LLC or Sole Proprietorship: The Tax Differences That Matter

The most common confusion in small-business formation is treating the LLC as a tax choice. It is not. A single-member LLC is by default taxed exactly like a sole proprietorship — same Schedule C, same self-employment tax — while the corporate-style taxation an owner might actually want requires an explicit election. The IRS taxes you by election, not by the name on your state filing. Orer News publishes information, not tax advice; the numbers below are structural, and a CPA should model your specific case.

What the LLC buys immediately is legal: separation of business debts and liabilities from personal assets, subject to the corporate veil being respected — separate accounts, no commingling, documented decisions. What it costs is state fees and, in some states, franchise taxes that can exceed a small firm's entire tax benefit.

How are the two actually taxed?

A sole proprietor reports business profit on Schedule C of the personal return and pays income tax plus 15.3 percent self-employment tax on net earnings up to the Social Security wage base — $176,100 for 2025, per the Social Security Administration. A single-member LLC makes the identical filing unless it elects otherwise. A multi-member LLC files as a partnership by default: the entity files an informational return and profit flows to members' returns with self-employment tax where applicable. Nobody escapes self-employment tax by forming an LLC alone.

What does an S corporation election change?

The election — available to either structure, including LLCs — splits owner income into salary and distributions. Salary runs through payroll with FICA withheld; distributions avoid self-employment tax. That split is where the advertised savings live, and also where the IRS watches: compensation must be reasonable for the work performed, per longstanding IRS doctrine, and the Service's enforcement history on unreasonably low salaries is real. The election adds payroll filings, payroll service costs, and stricter bookkeeping, so the arithmetic only favors it above meaningful profit levels — commonly modeled somewhere above roughly $40,000 to $60,000 of net profit, depending on a reasonable salary for the role.

What about the QBI deduction?

Both structures can qualify for the Section 199A qualified business income deduction of up to 20 percent of qualified pass-through income — subject to income thresholds, the nature of the business, and wage or basis limitations above them. The deduction is scheduled to phase down after 2025 under prior law as amended by 2025 legislation, so its value in 2026 planning depends on current-law specifics your preparer must verify. The structural point: 199A attaches to pass-through taxation generally, so it does not by itself choose LLC over sole proprietorship.

Which states punish the LLC?

Formation cost varies enormously. Delaware's LLC fee is modest, but California charges an $800 annual franchise tax on LLCs plus a gross-receipts fee above $250,000 of income; New York City unincorporated business tax can reach into sole proprietorships and partnerships alike; several states add annual report fees in the hundreds. A profitable California LLC can owe the state more than a sole proprietor would owe in total federal tax advantage from forming — which is why the state question precedes the federal one.

Choose the shell for liability and cost reasons, then choose taxation separately by election. Owners who conflate the two decisions pay for entity complexity they do not use, or run personal risk to avoid a fee they never actually computed.