LLC vs S-Corp vs Sole Proprietorship

What Changes, What Doesn’t, and When It Matters

If you’re self-employed (or thinking about it), you’ve probably heard all three of these terms:

• Sole Proprietor
• LLC
• S-Corporation

They’re often used interchangeably in conversation — but they are not the same thing.

Let’s start simple.

The Short Version (Skimmable Summary)

Sole Proprietor = You and your business are legally the same.

Single-Member LLC = Legal protection added, but taxes are the same as a sole prop (by default).

S-Corp (for an LLC) = A tax election that may reduce self-employment tax if profits are high enough to justify the added complexity.

Now let’s break each one down.

1️⃣ Sole Proprietor (Default Self-Employed Status)

If you:

• Start invoicing clients
• Don’t form a legal entity
• Don’t file special paperwork with your state

You are automatically a sole proprietor.

How Taxes Work

• File Schedule C with your personal 1040
• Pay:
  • Income tax
  • Self-employment tax (15.3%)

Self-employment tax covers:

• Social Security (12.4%)
• Medicare (2.9%)

Your net profit is subject to both income tax and self-employment tax.

There is no separate business return.

Pros

• Simple
• Inexpensive
• No extra filings

Cons

• No liability protection
• Full profit subject to self-employment tax

2️⃣ Single-Member LLC (Default Tax Treatment)

An LLC (Limited Liability Company) is created at the state level.

Important:

👉 An LLC is a legal structure, not a tax structure.

If you form an LLC but do not elect S-Corp status, the IRS treats you as a:

“Disregarded entity.”

That means:

• You still file Schedule C
• You still pay self-employment tax
• Taxes work exactly like a sole proprietor

The only major difference?
Legal liability protection.

Pros

• Legal separation between you and the business
• More professional structure
• Same simple tax filing as sole prop

Cons

• Still pay self-employment tax on all net profit
• State filing fees and compliance requirements

3️⃣ How to Elect S-Corp Status for an LLC

This is where taxes actually change.

An LLC can choose to be taxed as an S-Corporation by filing Form 2553 with the IRS.

Now:

• The business files its own tax return (Form 1120-S)
• You must run payroll
• You must pay yourself a “reasonable salary”

Here’s the key:

You pay payroll taxes (Social Security & Medicare) on your salary —
but not on the remaining profit distributions.

That’s where potential tax savings happen.

Simple Example

Let’s say your business earns:

Net Profit = $80,000

As Sole Prop or Default LLC:

All $80,000 is subject to self-employment tax.

As S-Corp:

You pay yourself:

• $50,000 salary (payroll taxes apply)
• $30,000 distribution (no self-employment tax)

You may save several thousand dollars in self-employment tax —
but you now have:

• Payroll costs
• Corporate tax filing fees
• More bookkeeping requirements

When Does S-Corp Make Sense?

There’s no magic IRS number — but in practice:

Many professionals start considering S-Corp status when:

✔ Profits are consistently above $40,000–$60,000 per year
✔ Income is stable (not wildly fluctuating)
✔ You’re comfortable with added compliance
✔ The tax savings exceed the admin costs

If net profit is under ~$40,000, the complexity often outweighs the benefit.

How to Report Side Hustle Income & a W-2 Job

If you have:

• A W-2 job
• And a side business

Your business profit still:

• Flows onto your 1040
• Stacks on top of your W-2 income for income tax purposes
• Is subject to self-employment tax (unless S-Corp elected)

Social Security has an annual cap — so high W-2 wages can affect how much additional Social Security tax you owe on the business side.

The Biggest Misunderstanding

Forming an LLC does not automatically reduce taxes.

The tax change only happens if:

• An S-Corp election is filed
• Payroll is properly run
• Reasonable compensation rules are followed

LLC = legal protection
S-Corp = potential tax strategy

They are not the same thing.

If you’re just starting out:

• Sole prop or default LLC is usually sufficient.

If profits are growing:

• It may be time to evaluate S-Corp status.

The best structure depends on:

• Profit level
• Risk exposure
• Administrative tolerance
• Long-term growth plans

And most importantly — this isn’t a one-time decision.
You can evolve your structure as your business grows.

 

FAQs

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