One of the biggest questions I get as a business coach is “Should I run my business as a Sole Proprietor or setup an LLC?”
Maybe you’ve asked that question yourself.
Perhaps you’ve been confused about which one makes sense from a tax perspective for your business.
Or maybe you’re actually thinking: “I don’t even know what either of those are and why should I care?!”
Today I want to explain the differences between the two and give you a simple and easy framework to know which is the right entity for your business.
Huge preface up front however, I am not a licensed tax professional and I don’t know your personal situation so I can only speak in generalities.
If you are still unsure after this post please consult your CPA or tax advisor!
And huge preface number two, this material applies primarily to those starting businesses in America since that is the tax code I am familiar with.
Sole Proprietor vs LLC: What The Heck Are They?
In the plainest terms possible a sole proprietor is what you are by default the moment you render a product or service to someone for payment.
There are no forms to fill out, there are no hoops to jump through.
Whether you know it or not, the moment you make money on the side (be it online or in person) you are a business known to the IRS as a Sole Proprietor.
And that phrase simply means you are a one-person business.
“Sole” meaning only and “proprietor” meaning business owner. Easy peasy.
By law if you make any side income in a calendar year you must report it on your tax return and you may owe income tax on it, Federal and sometimes also State depending on where you live.
Many people don’t report their side hustle income (I hate that word) but that is technically illegal.
The IRS views you as a sole proprietor and will simply tax your profits (income minus expenses) at your personal tax rate plus a self employment tax of 15.3% which covers your FICA taxes like Social Security and Medicare.
An LLC stands for a Limited Liability Company and is exactly that. It is a separate company or entity and NOT you.
This limits your liability should anything happen to the company (think law suits).
In essence it puts a wall between you the person and you the business, which is nice.
But the big differences to us real people is how an LLC is taxed vs a Sole Proprietorship.
An LLC needs to file its own tax return, separate from your usual 1040, and the profits from the business (income minus expenses) are passed through to you and then reported on your personal return and taxed at your personal rates.
So what’s the difference? And which one makes sense for you and your business?
Let’s dive into that a bit more.
The Easiest Way To Start Your Business Is As A Sole Proprietor
So should you run your business as a Sole Proprietor or an LLC?
Here’s the back of the envelope answer: be a sole proprietor and forget trying to form an LLC until you are making at least $50,000 a year in revenue.
When you are just starting a business you are usually making little revenue and the potential tax benefits of forming an LLC (more on those in a moment) won’t outweigh the annual cost of having to file a separate tax return and potentially pay a CPA to do it and keep your books.
As a Sole Proprietor you can do everything an LLC can do.
You can setup a separate checking account (which you should do from Day 1) at your bank of choice.
You can set up a DBA (Doing Business As) or Fictitious Name as it’s called in Florida so your account can be in your business name even though you are a Sole Proprietor.
And filing your taxes is a breeze.
Simply use TurboTax or H&R Block to file your 1040 and it will ask you if you made any side income which must be reported on your Schedule C of your 1040.
I used Turbo Tax to file my taxes for years. Super simple.
Just answer all the questions about the type of business activity, how much revenue you made and what all your expenses were (web hosting, advertising, materials, etc).
They will automatically calculate any taxes you would owe and add it all to your final number.
Just be sure to keep good records of your income and expenses each year in case of an audit.
When It Makes Sense To Form An LLC
I personally started my first business The Recording Revolution as a Sole Proprietor and ran it that way for 3+ years until I even considered forming an LLC.
So why the switch?
Two reasons: I was making a lot of money and I was scared of my tax returns being a giant red flag for an audit and I was curious to see if I would realize any tax savings this way.
Ah…tax savings. Two of my favorite words!
Let’s talk about the tax benefits of running your business as an LLC, how it works, and when it makes sense to form one.
The big difference with an LLC is that you no longer have one role, you now where two hats: owner and employee.
That’s right if you set up an LLC and specifically on the federal level choose an S-Corp election you must be both the owner of the business and an employee working for it.
What this means is that you must take a paycheck (W2 wage) like all employees in America.
But you also are entitled to taking some of your profits as a direct “bonus” called a Distribution To Shareholder.
You as the only holder of shares in your company are distributing profit to yourself. Make sense?
Now why does any of this matter and what is the benefit and point of it all? Great question.
Whatever profit you take as a Distribution To Shareholder is not liable for self employment tax. Meaning you can save that extra 15.3% of FICA.
You still pay federal (and potentially state) tax on all your profits but not that extra 15.3%. You MUST however pay FICA on your official W2 wages (i.e. your paycheck) as the employee of your company and by law you MUST take a “reasonable salary” for your position.
Meaning you can’t make your paycheck $100 a month if you are bringing in $10,000 a month.
How An LLC Can Cut Your Tax Bill
So let’s simply use a real example.
Let’s say you are a Sole Proprietor and you are making $70,000 in profit from your business.
Really you brought in $80,000 in revenue but you had $10,000 of expenses that year. Thus a net taxable profit of $70,000.
If you are filing jointly, at that income level (in 2018 at least) you are in the 12% tax bracket meaning you would owe $8400 in federal tax.
Add to that the 15.3% self employment tax and your total tax bill is $19,110.
Now let’s say you made the same amount of money but as an LLC with an S-Corp election.
You make the same $70,000 in profit but this time you only “pay” yourself a salary of $35,000 and you take the remaining profit of $35,000 as a Distribution To Shareholder.
Your W2 wages (i.e. paycheck) would be taxed at your 12% + 15.3% giving you a total of 27.3% or $9,555.
While your remaining $35,000 is only taxed at the federal rate of 12% or $4,200 bringing your total tax outlay to $13,755 (I’m ignoring state income tax for these examples).
That’s a tax savings of $5,355 just by earning the same amount of money as an LLC and not a Sole Proprietorship!
Now of course you have to factor in the costs of forming and filing your LLC and its tax returns, but you still come out way ahead in this example.
How To Form An LLC
So now you know the main differences between an LLC and a Sole Proprietorship and when it makes sense to run your business as either.
If you are at a point where you feel you need to form an LLC, then consider something like Legal Zoom to do it.
It’s fast, easy, and relatively affordable to setup.
I’ve used them for LLC formations as well as other things in the past and find their customer service awesome.
So let me ask you! Do you run your business as a Sole Proprietor or an LLC? And why? Leave a comment below!