to raise capital
• The complexities in how the business entity is set up

Sole Proprietorship vs. LLC

If your business will have only one owner, it makes sense to consider forming either a sole proprietorship or an LLC. These entity formats give you the greatest freedom to run your business without outside influences. You won't have any owners or members who have voting rights or who can sway company decisions. There are some significant differences between sole proprietorships and LLCs when it comes to liabilities protection and taxation. Every business has the right to take every legal tax deduction possible. Most business owners choose an entity type for tax reasons, but liability protection should significantly determine an entity type.  Below is a brief review of the differences between an LLC and a sole proprietorship.  

Sole Proprietorship

A sole proprietor is an unincorporated business that one owner owns.  In a sole proprietorship, you have complete control, and you don't need to consult anyone to make changes. Sole proprietorships do not file a separate tax return. When you file your annual tax return, you would most likely list your business income and expenses separately (Schedule C). Sole proprietors are considered self-employed and are required to pay self-employment taxes toward Medicare and Social Security. From a simplicity standpoint, it's one of the most straightforward business entities to form because there are no separate filings. The absolute downside of a sole proprietorship, it offers no liability protection. When you create a sole proprietorship, your business and personal assets are on and the same. If someone is successful in pursuing a lawsuit against you, your personal assets are exposed.

LLC

If you are the only owner and set up a Limited Liability Company (Single Member LLC), the LLC also gives complete control over your business. The most significant difference, when you form an LLC, your personal assets won't be at risk if your company faces lawsuits. The owner of an LLC is known as a "member." In all 50 states and the District of Columbia, one person can form an LLC as a single-member LLC.  It may not have all the same protections as a multi-member LLC. If your company has multiple members, then it would be considered a "multi-member LLC." Single Member LLCs are similar to sole proprietorships in that income and expenses are reported on the personal return, and there is no requirement to file a separate. Like a Sole proprietor, Single Member LLCs are considered self-employed and must pay self-employment taxes toward Medicare and Social Security. Ownership in an LLC is not restricted to an individual person—a member can be a corporation, another LLC, or a foreign entity.

There's no limit to the number of members that can own an LLC. If the LLC has multiple members, it is known as a "multi-member LLC.  Because the entity has multiple members, it does not have the option to be taxed as a sole proprietorship.  A multi-member LLC can be taxed as a partnership, a C corporation, and an S Corporation.  The entity MUST take positive steps to indicate to the IRS how it wishes to be taxed.  If the entity does not indicate to the IRS how it wishes to be taxed, the IRS will default the entity to partnership taxation.  Each member of a multi-member LLC  is only liable for its share of the business investment.

Sole Proprietorship vs. Single Member LLC Taxes

Sole proprietorships and single-member LLCs have one big thing in common: the IRS considers them both to be "disregarded" entities. "Disregarded Entities" refers to how the IRS disregards the business finances and the personal finances.  There is only a slight distinction; there's no difference between your personal income and business income in a sole proprietorship. In a single-member LLC, there's no difference between your personal income and your share of the company's profits. Both file only a single return. Below are some minor differences between the two entities you should become familiar with.

Sole Proprietorship Taxation

All sole proprietorship profits and losses are reported on your personal tax return on Schedule C as part of Form 1040.  All business income is taxable, even if you have not removed the business account funds to personal.

Sole Proprietor Self-Employment Taxes

As a sole proprietor, you are required to pay self-employment taxes on the net income from the business. The IRS does this to equate your business with that of employment.  If a company employs you, your employer would deduction Social Security and Medicare taxes from your paycheck.  They would be required to match the social security and Medicare taxes withheld.  Under a sole proprietorship, you are responsible for the employer's and employees' portion of the self-employment taxes. You do get to take a deduction for half of the self-employment taxes.

Estimated Taxes Payments

As a sole proprietor, you are responsible for paying your own taxes. You must pay estimated payments quarterly to avoid a penalty for underpayment of taxes.  To calculate your estimated payments, follow the following procedure;  

• Project your income and expenses forward to the end of the year, estimate how much tax you will likely owe, and
• Divide that number by four, and
• Divide the above number by three to determine the amount to set aside monthly, and
• Make your estimated quarterly payments

If you miscalculate your estimated taxes and fail to make them, you might be subject to huge IRS penalties, have a massive tax bill when you file your return, or both.

IRS Audit Rate

The audit rate for sole proprietors is considerably higher than the rate for entities with the same deductions.  As a sole proprietor, the IRS is always concerned that you are taking personal expenses as a business expense.  The best solution for this is the maintain a separate bank account for your business expenses.  Always pay for business-related expenses through your business accounts and purchase personal items with your personal funds. If you violate this rule, you could face penalties in an audit or even be charged with tax fraud. 

Sole Proprietorship- Tax Benefits

Benefits include:

• Easy tax filing, one single return
• Lowest tax rate of all business entities
• No separate tax return
• Similar deduction to that of an entity

Deducting health insurance for yourself, your spouse, and your dependents is one of the most significant benefits of a sole proprietorship over other business forms.  You can take this deduction as an adjustment to income, even if you do not itemize on your tax return. Your business must have a positive income to be able to take this deduction. If you have an area of your home that you exclusively use for business, you might benefit from the business use of home deduction

Sole Proprietorship- Tax Disadvantages

As a sole proprietorship, you have little control over how much of your net income is subject to self-employment taxes.  You could reduce your self-employment taxes by changing your taxing entity.  Your saving would depend on the business's profit and how much would be considered your "reasonable salary."

