LLC vs Sole Proprietorship: What Changes for Tax and Cost

LLC vs sole proprietorship taxes: does an LLC pay less?

Not by default. A one-owner LLC is a "disregarded entity" for federal income tax, treated as part of the owner's own return, so its profit goes on Form 1040 Schedule C (or Schedule E or F for a rental or farm), the same as a sole proprietor's (IRS; Schedule C instructions). The same expense rules apply, so an LLC unlocks no extra write-offs. Self-employment tax (Social Security and Medicare tax for people who work for themselves) is the same too: the owner pays 15.3% (the Social Security part only up to a yearly earnings cap) on net earnings from self-employment once they reach $400 (IRS; 26 CFR 301.7701-2(c)(2)(iv)).

What an LLC changes is legal and state-level: a separate entity, a liability shield set by state law, state fees and filings, and the right to elect corporate or S corporation tax later.

The choice stops being simple when:

• a second owner is involved (generally a partnership for tax, LLC or not; spouses have their own rules),
• your state charges every LLC a fixed yearly tax,
• you are weighing an S corporation election, or
• clients, contracts and 1099s already run under your own name and Social Security number.

Gather before deciding: expected revenue and profit for the year, the state or states where you work, who will own the business, and any contract or client that requires an entity.

What does an LLC change, then?

An LLC is an entity created under state law, separate from you (IRS). Contracts, invoices, the bank account and licenses can be in its name instead of yours. For employment taxes and certain excise taxes, the IRS also treats a one-owner LLC as separate, so payroll is reported under the LLC's name and EIN (IRS).

Liability is a state-law matter, not a tax rule. Delaware's LLC statute, for example, says the company's debts are its own and no member is personally obligated for them solely by being a member, but it also lets a member agree to be personally liable, which is what a personal guarantee on a lease or loan does (6 Del. C. § 18-303). Federal tax law adds its own exception: a responsible person who willfully fails to pay over tax withheld from employees' pay owes that amount personally, LLC or not, and the IRS generally has 10 years from assessment to collect it (IRS; 26 USC 6672; 26 USC 6502). How far the shield reaches in a dispute is a question for a lawyer in your state.

What does each one cost per year?

A sole proprietorship has no state fee to exist; an LLC pays to form and then pays whatever yearly report fee or tax its state sets. Two state examples:

A sole proprietor who uses a name other than their own may need a trade-name filing; see DBA or LLC. Local licenses and permits depend on your city, county and trade, so check them either way.

For your own state, see LLC cost by state for the formation fee and first-year bill, and LLC annual fees and reports by state for the years after.

What paperwork does an LLC add?

On top of the same federal return, a one-owner LLC usually adds:

1. A registered agent, a person or company at an in-state street address who accepts legal papers served on the LLC, kept current. Texas warns that failing to keep one can lead to involuntary termination of the LLC (Texas Secretary of State). See registered agents.
2. State reports and returns. The yearly or two-yearly report, and in some states a return of its own: California requires a one-owner LLC to file Form 568 even though the IRS disregards it (FTB).
3. An EIN once the LLC has employees or owes certain excise taxes; the IRS also lets it get one for a bank account or when state tax law requires one (IRS). See EIN for a single-member LLC, which also covers which number goes on a Form W-9.
4. A bank account in the LLC's name, kept apart from personal money. See business bank accounts.
5. An operating agreement. The IRS does not collect it; whether your state requires one is set by its LLC law. See operating agreement tax terms.

Moving an existing sole proprietorship over (EIN, bank, contracts and the switch-year return) is covered in sole proprietor to LLC.

Does an LLC open tax options a sole proprietor lacks?

Yes, if it qualifies. Only a corporation or an entity eligible to elect corporate status can choose S corporation tax, and only when its owners meet the tests, such as having no nonresident alien owner (Form 2553 instructions). An LLC can elect to be taxed as a corporation on Form 8832 or as an S corporation on Form 2553; a sole proprietor is an individual running an unincorporated business, so an entity has to come first (IRS; IRS).

An S election on Form 2553 is due within 2 months and 15 days after the start of the tax year it is to apply to, or at any time in the year before; a corporate election on Form 8832 can take effect up to 75 days before or 12 months after its filing date (Form 2553 instructions; IRS). Late-election relief and the rest are in how LLCs are taxed. When an S election pays off is covered in should you elect S corporation status; C corporation tax in LLC or C corporation.

