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What is the Difference Between a Sole Proprietorship and an LLC?

An important part of being self-employed is picking a business entity to file your taxes. There are quite a few options to choose from – sole proprietorships, partnerships, S Corps and LLCs. Each entity has its own pros and cons in terms of tax implications and ease of formation, but sole proprietorships and LLCs are the most popular choices.

Paying taxes on self-employment income as a sole proprietor  

Sole proprietorships are the easiest business entities to form, requiring little to no paperwork. This is why most freelancers just starting out operate as a sole proprietor. As the name suggests, sole proprietors operate with a single owner.

The sole proprietorship tax rate is 15.3%, as they pay self-employment taxes. And just like any other self-employed individual, half of the SE tax (7.65%) can be deducted from income taxes when filing Form 1040.

A self-employment tax calculator is a good tool to use in 2023 to total your tax liability. If you’re filing as a sole proprietor, use self-employment deductions to lower your income. You can write off health insurance premiums, vehicle mileage and even your home office.

Schedule C is where you’ll report all your expenses and find your  taxable income. To make finding tax write-offs easier, you can use a 1099 taxes calculator (or download an app like FlyFin).

A significant disadvantage of sole proprietorships is operating as a business with one employee. This might not be an issue if you’re a person who works as a rideshare driver or freelance hair stylist but it can affect 1099 individuals who run a small business and are responsible for managing all the business activities on their own.

Another disadvantage is the owner’s personal responsibility for any losses incurred by the business since sole proprietors file taxes as an individual. The IRS will also pay extra attention to your tax returns as it’s easier to mix personal and business expenses. Keeping good books is essential as a sole proprietorship, as every tax deduction needs to be backed up by proof.

How to navigate SE tax as an LLC

An LLC (Limited Liability Corporation) is a business entity where the owners are separate from the business. LLCs have the option to pay self-employment tax as a pass-through entity or as a corporation.

You may become an LLC if your business is growing and you need hire some employees. The biggest advantage of an LLC is that its owners’ personal assets are shielded from liability and debt. Its owners can share the losses faced by LLCs. Failure to pay off debt will only affect the business’ assets.

Form 1065 is the most important form to pay taxes as an LLC. If an LLC chooses to pay taxes as a pass-through entity, it can claim the Qualified Business Income Deduction and write off 20% of its taxable income.

LLCs can also write off business expenses like startup costs, business insurance, CPA fees and advertising costs as tax deductions. This is also helpful when paying estimated quarterly taxes. A tax estimate calculator can figure out if your tax liability is over $1,000.

Infographic entitled Sole Proprietorship vs LLC describing their differences when paying freelance income tax.

Can you switch from a sole proprietorship to an LLC?

Yes, sole proprietors can switch to an LLC if they want to grow their business or are interested in certain tax benefits available to LLCs. The process can take a while, and you’ll need a few things.

First, you’ll need to register your business with a unique business name. Then you’ll have to file the necessary documents with your state and pay the registration and application fees. You should also get business insurance, open new bank accounts exclusively for your business and apply for the relevant licenses and permits.

Apart from a few differences, sole proprietorships and LLCs operate pretty similarly. So when you’re choosing a business entity, take into account your line of work, your assets and your capital. Getting professional tax help is also a smart way to guide your decision.

FlyFin CPA Team

FlyFin CPA Team

With a combined 150 years of experience, FlyFin's CPA tax team includes tax CPAs, IRS Enrolled Agents and other tax professionals, offering users the most comprehensive tax advice and preparation.

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