Your choice of legal entity structure has significant implications for your business. Most importantly, it affects the taxes on your earnings and the degree to which you and any other owners are personally liable for your business’s debts.

Here’s what you need to know about the differences between operating as a sole proprietor vs. a limited liability company (LLC) vs. an S-Corp to decide which one is right for your business.

How Being a Sole Proprietor Works

A sole proprietorship is the default corporate structure for every one-person business. You don’t have to file any paperwork to elect it, so if you’ve been running your company without stopping to think about business entities, you’re a sole proprietor.

Because they’re the default choice, sole proprietorships are one of the most common business structures. If you’re an independent contractor or a freelancer, you might decide to remain a sole proprietor for simplicity’s sake.

Not only is there no paperwork or fee to set up a sole proprietorship, but there are also no annual reporting requirements or charges to maintain one, which isn’t true of other business entity structures.

While you can bring on as many employees as you want, there can only ever be one owner of a sole proprietorship. If you’d like a partner to help you run the business or equity financing through shareholders, you’ll need to use a different option.

Sole proprietorships aren’t really distinct from their owners like corporations or LLCs. As a result, there are no taxes at the business entity level.

Your sole proprietorship is a disregarded entity, which means you can largely ignore it for tax purposes and report your business income on your personal tax return.

Your net earnings after allowable business deductions are subject to ordinary income tax rates, just like W-2 wages.

In addition, you’ll owe a 7.65% self-employment tax, which is the employer half of the FICA tax or payroll tax, 6.2% for Social Security tax, and 1.45% for Medicare tax.

The lack of distinction between you and your business has its pros and cons for taxes, but there’s no real upside when it comes to liability. If someone decides to sue your sole proprietorship, you’ll be personally liable for it all.

You could plausibly have to liquidate a valuable personal asset to pay a business debt. As a result, one of the primary reasons people elect to transition out of sole proprietorship and into an LLC or S-Corporation is to limit their personal liability.

Finally, an often underappreciated consideration with sole proprietorships is that they’re not well-suited to building business credit or getting bank financing.

Many lenders see sole proprietors as riskier borrowing prospects than other business entities and are less willing to give them loans. You’ll have some problems building business credit as a sole proprietor. 

How LLCs Work

A limited liability company, or limited liability corporation, is a pass-through entity for tax purposes by default. Your profits are generally taxable as ordinary income plus 7.65% for self-employment, with no taxation at the entity level.

Unlike a sole proprietorship, LLCs limit your personal liability for business debts, as the name suggests. They’re separate legal entities from their owners.

Speaking of owners, LLCs can have more than one. The owners of an LLC are known as members, and most states don’t have any limits on their number or type.

That means they can be individuals or other business entities, or you can skip them altogether. Forming a single-member LLC is a popular strategy among those who want liability protection, but prefer to remain the only business owner.

To convert an existing sole proprietorship into an LLC or open one from scratch, you’ll need to take the following steps:

• Come up with a name: It must be unique from other LLCs in your state and usually has to include some variation of “LLC” or “Limited Liability Company”.
  
• Choose a registered agent: Registered agents are the point of contact for the LLC and must accept tax and legal documents on its behalf.
  
• File the state-appropriate paperwork: Depending on your state, you may need to file forms like articles of organization or a certificate of formation.
  
• Pay the state fees: Most states require that you pay a fee to set up your LLC. For example, California charges $70.

Depending on your state, it may also be necessary to draft an operating agreement, which establishes the internal governance rules for the business.

Even if it’s not legally required, it’s highly recommended if there are multiple members. For example, the operating agreement establishes who gets what percent of the company’s profits and subsequently pays taxes for them. 

In addition to the initial paperwork necessary to set up your business as an LLC, you’ll have ongoing reporting requirements and fees to pay each year. Check the rules for your state to confirm your responsibilities.

One other noteworthy feature of an LLC is that it lets you make an election to receive the tax treatment of an S-Corporation or C-Corporation.

That doesn’t affect your business structure – it’s still an LLC – but it does change how you pay taxes on earnings. Keep that in mind as we discuss how S-Corporations work.

How S-Corporations Work

Before you can fully appreciate S-Corporations, you need to know a little about how C-Corporations work. C-Corporations are the default form of corporation, and you’ll need to open one and file a separate form to get S-Corp status.

C-Corps give their owners the benefit of limited liability and corporate structure at the cost of increased paperwork, filing fees, and double taxation. That last one means earnings are taxable at both the corporate and individual levels.

For example, in 2021, C-Corps owe a flat 21% federal tax rate. If your C-Corp were to net $100,000 in profit, it would pay $21,000 in taxes to the IRS at the corporate level.

Next, it would have the option to pass on some or all of its remaining profits to you, the owner and shareholder. When you receive them, you would also pay taxes on the earnings at the individual level as either a salary or a dividend.