LLC Taxes

For tax purposes, IRS treats LLCs as either a sole proprietor or a partnership, and the number of members determines how it is taxed.

• A single-member LLC is treated as a sole proprietorship
• Multi-member LLCs are treated as a partnership

Single-Member LLCs

If you own your business as a single member, you will file your taxes like a sole proprietor. Your business profits and losses will be reported on a Schedule C and be submitted as part of  Form 1040, and you don't have to file a separate business tax return.

Multi-Member LLCs

If you have multiple members, you have options in how your business is taxed.  Your options are C Corp, S Corp, and Partnership.  If you do not choose any other option, the IRS will treat multi-member LLCs as partnerships. Unlike a sole proprietorship, your business profits and losses are reported on a separate entity return. Each LLC member is responsible for paying taxes on their share of profits as part of their personal income tax return. Member's share of profits and losses are typically listed as part of the Operating Agreement.  Most LLCs allocate profit and losses as a percentage of the ownership in the LLC. The LLC also can distribute profits and losses in what is known as "special allocation." A special allocation means that profits and losses are allocated according to a special allocation listed in the Operating Agreement and not according to the ownership interests.  Each member is responsible for paying taxes on their annual share of profits, regardless of whether they have been distributed or not. A multi-member LLC files taxes according to how it has elected to be taxed.  If the business has chosen to be taxed as a partnership, it would file Form 1065. Form 1065 is actually an informational return that lists the profits shared by each LLC member. If the business has chosen to be taxed as an S Corporation, it would file a Form 1120S.  As a C Corporation, the entity would file a Form 1120.

Self-Employment and Estimated Taxes

LLC members are responsible for determining their portion of self-employment and income taxes, and they are required to make estimated payments.  A single-member LLC member is treated as a sole proprietorship and is responsible for all self-employment and income taxes on the business profits. As a multi-member LLC, taxation is determined by how the entity has elected to be taxed.  If the LLC chooses to be taxed as a multi-member LLC taxed as a partnership, it can have "inactive." Members.  Inactive members have invested money in the business but are not responsible for making any business management decisions. These members would be exempt from paying self-employment taxes on their share of the profits.  If the entity is taxed as a multi-member, it would be best to seek an experienced tax professional to help find opportunities to lower the tax liability.

Single-Member LLC Tax Benefits

Single-member LLC taxation is very similar to sole proprietor taxation, and the single-member LLC follows the same rules that apply to a sole proprietorship.

Single-Member LLC Tax Disadvantages

Single-member LLCs are often misunderstood, and as such, the tax preparation fees tend to be higher.

Qualified Business Income Deduction

After December 31, 2017, many partnerships, sole proprietorships, S corporations, and some trusts and estates may be eligible to deduct 20% of their qualified business income (QBI) deduction under IRC Section 199A. This tax deduction was created as part of the 2017 Tax Cuts and Jobs Act. To qualify for the Qualified Business Income, a taxpayer filing a married filing joint return with income above $315,000 or $157,000 (single) must have employees or depreciable business property to claim this deduction. If your business is a personal service firm, and your income is greater than $415,000 (married filing jointly) and $207,500 (single), you can't claim this deduction. The following are personal service firm encompasses;

• Law firms
• Medical practices
• Consulting work
• Performing arts
• Athletics

If your income is between the amounts below, there is a phase-out calculation that must be performed;

:

• Between $157,000 and $315,000 (married filing jointly)
• Between $157,000 and $207,500 (single)

Startup Expenses

Sole proprietorships and LLCs can deduct "ordinary and necessary" business startup expenses.  These are expenses incurred before the business actively seeking business. These expenses include:

• Operating expenses
• Product costs
• Advertising costs
• Business travel expenses
• Business-related meals
• Cost of new equipment and assets

Liability Protection Differences Between A Sole Proprietorships and An LLCs

Sole Proprietorship Liabilities

As a sole proprietor, the court does not distinguish between you and your business. You can be held personally responsible for any obligations incurred by your business. In Bankruptcy or other legal proceedings, the courts may seize your personal assets to settle your company's debts. Your personal assets may include:

• Your home
• Your vehicle
• Money in your savings accounts
• Personal belongings

LLC Liabilities

In Bankruptcy or a lawsuit, LLC members have significantly more protection. Personal assets are typically protected and cannot be seized by the courts. If your creditor is successful in a suit and the business has positive income, your creditor can get some of that income as part of a charging order.

Choosing: Sole Proprietorship or LLC?

As seen above, there is little difference between a sole proprietorship and an LLC in available deductions.  However, there are significant differences when it comes to liability protection. Knowing this, if you have a high-risk business, you should focus your attention on liability protection. A high-risk business:

• Performance services for customers
• Sells high-risk products to customers
• More likely to incur large debts as part of the business practices
• Needs insurance to protect against lawsuits

A low-risk business:

• Sells low-risk products to customers
• Not likely to incur debts as part of the business practices
• Doesn't need insurance

Some business owners feel that obtaining insurance is the solution to the problem, and often this makes suing the business even more attractive. We are not suggesting that insurance is not a vital protection measure. If you have significant personal assets, it might be best to form an LLC.