You likely cannot escape paying taxes on business profits or filing an annual tax return. But how you're taxed can vary depending on how you've legally organized your business. Let's take a look at the tax implications of a sole proprietor vs LLC.
An LLC is a limited liability company that is often called a hybrid between a partnership and a corporation. It's like a corporation in that owners must file papers with their state. Also, it exists as a separate legal entity than if you were a sole proprietor.
As the name implies, a single-member LLC only has one member. If you have a single-member LLC, you may be able to choose if this is treated as a corporation. If not, the LLC is a "disregarded entity" and the activities will be reflected on the owner's federal tax return.
An LLC blends features of partnerships and corporations. It grants individual business owners stronger personal liability protections from debts of the LLC. The federal tax classification of the LLC influences the level of liability protection. It also¬†impacts the taxes they have to pay. According to the IRS, you can classify your LLC as:
A single-person LLC should choose their LLC activity on their tax return. They'll also need to file a Schedule C with Form 1040. They'll have to pay self-employment taxes like a sole proprietor. A disregarded entity may face similar financial liability as a sole proprietor. A partnership LLC should file Form 1065, U.S. Return of Partnership Income. Each partner should pay income and self-employment taxes on his share of partnership income rather than on cumulative business income. If the LLC is a corporation, it should file Form 1120 for a C corporation or Form 1120S for an S corporation. S-Corp owners should report their share of corporate income on Schedule-K1 of Form 1120S. The corporate tax rates may be more favorable than individual tax rates. But you should consider the complexity and costs before choosing this classification.
Sole proprietorships are single-owner, unincorporated businesses ranging from home-based businesses to retail trade businesses. A sole proprietorship is a popular form because it's straightforward and low cost. This entity allows you to run a one-man show with little administrative overhead. But, you become personally responsible for business debts and other obligations like taxes. A sole proprietor isn't treated as a separate business entity from the owner. So, business income earned and expenses incurred get passed through to you. You then have to file them on your personal tax return. A sole proprietor files their net business income or losses on Schedule C or C-EZ. This goes¬†along with Form 1040. The rate of taxation equates to your individual tax rate as opposed to a corporate tax rate. Also, sole proprietors pay self-employment tax on net business income.