This guide explains how a limited liability company differs from a sole proprietorship in terms of establishment, taxation and legal protection.
Understanding a Sole Proprietorship and an LLC
Hundreds of people decide to launch their own company every day. Such an important step requires careful planning. Aside from the business idea and plan, you also have to select the kind of business you would like to launch. It will have an impact on the division of responsibility, the way you will pay business taxes, earnings, and many other major aspects of managing an enterprise. These days, aspiring entrepreneurs are more likely to select an LLC or a sole proprietorship model. Why? Let’s take a closer look at this issue.
A sole proprietorship suggests the easiest route to conduct business. It works best for those who don’t like technicalities since you shouldn’t spend time and money on official registration. Just start making deals, that’s all. Of course, you might also be required to obtain some licenses or permits, but in general, the procedure for founding a sole proprietorship is significantly easier and faster compared to an LLC. One more advantage of this choice aims at the ease of taxation. All losses and gains of a sole proprietorship are reflected in the personal tax return of the business owner. As the entity is inseparable from its organizer, the latter bears responsibility for the company’s debts and liabilities with all of its property.
Speaking about the LLC business model, it has some differences. Here, the registration process creates an independent legal entity, which will run the enterprise under its own name. It guarantees limited liability protection, ensuring the safety of the personal assets of the members. However, when the issue concerns taxes, an LLC resembles a sole proprietorship. As standard, a company’s revenues and losses are shown in its owners’ personal tax returns.
How Does a Sole Proprietorship Pay Taxes?
The Internal Revenue Service (IRS) treats sole proprietorships as flow-through taxable units. The pledge to pay business taxes on its profits and losses falls entirely on the company’s owner, who should report them on their personal return. To comply with the legal framework, you are to submit Form 1040 and Schedule C regularly. Pay attention to the fact that all income, including money put in a savings account, should be declared.
Apart from the income tax, a sole proprietorship has the responsibility to pay the self-employment tax. Its rate is 15.3%. This includes 12.4% for Social Security and 2.9% for Medicare. Nonetheless, the good news is that you can claim a tax deduction for half of the amount you have paid.
Do you have any doubts about paying income tax or self-employment tax? To get to the bottom of this, you first need to estimate your company’s net earnings or loss. To that end, subtract the costs pertaining to maintaining the business from the organization’s total income. If the profits exceed expenses, then the remaining amount stands for net income. This is to be stated in Form 1040 or Form 1040-SR for the self-employment tax. If a business’s expenses exceed an income, the difference refers to a net loss. Most often, when filling out Form 1040 or Form 1040-SR, a part of the net loss may be deducted from the entity’s total gross revenue.
Under the IRS standards, the obligation to pay self-employment tax arises if the net income is at or above $400. When it is under $400, the need to submit a business tax return depends on other statutory criteria.
A sole proprietorship does not have an employer to withhold Social Security and Medicare taxes. Therefore, the estimated tax approach is used to pay them. You just have to complete Form 1040-ES analogous to Form 1040 and Form 1040-SR.
Filling out Form 1040-ES isn’t particularly challenging. If you are doing it for the first time, you have to begin with calculating your expected payment by following the algorithm below:
- Estimate the amount of income your organization expects to generate over the year;
- Divide the expected annual income by 4 according to the number of quarterly payments;
- Divide the quarterly payment by 3 to get the amount you need to put aside each month to pay your taxes.
Of course, it may seem a bit complicated to predict the amount of your annual income in advance. Thus, if you estimate your income too low or too high, you need to re-do Form 1040-ES to recount your tax for the next quarter.
By and large, the major downside of sole proprietorships in terms of taxation is the necessity to pay tax on all the proceeds of the venture. However, it is somewhat offset by the pros including:
- The lowest tax rate;
- Good tax deductions to cut costs;
- No corporate tax;
- An easy process for filing tax returns.
LLCs and Taxation
Unless the owners have specified otherwise, by default, the IRS treats a limited liability entity as a pass-through (or flow-through) tax unit. In relation to the number of members, an LLC might be taxed in 2 ways:
- A firm with a sole member pays taxes as a sole proprietorship;
- If an LLC enterprise has more than one company member, such a business venture will be taxed as a partnership.
Let’s take a deeper look at the features of the LLC tax regime.
The tax status of a single-member LLC stands very close to that of a sole proprietorship and is governed by the same rules. That is to say, the owner of such a foundation also provides business earnings and expenses on Form 1040 and Schedule C. Furthermore, you will be able to qualify for most of the allowances to which a sole proprietorship is entitled.
