Is A LLC Taxed As Sole Proprietorship?

What business structure should I choose?

Choosing the appropriate entity structure for your business is a pivotal decision with wide-ranging implications as you embark on your business journey. It is important to understand that LLC Sole Proprietorship does not exists as an entity. A sole proprietor is person who owns an unincorporated company. However, if an entrepreneur is the sole member of a LLC, you are not a sole proprietor if you elect to treat the LLC as a corporation.

To choose the best structure for your business, it is crucial to carefully evaluate various aspects of your initial selection, such as ownership/control dynamics, asset safeguarding, and tax optimization. For instance, you may have heard that the popular LLC can be taxed as a sole proprietorship, which may sound appealing.

Furthermore, it is important to periodically review your choice to ensure it continues to align with your personal and business requirements. For instance, you might initially operate as a sole proprietorship, but as your business expands, you may contemplate bringing in co-owners or adjusting the capital structure. Alternatively, you might consider restructuring to protect your assets from potential business liabilities. If you decide on the popular LLC structure, you may want the LLC to be taxed as a sole proprietorship, for example.

The most prevalent business structures include sole proprietorships (including joint ventures involving spouses), limited liability companies, partnerships, S corporations, and regular “C” corporations. Also included is the attractive single-member LLC, which may be taxed as a sole proprietorship. Each option has its pros and cons, and there is no one-size-fits-all choice. While similar in nature, there are key differences between a single-member LLC and a sole proprietorship from tax structuring, legal protections and more. Determining the optimal structure necessitates an evaluation of both tax-related and non-tax-related considerations. In this article, our California LLC lawyer in Los Angeles discusses some of the factors that warrant careful consideration.

Tax Considerations

A sole proprietorship is an unincorporated business owned and run by one person. Unlike a sole proprietorship, an LLC is a hybrid of a partnership and a corporation and it allows the liability protection of a corporation while providing the tax advantages of a partnership. An LLC is also a “passthrough” business on your taxes.

• Yearly tax responsibilities: Will you need to submit separate tax returns for the business and pay taxes at the business level?
• Compensation and benefits packages: How are you able to receive income from the business, and what are those payments’ tax implications?
• Reorganization: How straightforward is it to make changes to the ownership and capital structure of your company?
• Business cessation: What are the consequences of ending the business? This varies significantly based on the type of business entity.

Non-Tax Considerations

While tax planning is a crucial aspect of managing a growing business, it should not override overall prudent company decision-making. When choosing a business structure, remember to also take into account non-tax-related factors, such as:

• Business growth: Choosing an entity can influence how you run and expand your company.
• Protection of assets: Different forms of business entities offer varying levels of protection against both business-related and non-company-related creditors.
• Estate planning: Choosing an entity can have implications for your potential estate tax liability and estate planning.
• This article specifically addresses the yearly income tax implications for sole proprietorships (inclusive of married couple joint ventures), limited liability companies, and partnerships.

What is a sole proprietorship?

A limited liability company (LLC) can be formed by an individual or a group of entrepreneurs, while a sole proprietorship is a business that’s owned and operated by one person. A sole proprietorship is essentially an extension of an individual. It is an unincorporated company owned by a single person (or a married couple who choose to be regarded as a single owner). There is no such thing as a LLC Sole Proprietorship. While it is a common choice for new small companies, it may not always be the most advantageous option when considering both tax and non-tax elements.

From a tax standpoint, if there is only one owner, you do not need to formally elect the status of sole proprietorship; the Internal Revenue Service will automatically assume it is a sole proprietorship, unless you opt for incorporation or establish a limited liability company (LLC) that chooses to be regarded as a corporation.

For federal tax purposes, a single-member limited liability company is classified as a ‘disregarded entity’ (though it still offers asset protection). An owner reports the business’s income and expenses using Schedule C and then transfer this information to their individual Form 1040. In this case, an LLC can be taxed as a sole proprietorship.

If you start your one person company and you don’t form a corporation or an LLC, you’ll automatically be a sole proprietor. In a sole proprietorship, the business itself is not a separate taxable entity. A sole proprietorship is an unincorporated business that has just one owner who pays personal income tax on profits earned from the business. All liabilities and assets of the business are considered directly owned by the owner of the business. Similarly, all business expenses and income are viewed as your personal income and expenses.

You report expenses and income on either Schedule C-EZ or Schedule C, which is a part of (Form 1040), or your yearly individual tax return.

For instance, let’s consider Alec, who runs a sole proprietorship in the form of a tattoo parlor. He earned $400,000 in business income, which he reports on Schedule C Part I. Alec then lists his operational expenses, including items like tattoo inks, advertising, employee wages, and depreciation, on Schedule C Part II. These expenses are deducted from the overall income to end up at the net profit or loss amount at the end of the form.