Depending on how you receive the income, it would be taxable at different rates:

• Salaries: As an owner of a corporation, you can pay yourself wages. They would be a deduction that reduces your corporation’s taxable income, but you would pay ordinary income taxes and self-employment taxes on them at the individual level.
  
• Dividends: You can also pay yourself through dividends, which almost always qualify for lower tax rates than ordinary income. They’ll be taxable at 0%, 15%, or 20%, depending on your personal income levels. However, dividends don’t reduce your corporation’s taxable income.

Now, let’s get back to S-Corps. S-Corps offer most of the same advantages and disadvantages as C-Corps. They limit your liability and allow for multiple shareholders at the cost of increased filing requirements and fees.

However, they do away with the double taxation problem. There are no taxes at the business level. You pay ordinary income on the business profits at the individual level only.

In addition, you only have to pay the self-employment tax on the earnings that you receive as a salary, not any of the business profits or dividends (usually referred to as distributions).

Note that you must take a “reasonable” salary, though. You won’t get away with reducing your personal income tax by paying yourself $20,000 for the year as a self-employed marketer if the going rate for an employee of your caliber is $65,000.

Finally, S-Corp distributions can be tax-free, taxable as a dividend, or a capital gain, depending on the circumstances. Tax planning for S-Corps is highly complex, and you’ll need to rely heavily on an expert advisor to help you utilize the tax status properly.

Sole Proprietor vs. LLC vs. S-Corp

As you can see, there’s a lot to consider when deciding between doing business as a sole proprietor, an LLC, or an S-Corp. Let’s review the most significant pros and cons of each, starting with sole proprietors.

Pros and Cons of Sole Proprietors 

Advantages	Disadvantages
No forms or fees to set upSimple and free to maintainStraightforward taxes and reporting requirementsComplete control as sole owner	Unlimited liability for business debtsFew advanced tax reduction strategiesNo option for partnersLimited ability to build business credit

Sole proprietors are often best for people who value simplicity. They require no time or money to set up, and you’ll have an easy time maintaining them each year.

The most significant danger for a sole proprietor is that you’re responsible for all your business’s debts. That makes them the worst choice for occupations that involve a high likelihood of being sued.

Next, let’s take a look at the pros and cons of LLCs.

Pros and Cons of LLCs 

Advantages	Disadvantages
Limited liabilityFreedom to elect various tax treatmentsLimitless ownership models	Medium level of initial and ongoing paperwork and fees

An LLC may be the best option for someone who values flexibility. You have a lot of control over the ownership structure as well as the tax treatment of earnings.

The setup and maintenance requirements are also manageable, and it gives you the benefit of limited liability. All in all, LLCs are a well-rounded and balanced choice.

Finally, let’s look at S-Corps.

Pros and Cons of S-Corps 

Advantages	Disadvantages
Sophisticated tax strategies availableLimited liabilityFlexible ownership strategies	Demanding and expensive to set up and maintain S-Corporation status

An S-Corp is likely the most complex legal entity of the three options here. There are a lot of moving parts and additional reporting responsibilities for taxes and general corporate requirements.

For example, S-Corps have their own annual tax returns and filing requirements, and owners need to establish a board of directors.

As a result, S-Corps are usually best for advanced businesses with sophisticated operations. They have the time and money to deal with the increased requirements and can use the structure to create tax savings.

Which One Should You Pick?

Now that you can thoroughly compare and contrast a sole proprietor vs. LLC vs. S-Corp, the million-dollar question becomes which one is best.

As you can probably guess, the answer is that it depends. There is no universally correct option for every scenario.

Each structure has its own tax advantages and limited liability protection levels. You’ll need to assess your business’s needs and circumstances to make the best decision.

For example, if you’ve recently started your company as a solo small business owner, it might be best to stick with a sole proprietorship for a while.

You don’t know how things will go, and sole proprietorships don’t require as much investment. Besides, you’re likely to be earning less in the early stages, and your legal structure means less when you have lower profits.

Conversely, if your business is well-established with revenue and expense patterns that you can safely predict, becoming an LLC owner might be the better choice.

Maybe you’ve accumulated more assets that you’d like to protect by limiting your liability. You may also be more likely to receive a tax benefit from more sophisticated tax plays because you have a higher, consistent income.

Besides, you could always make an S-Corp election later, if you want.

Build Credit For Your LLC or S-Corp

Regardless of your business entity structure, building business credit is an important part of your company’s development. Just like personal credit does for consumers, your business credit affects how likely you are to get affordable financing.

It can also impact matters like the price of your business’s insurance premiums and its ability to secure contracts with vendors or the government.

If your business is an LLC or an S-Corp, one of the best ways to build your business credit is to open a CreditStrong Business credit builder account.

To qualify, your business just needs to be one of the accepted legal entities and at least three months old. Because the account is a secured installment loan, there’s no credit score requirement.

That means that once you get approval, you start making monthly installments. A portion of each one goes into a locked business savings account, which we’ll release to you once you pay off the loan or decide to close your account. Give CreditStrong for Business a try today!

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