If you run your own business and form a limited liability company (LLC), it will be a single-member LLC, as LLC owners are called members. You’ll be considered a disregarded entity if you don’t hire employees.
In essence, the IRS will disregard your LLC status when filing taxes. A disregarded LLC is taxed as a sole proprietorship, also a disregarded entity.
Read on to learn precisely how this will impact your business and whether it fits you best.
How LLCs Are Taxed
Single-member LLCs are, by default, taxed as sole proprietorships. However, both are pass-through entities, which means income passes through the business to the owner, who reports it on their tax return.
But LLCs are unique because they can elect to be taxed as a corporation if the members decide it makes financial sense. This is done by filing an election form with the IRS. You can choose to be taxed as a C-Corp or an S-Corp.
C-Corp status means income is taxed at the current rate for corporations (21% as of late 2022), which is lower than the usual individual taxpayer rate. But keep in mind that C-Corp shareholders – who are members in the case of an LLC – must also pay taxes on their distributions. This is called double taxation.
However, members are subject to self-employment tax in an LLC that is taxed by default as a sole proprietorship or partnership. Once such LLC switches to being taxed as a corporation, self-employment taxes no longer apply.
Similarly, self-employment taxes do not apply to members with S-Corp status, which is the main advantage of electing S-Corp status.
With S-Corp status, members are generally paid as company employees, which means more accounting and payroll expenses. Therefore, S-Corp status is only beneficial when the self-employment tax savings are more significant than those additional expenses.
If you choose to be taxed as a corporation, whether a C-Corp or an S-Corp, your LLC is no longer a disregarded entity.
What’s the Difference Between a Disregarded Entity LLC and a Sole Proprietorship?
The default taxation of a single-member LLC as a sole proprietorship is the primary similarity between a disregarded entity LLC and a sole proprietorship, but several differences exist.
1. Entity Formation
A sole proprietorship does not require registration with the state. To start a sole proprietorship, you simply need to start doing business. There is no cost or paperwork.
An LLC, on the other hand, requires filing articles of organization with your state. Then, depending on the state, you’ll be required to pay a fee ranging from $40 to $500.
You’ll also need to appoint a registered agent for your business and include their information on the articles of organization, along with the business name, address, and other information. A registered agent is a person or company authorized to accept and respond to official correspondence on behalf of your business, such as legal, tax, or financial documents.
As the sole member of the LLC, you can choose to be your registered agent, appoint another person, such as an attorney, or hire a registered agent service.
Single-member LLC and sole proprietorship owners have complete control of their business and can manage it any way they see fit.
But with a single-member LLC, the LLC is its entity and can enter contracts, take on debt, and purchase property separately from its owner. This creates personal liability protection, as the obligations are on the LLC, not the member.
With a sole proprietorship, you and the business are legally viewed as the same, so when you enter contracts or take on debt, the debt is yours, and you’re personally liable.
3. Personal Liability Protection
Again, personal liability protection is the key difference between an LLC and a sole proprietorship. With an LLC, if the business cannot pay its debts or is sued, the member’s assets are generally not at risk.
In a sole proprietorship, if the business cannot pay obligations or is sued, the owner’s assets, including their home, are at risk since the business and the owner is legally the same.
4. Annual Requirements
A sole proprietorship does not have to file reports with the state. It may need to obtain and renew business licenses and permits, but no documents must be filed with the state for the business entity.
On the other hand, an LLC must file annual or biennial reports in most states. These reports come with a fee, which varies by state.
A disregarded entity LLC is taxed by default as a sole proprietorship, which is more complex than a sole proprietorship. Yet the main reason many entrepreneurs choose an LLC is personal liability protection.
If you’re unsure which business structure is right for you, check with your tax advisor or attorney. Choosing the option that gives your business the best chance of success is important.