Differences in Taxation of LLCs and Sole Proprietorships

If you are starting a business, one of the most important considerations is how your choice of entity will be treated for tax purposes. Please see below for some important information on the differences between the two most common types of businesses our Mesa accountants work with:

Sole Proprietorships

Sole proprietorships are the simplest of business types when it comes to initial set-up and ongoing reporting. They are also simple from a tax standpoint, and do not require separate income tax returns. Instead, profits and losses are reported on Schedule C of the business owner's personal income tax return. Self-employment taxes are reported on Schedule SE.

LLCs

When a business owner decides to create a Limited Liability Company (LLC), if it is a "single-member" LLC (just one owner of the business), it will be treated as a "disregarded entity". Essentially, this means it will be taxed like a sole proprietorship unless the business owner elects to be taxed as a corporation by timely filing a form with the IRS. Arizona LLCs with more than one member (owner) are automatically taxed as partnerships by the IRS unless the business timely files the required form with the IRS to elect corporate income tax treatment.

When LLCs either choose to accept the default partnership tax treatment, or fail to file the required form in a timely manner, the business must submit an informational return to the IRS each year. Instead of paying taxes with the return though, the profits and losses are passed through to each owner who then must report their income on their own personal tax returns.

In contrast, if an LLC elects C-corporation income tax treatment, the entity itself will file and pay income taxes on Form 1120, with no "pass-through" of profits or losses. 

Taxation for your business is an important consideration; the right choice for your business will depend on a number of factors. Business owners should consult a tax professional to determine how different entity structures might impact taxation. To learn more, contact our CPA firm today.