This net amount is then taken from Schedule C and documented on the first page of Alec’s Form 1040, his individual return.

Sole proprietorships do not have a unique tax rate schedule. The entrepreneur’s individual tax bracket is responsible for determining the tax paid on the sole proprietorship’s earnings. A single-member LLC may be taxed as a sole proprietorship, in the manner described.

A sole proprietorship’s main advantage lies in its simplicity, not just for federal income tax reasons, but also for record-keeping and accounting. As the owner of the business, you can withdraw or invest money in the business without the need for extensive tax records or formal corporate procedures. Thus, it may be attractive for an LLC to be taxed as a sole proprietorship.

While it may be attractive for an LLC to be taxed as a sole proprietorship, it is important to note that owners of sole proprietorships are responsible for self-employment tax. Thus, if during the tax year you make more than $400 in net profit, you need to calculate and pay self-employment tax, which is levied on all of the company’s net profits beyond that monetary threshold. Using Schedule SE, you determine the amount you owe. This document accompanies your Form 1040.

Additionally, sole proprietors typically need to make quarterly estimated tax payments that cover both self-employment taxes and income tax. So, while an LLC may be taxed as a sole proprietorship, there are other considerations to be made.

Spousal joint ventures can function as sole proprietorships

While a sole proprietorship is typically a business with a single owner, many spouses jointly run family businesses and both regard themselves as owners.

In cases where spouses view themselves as co-owners, the IRS categorizes this joint operation as a “partnership,” even without an agreement for a formal partnership. Consequently, the IRS recommends filing a partnership return and issuing Schedule K-1s to both spouses, instead of using a Schedule C to report business expenses and income. This can introduce added complexity during tax return preparation.

That said, there exist three alternatives to bypass filing a partnership tax return for your company. The most suitable option for a married couple hinges on each individual’s level of participation in the company.

1. One spouse has minimal involvement: If only one partner actively manages the business, it qualifies as a traditional sole proprietorship. This allows you to file in the form of a sole proprietor, even if your husband or wife contributes only a little or provides input on major decisions.

2. Both spouses are actively engaged in the company: If both of you invest substantial effort into the company, you could consider designating one as the owner for tax reasons while treating the other as an independent contractor or employee. It is advisable to consult a tax professional to explore both situations—independent contractor versus employee—and analyze the financial implications to determine the best option. Either choice can spare you the complexity of partnership returns and potentially lead to further deductible operating expenses.

3. Both husband and wife are genuine co-owners: If both spouses genuinely share ownership of the company, you have the option to have a special election to be recognized as a “spousal” joint venture.

Note: As of 2007, a sole proprietor’s spouse receives an equal amount of Social Security credit as the sole proprietor. Previously, a spouse had to file a separate Schedule C or receive a paycheck to accrue Social Security credits. This change ensures that both spouses accumulate equal credits through a joint tax return.

Opting for Qualified Joint Venture Status

If both spouses are actively involved in the company and file a joint tax return, they have the option to choose qualified joint venture treatment for tax purposes instead of being classified as a partnership. It is important to note that the joint venture can only consist of the two spouses; if there are other people involved (even family members like children), this provision is not applicable. Further, the couple must have significant involvement in the business.

When this election is done, each partner accounts for their respective share of gains, losses, income, and other items as if they were a sole proprietor. Rather than submitting Form 1065 (and providing yourselves with Schedule K-1s detailing your portions of expenses and income), you both submit a Schedule C-EZ or Schedule C and directly report the deductions and income on your joint tax return. The election is effectual unless the business obtains approval from the IRS to make a change, or it no longer fulfills the eligibility criteria.

Caution

It is worth noting that according to marital property laws in many states, both partners may be viewed as owners of the company assets in the event of a divorce, notwithstanding whose name is provided as the owner on tax forms or property records.

LLCs and Partnerships Income and Loss Flows To The Owners’ Personal Tax Returns

Limited Liability Companies (LLCs) and partnerships do not have their own distinct tax obligations. Additionally, LLC Sole Proprietorship is not a legal entity and therefore has no tax category. This means that there is no federal tax paid at the LLC or partnership level; all business deductions and income are passed on to the individual members or partners.

However, it is crucial to note that the non-tax implications of choosing between partnerships and LLCs carry significant weight.

In terms of safeguarding assets, operating as a partnership poses considerable risk. Not only can your personal assets be accessible to your business creditors, but you are also personally accountable for your partners’ actions.

Partnerships Distribute Deductions and Income

A partnership is regarded as an unincorporated company with at least owners. If your unincorporated company has multiple owners, the Internal Revenue Service will categorize it as a partnership. This is the case unless you choose to be taxed in the manner of a corporation.

