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Should I Switch from a Sole Prop to an LLC or S Corp?

Not all businesses are treated equal when it comes to personal liability and taxes. Find the best legal entity for your business, your stage, and your income.

Taxes
July 29, 2021

How do you decide what legal entity best suits your business?  This depends on how much personal risk you’re willing to take, and how you want to be taxed on your earnings.  

Best Fit for the Solo Business Owner: Limited Liability Company (LLC)

For high-income freelancers focused on knowledge-work - designers, developers, coaches, marketers, content creators - the Limited Liability Company (LLC) is the best combination of legal protection and simplicity. In specific, you would be a single-member LLC as a solo business owner.

Personal liability: An LLC is a legal, separate business entity that protects your personal assets from business debt or business lawsuits.  Your home, your retirement investments, your bank accounts are off limits, so long as you keep your business and personal finances separate.  

How you’re taxed: The LLC is a pass-through entity, meaning your earnings are taxed on your personal income tax returns without being taxed separately as a company. This makes filing taxes easy. Every year, you report your business income and expenses on a Schedule C, Profit and Loss From a Business in your personal IRS Form 1040 tax return. If you run a loss during the year, those losses also flow through to your personal taxes, lowering your overall tax burden.

How to form an LLC: LLC’s are relatively easy to form online - just make sure you choose a reputable company, not just the cheapest. Good providers will streamline the process of choosing a business name, choosing a registered agent - the person designated to receive official correspondences (usually a lawyer or accountant, but this can be you), creating an operating agreement (standard templates should do just fine for your solo business), and filing articles of organization in your state. State filing fees vary dramatically, from $50-$500.

A side hustle just starting out: Sole Proprietorship

If you simply start getting clients and earning money without forming a legal business entity, you default to a sole proprietorship. It’s a great option when you’re first getting up and running - it’s easy, it’s free, and your taxes are simple. But it comes with liability risk.

Personal liability: Although it’s the simplest option, a sole proprietor has no legal distinction, which means you are personally liable for any debts and obligations of the business.  A business creditor - anyone your business owes money to - can go after your personal assets to get repayment.  Although unlikely, even knowledge workers may be open to lawsuits and financial liability for errors, mistakes, and omissions that harmed a customer.  

How you’re taxed: Like an LLC, a sole proprietorship is a pass-through entity, and your earnings are taxed on your personal income tax returns.  You’d report business income and expenses Schedule C, Profit and Loss From a Business in your personal IRS Form 1040 tax return.

How to form a sole proprietorship: What do you have to do? Nothing! That’s right. If you focused on getting clients, making sales, earning money, and put off this whole entity thing while you were getting up and running, no sweat. You’re already a sole proprietorship.


Another option for the high-earning solo business owner: S Corp

The S Corporation is not actually a business entity, just a tax designation that allows an extra tax savings of paying less in self-employment taxes. But, this is often eaten away by the loss in tax savings from limited retirement contributions.  


Personal liability: All S Corps begin as an LLC (or C Corp - more on that below) as the legal business entity.  This means you get the benefits of a legal entity that separates you personally from your business.  As long as you keep your business and personal transactions separate, anyone that comes after your business assets cannot also go after your personal assets. 


How you’re taxed on earnings: In an S Corp, you wear two hats - the employer (the S Corporation) and the employee (who actually does the work).  We know you always wanted to duplicate yourself.  As the employee, you pay yourself a reasonable salary - what you would pay someone else to do your job.  You would report this as W2 income on your personal taxes.  As the employer, you take home the net profit of the business, after all expenses, including that salary you paid yourself. S corporations file taxes through a Schedule 1120S. The benefit of an S Corp is that you only have to pay self-employment tax (15.3% that goes towards Medicare and Social Security) on the reasonable salary, not on the net profit over and above your salary.  


Warning: We got you all excited, but there is a catch. S Corps limit the amount you can set aside in retirement contributions, and therefore eats away at that self-employment tax benefit.  Remember, retirement contributions are the best way to save for yourself and save on taxes.  As an S Corp, your retirement contribution limit is based on your salary.  If you keep your salary low, your retirement contributions will be low, and you won’t save on taxes.  You gotta get specific with your personal calculations to figure out if the S Corp is a good fit for you. 


How to form an S Corp: You probably don’t want to do this one yourself.  If you’re already established as an LLC, you apply with the IRS with Form 2553 to be taxed as an S Corporation. Things can get complicated - some states don’t recognize S Corp status on state income taxes, calculating your taxes is no longer straightforward, and you have to stay on top of ongoing paperwork with the government. We recommend consulting with your attorney and tax professional if you go down this path.  


A last note on the C Corporation.  The C corporation is generally used for businesses with multiple shareholders or investors, run by a board of directors, and is a poor choice of business entity for a business-of-one. It comes with copious formation paperwork, and they are expensive to set up and maintain. You’re also double taxed.  Shall I go on?  Didn’t think so.  



Self-Employed and Small Business CPA
Joni Becker
Joni M. Becker, Masters of Business Taxation (MBT) and CPA, is the author of My Tax Tutor for Small Business Owners and has been helping sole proprietors and small businesses navigate the complicated world of taxes for over 35 years. She is passionate about sharing her knowledge with the business-of-one.