The key is that choosing to become a sole proprietor or establish an LLC should not cause you headaches. It is rather easy when someone decodes it in simple language. In the case of sole proprietor vs LLC, you can imagine it is like the difference between riding a bike and driving a car. They both will take you where you need to be, but they operate in different ways and have different rules. So, let us simplify this to the extent that your neighbour’s kid would understand.
What is the General Difference Between LLC and Sole Proprietor?
Being a sole proprietor is equivalent to being the captain of your ship. It all belongs to you, you make all the decisions, and you are responsible for everything that is going on. Only you and your business – no documentation to create something special, no elegant equipment. Did you begin selling cookies in your kitchen? You are a sole proprietor, congratulations!
An LLC (Limited Liability Company) is as though you had a bubble around your business. You are still the boss, but your assets (such as your home and automobile) are also protected in the event of something happening to your business. Just imagine that you are riding a bike and wearing a helmet, you are still pedalling, but you have an additional layer of safety gear.
What is the Taxation on a Sole Proprietor?
Being a sole proprietor, you and your business are twins in the eyes of the IRS. This means:
The income of your business is directly added to your tax returns. No additional tax returns on your business! You fill in a form called Schedule C, which is simply a form that tells you, “I made some money out of my business this year.”
However, there is a catch: you pay what is known as self-employment tax. This is equivalent to compensating the worker and the employer a portion of the Social Security and Medicare taxes. It is currently 15.3% of your profitable business. Ouch, right?
The positive news is? There is a deduction of business expenses. The new work on a computer? Deductible. Office supplies? Deductible. Is it a part of your home when you work from home? And, of course, it’s deductible!
How Is an LLC Taxed?
Plot twist! A single-member LLC is taxed, by default, just like a sole proprietor. This is what the IRS refers to as the disregarded entity status. Souped-up name, same effect, your LLC earnings are reported on your tax form, as usual. However, here is where LLCs become cool, you can choose! You have the option of being taxed as:
The default is a sole proprietor.
- An S-Corporation
- A C-Corporation
You can control your taxes like a remote. Most small business owners are content to use the default, as it is easy, although it is pleasant to have options.
Is an LLC a Way to Save Self-Employment Taxes?
If your LLC maintains default taxation, you will also be subject to self-employment taxes, specifically the 15.3% rate we discussed above. However, when your LLC selects S-Corporation taxation, then it is interesting. Under the S-Corp election, you receive a salary, which is considered a reasonable one, and it is subject to regular payroll taxes. Any additional profit that you withdraw can escape self-employment tax.
Do I need a Secluded Company Bank Account?
With sole proprietors, you are not required by law to open a specific business bank account. You can combine your personal and business money within one account. Just imagine that you kept your socks and underclothes in different drawers. Yes, you can mix them all up, but then life is so much easier when things are in their place. Moreover, in case they ever consider looking at the expenses that you have in business, they will have to look through a haystack.
In the case of LLCs, not only is it wise to keep business and personal funds separate to preserve the protection we discussed, but it is also required by law. Combine them, and you may lose your legal defence.
What do you decide in the Sole Proprietor vs. LLC debate?
Just pose yourself these easy questions:
Do you desire legal immunity for your assets? If so, be biased towards LLC. Please accept more paperwork and annual fees. In that case, a sole proprietor could be your friend.
Will you be making significant profits in areas where S-Corp taxation can help you save? In the case of yes, LLC provides you with this option. Consider that, at any time, you can be a sole proprietor and then convert it to an LLC. Many companies start their existence and evolve into more complex forms as they grow larger.
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Conclusion
You don’t need to be afraid when deciding whether to use a sole proprietorship or an LLC. Each of them has its purpose, and they could be very effective in small companies. It boils down to knowing what you’re getting into and choosing what makes sense in your current situation.
Tax decisions should not keep you awake at night! It does not matter whether you select a sole proprietorship or an LLC; what is important is that you are venturing into your business. The tax stuff is something that can be sorted out as one goes along. You see, there is no single business owner in the world who has not been in your shoes, trying to find the answer to the question of what the best course of action is. And in case you are still lost at which end is up, then no worries, that is what the H&M Tax Group professionals are here to do! These people can guide you through these decisions without giving you a headache, so you can focus on what you do best: running your awesome business.
