Sole Proprietorship vs. LLC: Tax Considerations for Small Businesses

It’s an understatement to say that small business owners, especially new ones, have a lot on their plates. From marketing and team supervision to managing payroll and bookkeeping, there’s a lot to take on! However, one of the most important things a small business owner does is ensure their taxes are paid on time every year. In this guide, we navigate sole proprietorship taxes, deadlines, IRS forms, income tax returns, federal tax returns, state tax, business profits, and all filing requirements to prepare small business owners, independent contractors, and self-employed individuals for the tax year. 

When setting up a new business, it’s important to learn how to choose a business structure that’s right for you and determine how it will affect the specifics of your business’s taxes. Many small businesses opt to form sole proprietorships. So, what is a sole proprietorship? It is someone who owns an unincorporated business by themselves. It’s the easiest and most straightforward business structure to form.

If you’ve already decided to become a sole proprietor, your next question is probably, “How are sole proprietorships taxed?” Fortunately, since this is one of the least complicated business structures, the taxes are similarly straightforward.

How is a Sole Proprietorship Taxed?

Sole proprietors are taxed at the individual income tax rate, similar to how they were taxed before becoming business owners. This involves the owner reporting and paying their sole proprietorship taxes as part of their personal tax return. This differs from a C corporation or S corporation, as they report taxes on a separate business tax return. 

The IRS classifies sole proprietorship taxation as “pass-through taxation” because the tax liability “passes through” to the owner of the business on their personal tax return. Sole proprietors will complete a separate form for their proprietorship taxes on Schedule C . Schedule C then gets filed with the personal income tax form, Form 1040. 

A couple of notes about taxes for sole proprietorships:

1. Pass-through taxation means that the net income from the business will increase the owner’s personal taxable income—meaning the business income might push them into a higher tax bracket. 
2. Income taxes are not considered a business expense. Some business owners post income tax payments on their profit and loss statements as expenses; however, this is incorrect for sole proprietors—these payments are considered distributions of equity, not expenses.

Sole Proprietorships as LLCs

Some sole proprietors opt to form an LLC (Limited Liability Company). However, some LLCs will still file taxes as sole proprietors. This is because LLC is a legal status granted at the state level but not the federal level. Therefore, single-member LLCs are subject to sole proprietorship taxation. 

A limited liability company with two or more members is classified as a partnership for federal income tax purposes. However, either single- or multi-member LLCs can elect to file their taxes as a corporation by completing IRS Form 8832.

Business entity formation can provide many tax benefits for new business owners, but it can get complicated quickly if you’re unfamiliar with the various structures. Consider consulting an entity formation professional who can ensure you get the maximum benefit from your business structure. 

Determining Sole Proprietorship Income Tax Liability

Sole proprietors do not pay taxes on the full amount of the business’s income. Instead, they will only pay a sole proprietorship tax on the profit of the business. This means they’ll get taxed on all profits (total income minus expenses) regardless of how much money they withdraw from the business. Therefore, the sole proprietorship’s taxable income will be close to the “net income” or “net profit” number at the bottom of the profit and loss statement, but with a few adjustments.

Like any business, sole proprietors can deduct business expenses on their return; however, they’ll want to ensure that they’re managing their small business bookkeeping correctly to report taxable income and any applicable deductions accurately.

A common mistake that sole proprietors make, for example, is recording cash activity, such as owner’s withdrawals, cash deposits from loans or investments, and debt payments—as expenses or income on their profit and loss statement when these activities do not impact taxable income. These incorrectly recorded transactions will mess with the total profit calculation and can result in either paying too much or too little on taxes. 

Paying too much is obviously a disadvantage because that’s money that a new business owner could be using to grow their operations. Paying too little could result in fines or penalties from the Internal Revenue Service (IRS), definitely not what a small business owner wants. 

Tax Deductions for Sole Proprietorships

One of the best parts of taxes for small businesses is the ability to itemize deductions and decrease the overall tax bill. 

Some common tax deductions for sole proprietors include:

• Health insurance deduction
• Business vehicle usage and mileage
• Self-employment tax
• Home office deduction
• Banking and insurance fees
• Professional development 
• Business meals 
• Traditional IRA contributions 
• Phone and Internet services 
• Professional services 

A sole proprietor who wants to make the most of their deductions would be wise to consult a professional accountant who can ensure they’re maximizing their deductions and taking advantage of everything they’re eligible for. When business owners fail to take advantage of qualified deductions, they leave money on the table for the IRS!

What Taxes Do Sole Proprietors Pay?

Sole proprietors are responsible for the following taxes:

• Federal income tax
• Applicable state income tax
• Self-employment tax
• Federal and state estimated taxes paid on a quarterly basis
• If applicable, sales tax

So how much do sole proprietors pay in taxes? For a full breakdown of estimated taxes, check out this guide to calculating quarterly estimated taxes.

Make Sole Proprietorship Taxes Easier with an Expert Accountant

If you’re worried about meeting the sole proprietorship taxes or don’t have the bandwidth to do the work of figuring it out, consider getting help from a professional accountant. Working with a small business tax accountant will help your sole proprietorship save money and avoid penalties, and it will leave you with more time to focus on the work your business really needs to get ahead. Get help now by scheduling a free consultation with one of our experienced tax pros!