From a federal standpoint, a partnership is not subject to its own separate income tax, unlike corporations. Instead, the losses and income from the partnership are allocated between the partners, who then report their respective shares on their individual tax returns and pay taxes based on the individual tax rates.

While a partnership does not have to pay federal income tax, it must submit Form 1065 to disclose its losses and income to the IRS. Additionally, the partnership reports each partner’s portion of loss and income on Schedule K-1 of Form 1065.

For tax reasons, all partnership income must be recorded as given to the partners, who are responsible for paying taxes on it through their personal returns. This applies regardless of whether the partners physically were given their income shares, and even if the partnership contract mandates retaining the funds in the company in the form of partnership capital.

Partnerships are typically considered one of the most adaptable business structures for tax purposes. This is because the distribution of losses and income to each partner can vary, allowing for a divergence in profit and loss percentages—provided there is a legitimate business rationale beyond tax reduction for this allocation.

For instance, one partner may receive forty percent of any earnings but bear sixty percent of any losses. This arrangement can be particularly advantageous in the initial stages, when many businesses experience losses rather than profits. The partnership distributions enable a partner to offset these losses against other income derived from another job or investments.

Keep in mind

It is important to note that partners cannot deduct losses that surpass their company investment. However, any losses that cannot be deducted due to this rule may be carried forward and deducted in following years if the partner boosts their investment.

Taxation is Assessed at the Partnership Level

While individual partners are responsible for paying income tax, the partnership itself makes the majority of the decisions regarding how income is calculated, instead of the individual partners via their personal tax returns.

These decisions encompass:

1. Choosing general accounting methods,
2. Determining depreciation methods, and
3. Accounting for certain items like business and organization start-up costs, as well as installment sales.

Partners are obligated to report partnership-related items on their individual tax returns in the same manner as they were reported on the partnership’s return.

There are various non-tax considerations that may affect your choice of whether a partnership is the most suitable business structure for you. We strongly advise seeking legal guidance when establishing a partnership and drafting the partnership agreement.

LLCs Transmit Deductions and Income to Members

A limited liability company (LLC) is a structure established and regulated by state law, possessing characteristics akin to both a partnership and a corporation. LLC owners typically benefit from liability protection, a safeguard previously only available to corporate shareholders. While each state has put in place legislation for LLCs, there may be slight variations in laws across states.

For federal tax purposes, an LLC’s taxation is determined by either:

– The default classification, which hinges on how many members an LLC has, or

– An election for the LLC to be taxed in a way different from the default treatment.

Most states—although not all—will adhere to the federal classification and have the LLC taxed thus. That said, there may be exceptions. It is advisable to review your state’s tax laws to understand the specific regulations that apply in your jurisdiction.

Default Classification Based on Quantity of Members

For federal tax purposes, a single-member LLC is disregarded. This means the LLC is taxed as a sole proprietorship. The owner has to submit a Schedule C along with their Form 1040. In the case of multiple members, the default classification designates the LLC as a partnership. This requires the LLC to submit a Form 1065 and provide each member with a Schedule K-1. Members then report the values indicated on their K-1 forms on their personal Form 1040.

Opting Out of Automatic Treatment

If an individual prefers not to have their LLC taxed according to the automatic classification, you can submit Form 8832 and choose to be taxed in the manner of a corporation. This form is only necessary if you wish to deviate from the default classification for federal tax reasons.

Comparing LLCs and S Corporations

While S corps offer limited liability and beneficial flow-through taxation, LLCs offer additional advantages for growing businesses. Similar to partnerships, an LLC boasts the flexibility to allocate distributions unevenly among its owners. For instance, an LLC member with a fifty percent ownership stake in assets may have the right to sixty percent of the income if specified in the operating agreement.

By contrast, S corps generally must distribute profits proportionally based on each owners’ shares. Additionally, an LLC may have as many investors as it likes, while an S corporation is capped at one hundred shareholders.

That said, operating as an LLC taxed like a partnership also comes with potential drawbacks. Recent legal changes necessitate a reevaluation of the conventional belief that dividend and salary income from the company, which offers three big advantages:

1. Income from dividends is not affected by self-employment tax.
2. Income from dividends is not factored into determining earnings for the 0.9 percent surtax on income in excess of $200,000/year ($250,000 for married couples).
3. Income from dividends from your active business or trade is not regarded as net investment income, and thus may not be eligible for the 3.8 percent net investment income tax.

Other Considerations

There are various non-tax considerations that may impact your choice of whether an LLC is the most suitable business structure for you. We strongly recommend seeking legal advice when establishing an LLC and drafting the operating agreement.