What is the difference between a sole proprietorship and an LLC?

Are you self-employed and wondering if you should form a limited liability company (LLC) for your small business? Before you take the plunge, read on to make sure you understand the difference between these two types of business entities.

A sole proprietorship is an unincorporated business owned by one person. Other common synonyms for a sole proprietorship include self employed, independent contractor, and self-employed. Your business is not a corporation or partnership, and you report your business income and expenses on Schedule C as part of your personal income tax return (Form 1040). Other tax forms may also be required, such as Schedule SE (to report self-employment tax on your earnings), Form 4562 (to report business asset purchases and depreciation expenses), and Form 8829 (if you have a home office).

A limited liability company is a legal entity formed in accordance with the laws of each state. Typically, an LLC is created by filing documents with your state’s commercial department (sometimes called the Secretary of State’s office) known as Articles of Organization. An LLC can be owned by one person (a single-member LLC or SMLLC) or by more than one person (a multi-member LLC or MMLLC).

For tax purposes, an LLC can choose how it wants to tax. An SMLLC can be taxed as a sole proprietorship or a corporation. An MMLLC can be taxed as a partnership or corporation.

So if your business is currently a sole proprietorship and you later convert it to an LLC, you can still pay taxes as a sole proprietor even if your business is now an LLC for legal purposes. You would continue to file Schedule C and put the LLC’s name at the top of the form instead of your personal name.

You also have the option of paying taxes as a corporation. To choose C Corporation tax status, you must file Form 8832 with the IRS. You should file a corporate income tax return on Form 1120. To choose S Corporation tax status, you must file Form 2553 with the IRS. And you would file a corporate income tax return on Form 1120S.

Whether or not you should convert your sole proprietorship into an LLC, and how your new LLC should be treated for tax purposes, is a challenging decision that involves several critical factors. Before making a change, be sure to do some research and consult with a tax professional who is well versed in the entity’s choice topics.