LLC vs. Sole Proprietor: A Simple Guide to Choosing the Right Structure

Deciding how to structure your business is one of the most important first steps you'll take as an entrepreneur. It can feel overwhelming, with all the legal jargon and tax implications. But don't worry—the choice is simpler than you might think. It comes down to two key questions: how much risk are you comfortable with, and how are you paying yourself?

Let's break down the two most common business structures for solo entrepreneurs: the sole proprietorship and the Limited Liability Company (LLC).

The Sole Proprietorship: The Easiest Path

A sole proprietorship is the simplest and most common form of business. If you start selling a service or product on your own, you've essentially created one. There's no legal separation between you and your business.

Pros:

• Simple to start: There are minimal legal formalities. You can begin operating immediately.

• Easy taxes: Your business income and expenses are reported on your personal tax return (using a Schedule C). There are no separate business tax returns to file.

• Full control: You have complete control over all business decisions.

Cons:

• Unlimited liability: This is the most significant drawback. There is no legal distinction between your business and your personal assets. If your business is sued or incurs debt, your personal assets—like your home, car, or personal savings—are at risk.

  
  

The LLC: A Layer of Protection

An LLC is a legal business structure that separates your personal assets from your business liabilities. Think of it as a legal shield.

Pros:

• Limited liability: This is the main reason most people form an LLC. If your business is sued or faces financial trouble, your personal assets are generally protected. Only the assets within the business are at risk.

• Credibility: Having "LLC" after your business name can add a level of professionalism and legitimacy in the eyes of clients and vendors.

• Tax flexibility: A single-member LLC is automatically taxed by default as a sole proprietorship (a "disregarded entity"). This gives you the liability protection without the tax complexity.

Cons:

• More administrative work: You must file formation documents with your state and maintain legal compliance, which often includes paying an annual fee.

• Startup costs: Forming an LLC requires a fee, which varies by state.

For most new businesses, starting as an LLC is the smart choice. It gives you the legal protection you need with the tax simplicity you want, and it sets you up for a smooth transition as your business grows.

The Next Level: LLC as a Sole Proprietor vs. an S-Corp

As a single-member LLC, you're a "disregarded entity" for tax purposes. This means that all of your business's net income flows directly to your personal tax return, just like a sole proprietorship. This is simple, but it can be expensive. Every dollar of your net income is subject to two taxes:

1. Income Tax: Your regular personal income tax rate.

2. Self-Employment Tax: A flat 15.3% to cover Social Security and Medicare. This tax applies to every single dollar you earn from your business.

When your business starts to take off, this 15.3% tax can become a huge financial burden. This is the tipping point where it may be time to consider a tax election change.

The S-Corp Solution: Becoming an Employee of Your Own Business

Instead of continuing to be taxed as a sole proprietor, your LLC can elect to be taxed as an S-Corporation. For tax purposes, you put on a new hat and become a W-2 employee of your own company. This strategic move allows you to split your business's profits into two parts:

1. A "reasonable salary": This is the portion you pay yourself as an employee. This part is subject to regular payroll taxes (Social Security and Medicare), which are split between you and the business.

2. Distributions: The remaining profits are taken out as a distribution. This is the magic part—these distributions are not subject to self-employment tax.

The goal is to pay yourself a reasonable market-rate salary and then take the rest of the profits as a tax-free distribution.

The Tipping Point: When to Make the Switch

The decision to elect S-Corp status is primarily driven by your profitability. The tax savings must outweigh the new administrative costs, which include running payroll and paying for more complex accounting and tax filing services.

A good rule of thumb is to consider making the switch when your business's annual net profit reaches somewhere between $60,000 and $80,000. At this level, the tax savings you'll get from the distributions will most likely exceed the new administrative costs.

For example, if you make a net profit of $75,000 as a sole proprietor, you'll pay about $11,475 in self-employment tax. As an S-Corp, you might pay yourself a reasonable $45,000 salary (taxable) and take a $30,000 distribution (non-taxable). In this scenario, you could save over $4,500 in self-employment taxes, more than enough to cover the new administrative costs.

Ultimately, choosing an LLC over a sole proprietorship is a wise first step for any new business. It protects your assets while maintaining tax simplicity. And when your business grows to the point where that tax simplicity becomes a burden, we'll be ready to guide you on the next strategic move to an S-Corp.

Are you ready to talk to a professional about which structure is right for you?