If an LLC company has 2 or more owners, then the business will be taxed as a partnership. The duty to declare income and losses earned in the course of conducting business falls on its owners. Every MM LLC member pays personal income tax, the amount of which depends on the profit share, which, in turn, is usually determined by the ownership share. Apart from pro-rata, there is also a specific distribution of funds, the procedure for which is stated in the LLC Operating Agreement.
As in the case of individual entrepreneurship, multi-member LLC owners are obligated to declare all of their profits, even a portion sent to the reserve funds. For the LLC owners and the IRS to know how much tax to await, the firm is to draft and file an information return by filing Form 1065. This paper sets forth the method of allocation and the amount of each participant’s profits.
Estimated taxes and the self-employment tax
LLC members, who ensure its everyday active functioning, are not considered to be employees. The law defines them as self-employed individuals, which imposes the requirement to pay the corresponding tax. Hence, the owners of an LLC pay self-employment tax and estimated taxes in the same manner as a sole proprietorship. The single difference lies in the fact that the sum of the tax is based on each owner’s share of the profit. The funds payable as a self-employment tax should be listed on Schedule SE attached to the personal income tax return.
Additionally, one should not forget that not all participants may want to engage in the management of the venture. Some of them prefer to simply invest to make a regular profit. Such participants are called inactive and may be exempt from the self-employment tax.
The tax advantages of an LLC have much in common with sole proprietorships, from the ease of filing to the wide range of tax deductions. However, LLC taxes are likely to be more expensive. Plus, the taxation procedure for multi-member LLC members can be somewhat confusing. In this case, it may be worthwhile to enlist the help of a specialist.
If you conduct business as a sole proprietorship or have founded a limited liability company, the law will allow you to enjoy a tax deduction. As such, a sole proprietorship or an LLC taxed as a partnership may qualify for a pass-through tax deduction. It allows entrepreneurs to deduct 20% of their net business income.
To determine whether you can get a flow-through tax deduction, you have to consider the level of revenue and some further factors. Thus, the owners can apply if they meet one of the following requirements:
- Income is up to $163,300 (or up to $326,600 when the entity is owned jointly by spouses), and there are employees or property to be depreciated;
- Earnings are over $213,300 (or more than $426,600 for cohabiting spouses), as long as the enterprise does not provide personal services.
What kind of business falls into the personal services category? As a rule, the following ventures are included in this group:
- Consulting work;
- Law firms;
- Medical practices;
- Performing arts.
As for entrepreneurs with an income from $163,300 to $213,300 (or between $163,300 and $326,600 for spouses living together), there is a special procedure for them. In this case, the deduction is calculated using a different step-by-step method.
Another attractive tax deduction for LLCs and sole proprietorships are the “ordinary and necessary” expenses involved in setting up a business. These are as follows:
- Advertising costs;
- Operating expenses;
- Business travel expenses;
- Product costs;
- New equipment and assets;
- Business-related meals.
The legislation also provides entrepreneurs with the chance to obtain a health insurance deduction. Not only the insurance the owner has purchased for themselves but also those bought for a spouse or dependents is taken into account. The tax deduction for health insurance is taken from gross earnings. Keep in mind that you couldn’t claim this benefit if the business suffered a loss.
Finally, another common option is home office deduction. It is designed for sole proprietorships running a company from home, and it allows you to write off expenses such as rent or utilities.
What’s Better: a Sole Proprietorship or an LLC?
To ensure the best growth and development conditions for the future firm, there are a few aspects to examine when choosing a business structure. Taxes are undoubtedly a crucial aspect of any venture, but in this respect, an LLC is often quite close to a sole proprietorship. Although LLC owners can select a corporate treatment, by default, both these types of entities belong to “pass-through” tax units. In fact, the tax status of a single-member LLC is identical to that of a sole proprietorship. Either way, the duty to pay taxes falls on the owner, who reports the firm’s profits, as well as expenses, on their personal tax returns.
To assess whether an LLC or a sole proprietorship fits you, the first criteria you are to look into are risks and liability. For example, opening a sole proprietorship may be more reasonable if your business meets the following criteria:
- Low financial risk ratio;
- Small client base;
- Little chance to face lawsuits;
- Small or medium income.
An LLC, on the other hand, is appropriate for companies with characteristics such as:
- Extensive client base;
- A significant level of expected profits;
- High probability of financial risks.
Naturally, operating as a sole proprietorship, you might protect yourself from any surprises by purchasing insurance. Nevertheless, in some cases, it is not relevant, as the cost of the insurance policy can be quite high. To insulate your property and savings, registering an LLC is a preferable solution.
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