Starting a business is exciting, but one of the first major decisions you’ll face is choosing the right legal structure. Many new entrepreneurs default to operating as a sole proprietorship because it’s simple and requires minimal paperwork. Others opt for a Limited Liability Company (LLC), believing it will provide tax benefits and legal protection.
The question is: When it comes to taxes, which structure is better? Will an LLC actually save you money, or is it just an unnecessary extra step?
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The Basics: What’s the Difference Between an LLC and a Sole Proprietorship?
Before diving into the tax details, let’s define these two business structures.
Sole Proprietorship
A sole proprietorship is the simplest and most common business structure for solo entrepreneurs. If you start a business and don’t formally register it as an LLC or corporation, you are automatically considered a sole proprietor.
Key characteristics:
- No separate legal entity—the business and the owner are the same in the eyes of the law.
- The owner is personally liable for all business debts and legal issues.
- All business profits are reported on the owner’s personal tax return.
Limited Liability Company (LLC)
An LLC is a legal business structure that provides liability protection while maintaining flexibility in taxation. While an LLC requires more paperwork and fees than a sole proprietorship, it offers certain legal and financial benefits.
Key characteristics:
- The business is legally separate from the owner(s), offering liability protection.
- Taxation is flexible—an LLC can be taxed as a sole proprietorship, partnership, S corporation, or C corporation.
- Requires formal registration with the state, along with ongoing maintenance fees.
Now, let’s get into the most important factor for many entrepreneurs—taxes.
Taxation of a Sole Proprietor vs. an LLC
Both sole proprietors and LLCs (by default) are considered pass-through entities, meaning the business itself does not pay federal income taxes. Instead, profits “pass through” to the owner’s personal tax return.
However, taxation can still differ significantly between the two structures.
Income Taxes
Since both sole proprietors and single-member LLCs report their business income on Schedule C of their personal tax return, there is no inherent income tax advantage to forming an LLC. The owner pays taxes based on their individual income tax bracket.
Multi-member LLCs, however, must file a partnership tax return (Form 1065), and each member receives a Schedule K-1 to report their share of profits.
Self-Employment Taxes
One major tax consideration is self-employment tax, which covers Social Security and Medicare. Currently, self-employment tax is 15.3% (12.4% for Social Security and 2.9% for Medicare).
- Sole Proprietors: All business profits are subject to self-employment tax.
- LLC (default taxation): If taxed as a sole proprietorship or partnership, the entire net income is subject to self-employment tax.
- LLC (S Corporation election): An LLC can elect to be taxed as an S corporation, reducing self-employment tax liability by classifying part of the income as a salary (subject to self-employment tax) and part as distributions (not subject to self-employment tax).
This S corp tax strategy is one of the main ways an LLC can provide tax savings over a sole proprietorship.
The Qualified Business Income (QBI) Deduction
Both sole proprietors and LLC owners can take advantage of the Qualified Business Income (QBI) deduction, which allows eligible businesses to deduct up to 20% of their net income.
For example, if your business earns $100,000 in profit, you may be able to deduct up to $20,000 from your taxable income, reducing your overall tax liability.
Business Deductions
Both sole proprietors and LLCs can deduct common business expenses, including:
- Office rent and utilities
- Business travel and meals
- Marketing and advertising costs
- Equipment and software
- Health insurance premiums (for eligible owners)
The key difference is that LLCs often have an easier time proving their legitimacy to the IRS, reducing the risk of an audit.
When an LLC Is a Better Tax Option
While sole proprietorships work well for small, low-risk businesses, an LLC can provide tax advantages in certain situations.
If You Plan to Earn Over $50,000 per Year
Once your business earns around $50,000 or more annually, electing S corporation taxation for your LLC can help reduce self-employment taxes.
If You Want Liability Protection
Although not a tax benefit, forming an LLC protects your personal assets from lawsuits and business debts. Sole proprietors have no such protection.
If You Want to Build Business Credit
LLCs can establish business credit and obtain financing more easily than sole proprietors, allowing for greater tax planning opportunities.
When a Sole Proprietorship Might Be the Better Choice
Despite the advantages of an LLC, a sole proprietorship may be the right choice if:
- You are running a small, low-income business.
- You want to avoid state LLC fees and ongoing administrative requirements.
- You are comfortable with personal liability risks.
Key Takeaways
So, should you form an LLC or stick with a sole proprietorship? Here’s a summary:
- Taxes: By default, LLCs and sole proprietorships are taxed similarly, but an LLC can elect S corp taxation to reduce self-employment tax.
- Liability Protection: LLCs offer personal asset protection; sole proprietors are personally liable for business debts.
- State Fees: LLCs require registration fees and annual maintenance, while sole proprietorships do not.
- Growth Potential: LLCs provide a stronger foundation for business expansion and financing.
Ultimately, if you are a solo entrepreneur making modest income, a sole proprietorship may be fine. But if you plan to grow, protect your assets, and save on taxes, forming an LLC—especially with an S corp election—can be a smart move.
Still unsure which path is best for you? Consulting a tax professional can help you make the most tax-efficient decision for your business.
