Sole proprietor vs. LLC: what changes when you form one

What a sole proprietorship is

The IRS defines a sole proprietor as someone who owns an unincorporated business by themselves. The SBA says you are automatically a sole proprietorship if you do business activities but don't register as any other kind of business. There is no separate entity. The business's assets and liabilities are your assets and liabilities, and you can be held personally liable for the business's debts.

For federal taxes, you report the business's profit or loss on Schedule C with your personal return, and you pay self-employment tax, the Social Security and Medicare tax for people who work for themselves, on Schedule SE. You may also need to make estimated tax payments during the year.

What changes when you form an LLC

An LLCLLC An LLC (limited liability company) is a business entity registered with a state that exists separately from its owners. is created under state law, so you form it with your state, and the fees, forms and ongoing requirements vary by state. Its owners are called members. Once it exists, the company signs the lease, holds the bank account and owes the suppliers.

That separation is the main change. The SBA says an LLC protects you from personal liability in most instances, so your personal assets aren't at risk if the LLC faces bankruptcy or lawsuits. The separation only holds if you maintain it: the LLC's own bank account, its own records, and business expenses paid by the business.

What liability separation doesn't cover

Limited liability is not a force field. If you sign a personal guaranteePersonal guarantee A personal guarantee is a promise that you, personally, will repay a business debt if the business does not. for a lease, a loan or a supplier account, you are personally on the hook for that debt, LLC or not. Insurance and clear contracts still matter. How liability protection works in your state, and where it ends, is a question for an attorney.

What doesn't change: federal income tax, by default

This surprises a lot of people. For income tax purposes, the IRS treats a one-member LLC as a "disregarded entity," separate from its owner in law but not for income tax, unless it files Form 8832 to be taxed as a corporation. If you own it as an individual, its activity generally goes on the same Schedule C, and you pay self-employment tax on its net earnings the same way a sole proprietor does.

One exception: for employment taxes and certain excise taxes, the IRS treats a single-member LLC as a separate entity. If the LLC hires employees, payroll runs under the LLC's own name and EIN.

So forming an LLC is a legal decision first. Your federal income taxes change only if you make an election, such as electing to be taxed as an S corporationS corporation An S corporation is a federal tax status, not a kind of company you form with your state. An eligible corporation, or an eligible LLC, elects it with IRS Form 2553, and its income then generally passes through to the owners' personal returns. or a C corporationC corporation A C corporation is a corporation taxed as a separate taxpayer under the regular corporate rules, which is how a corporation is taxed unless it elects S status. The corporation pays federal income tax on its profit, and shareholders may pay tax again on dividends..

EIN considerations

The IRS says you need an EINEIN An EIN (Employer Identification Number) is your business's federal tax ID number, issued by the IRS. if you have employees or pay certain employment or excise taxes, and to operate a partnership, an LLC or a corporation. If you don't need one for federal tax purposes, you can still get one for banking or state tax purposes. It is free from the IRS.

For a single-member LLC, the IRS adds a detail: one that is disregarded, has no employees and has no excise tax liability does not need an EIN for federal tax and uses its owner's name and number instead. The IRS also says most new single-member LLCs will need one, and an LLC can get one if a bank or the state requires it.

Separate banking and recordkeeping

Whichever you are, open a business bank accountBusiness bank account A business bank account is an account in the company's legal name, and it is where the business's provable financial history comes from. and run every business dollar through it. For an LLC, the account belongs in the LLC's legal name. It keeps the legal separation real and gives you the records you need for taxes, credit and a monthly P&LP&L A profit and loss statement shows whether your business made money over a period of time, revenue at the top, costs beneath it, profit at the bottom..

Keep receipts for inventory, freight and every expense, and close the books each month. The field guide on setting up your first month of books, linked below, walks through it.

Sales tax and resale are separate issues

Forming an LLC doesn't register you to collect sales tax, and it doesn't give you a resale certificateResale certificate A resale certificate is documentation used under applicable state rules when buying qualifying inventory for resale, so the supplier does not collect sales tax on that purchase.. Those are state processes, and they apply to the business whether it is a sole proprietorship or an LLC. Where you have to register depends on sales tax nexusSales tax nexus Nexus is the connection between your business and a state that creates an obligation to register for and collect that state's sales tax., and an EIN and a resale certificate are different documentsEIN vs resale certificate An EIN is a federal tax ID for your business. A resale certificate is a state-level document used when buying qualifying inventory for resale.. Rules vary by state.

When forming an LLC starts to matter

• You're signing a lease, opening supplier accounts or borrowing.
• You hold inventory, a vehicle or a space where something can go wrong.
• You're bringing in a partner.
• Suppliers, landlords or banks want to deal with a business entity, not a personal name.

None of these is a legal deadline. They are the points where the separation starts to be worth the paperwork. Talk to an attorney or CPA about your situation.