LLC vs Sole Proprietor: What You're Actually Buying

Do you need an LLC to save on taxes?

You might be thinking, "Ralph, everybody online says an LLC saves you a pile in taxes." Nope. Not by itself.

I get the LLC vs sole proprietor question more than almost any other, usually from someone whose side work just stopped being small. A listener named Sophia wrote in about exactly that. She designs for clients, made about $31,000 this year, and expects around $45,000 next year. She has signed real contracts, and one client is a company with 200 employees. One friend told her an LLC will save a pile of taxes. Another said it's just paperwork and a yearly fee.

Both friends are half right.

Why an LLC Won't Change Your Tax Bill by Itself

Most people start as a sole proprietor, which just means you haven't set up an entity at all. A single-member LLC is a real legal entity, but by default you're taxed the same way. Both report on Schedule C. Both pay the 15.3% self-employment tax, which is 12.4% for Social Security and 2.9% for Medicare.

Same return. Same tax.

What an LLC Does Change: Liability

Say you sell handmade kites and one crashes through a neighbor's window. As a sole proprietor, someone can sue you personally, because nothing separates you from the business. With an LLC, the claim should stop at the business.

I'm not an attorney. This is practical advice, not legal advice.

Where the Savings Come From

An LLC can elect to be taxed as an S corporation. You pay yourself a reasonable salary, and Social Security and Medicare tax apply to that salary, not to the profit you take as distributions.

The catch is a separate tax return and payroll, and both cost money. Somewhere around $50,000 to $60,000 of net profit is where it usually starts to make sense, and sometimes lower, depending on your situation. Sophia is heading toward that range, so it's worth running real numbers.

Three Things to Do This Week

1. Open a business bank account

Do this before you file anything. Mix personal and business money and a judge can pierce the corporate veil, which means treating your LLC like it was never there.

2. Run every client payment through it

Contracts in the LLC's name, payments into the LLC's account. Get an EIN and write an operating agreement. An LLC you paid an online service to file is not the same as an LLC you actually set up.

3. Write down your net profit

Revenue minus expenses so far this year. That number tells you whether an S corporation is worth the payroll and the second return.

Start With the Money, Not the Filing

No shame here. Plenty of people file first and set up later, and you can fix that today.

Separate the money.

Know your profit.

Then ask what a filing can do for you.

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