What if there are two owners?

Two people who run a business together and divide the profits are generally a partnership for federal tax, with or without an LLC (26 CFR 301.7701-1(a)(2)). An LLC with two or more members is a partnership by default too (26 CFR 301.7701-3(b)(1)).

Either way, the partnership files Form 1065 and gives each partner a Schedule K-1 to report on their own return (IRS). Forming an LLC does not change that return; it adds the state entity, its fees and a shield partners lack without one: Delaware's partnership law, for example, makes every partner liable for all of the partnership's obligations (6 Del. C. § 15-306). The exception is spouses: a married couple filing jointly who both materially participate in a business they co-own without an entity may elect qualified joint venture status and each file a Schedule C; owning it through an LLC removes that option, though community property states have a separate rule (IRS). See spouse and family LLCs. Already working together without an entity: see business partners without an LLC.

Does my state make an LLC expensive?

It can. The state, not the IRS, sets an LLC's yearly cost, and some states charge a fixed amount whatever the profit: California's $800 annual tax (above) and Delaware's $400 annual tax on every LLC formed or registered there (6 Del. C. § 18-1107). A sole proprietor pays neither.

Forming in a cheaper state may not avoid your home state's charge: California's annual tax applies to every LLC doing business in California, wherever it was formed (FTB). On a small profit, a fixed yearly tax takes a large share of what the business keeps. Details: California minimum tax and LLC fee and Texas franchise tax.

Do I need an LLC, or can I stay a sole proprietor?

Staying a sole proprietor can fit a one-owner business with no employees, little exposure to claims, no client asking for an entity and no S election in view, especially in a state with a fixed LLC tax. These signals change the picture:

If one owner only wants a business name, see DBA or LLC.

Example

These examples are illustrative, in US dollars.

A Texas bookkeeper netting $60,000 alone

As a sole proprietor or as a one-owner LLC, the $60,000 goes on Schedule C. Self-employment tax is the same either way: about $60,000 × 92.35% × 15.3% = $8,478. Forming a Texas LLC adds the $300 certificate of formation and a franchise tax information report each May 15. With revenue far below the no-tax-due threshold, no franchise tax is due.

A California web designer netting $80,000 on $100,000 of revenue

The federal return does not change: Schedule C and Schedule SE either way. A California LLC adds $70 to form, the $800 annual tax every year from the first year, Form 568 every year, and a $20 Statement of Information within 90 days of forming and every two years after. His $100,000 of total California income (revenue, not profit) is under $250,000, so no LLC fee is due. As a sole proprietor, none of these apply.

Two friends selling coffee at weekend markets

They split the profit evenly and never formed anything. They are already a partnership: one Form 1065 and a Schedule K-1 to each, and each pays self-employment tax on their share. Forming an LLC keeps the same Form 1065; it adds the state filing, the yearly state charges and the shield.

Different for you?

• You are paid on 1099s and weighing an S corporation: see do independent contractors need an LLC and should you elect S corporation status, then business formation to set it up.
• Clients, contracts and 1099s already run under your name and Social Security number: the switch order is in sole proprietor to LLC; for help moving it over, see business formation.
• A second owner is joining, or you already split profit with someone: past years may need partnership returns whether or not you form an LLC; see business partners without an LLC, corporate tax for missed Form 1065s, and business formation to set up the LLC.
• Past years of business income were never filed, or have no books: forming an LLC does not change those years; see Schedule C expenses for unfiled years and bookkeeping.
• You hold a professional license (medicine, therapy, law, accounting, engineering): your state may require a professional LLC or professional corporation instead; see professional LLC or professional corporation and business formation.
• You live outside the US, or an owner is not a US person: see forming and running a company from abroad or, for a US citizen abroad, LLC or S corporation while living abroad, and cross-border tax.
• You work in California or another state with a fixed LLC tax: see California minimum tax and LLC fee, LLC annual fees and reports by state and business formation.
• Your spouse co-owns the business: see spouse and family LLCs.
• You sell online: see LLC for an online store.
• You own rental property: see rental property in an LLC.
• You plan to raise money or keep profit in the company: see LLC or C corporation.