A sole proprietorship isn't a separate legal entity and gets taxed as personal income, creating the highest tax burden. An LLC is a legal entity that can be taxed as a sole proprietor, partnership, or S corporation depending on your election. Your choice of legal entity and tax structure affects self-employment taxes, income classification, and audit risk.
What is the difference between a legal business entity and a tax structure? Now, I'm not an attorney, so this is not legal advice, just explaining some base differences so that when these terms come up, you feel more in the know. So you have words you've heard of like sole proprietor, LLC, S corp, partnerships, C corporations, nonprofits, trusts. These are all names that reference sometimes a legal entity, sometimes a tax structure, sometimes both. So some basics: a sole proprietorship is not a separate legal entity. Usually, this is created either by not doing anything and using your Social Security number to operate your business, or by getting a DBA, a Doing Business As, which is a legal phrase that you would set up with your state. A sole proprietor is a tax status, which means you're basically going to be taxed the worst way possible. Then you have partnerships, you can legally set up a partnership entity, and that partnership can be filed like a partnership. Most people don't set up general partnerships anymore, and you'd need to talk to your attorney about that, maybe there's a play. I, in the decade plus that I've been doing this, haven't seen a client have an actual general partnership set up. What they normally set up is an LLC, a limited liability company. That is a legal entity. Now that being said, the LLC, based on how many owners it has and certain tax elections you make, can have a tax status like one of these many things. So an LLC, legal entity, tax structure, If it's owned by one person and no separate tax elections have been made on it, that's a single-member LLC, and that would be taxed as a sole proprietor. If I have more than one member, now I have a multi-member LLC, and if I don't make any sort of separate tax election on it, it'll default to have a tax status as a partnership tax return. I can also choose to tax the LLC as an S corporation. The S corporation is a tax status only, meaning you can't go to your state and say, I'd like to set up an S corp. You actually either set up an LLC or a C corporation, and then you tell the IRS in a simple form, Form 2553, You tell them with that form, I want you to tax me like an S corporation. And then the last entity that I'm going to talk about is a C corporation, that is often a tax status and a legal entity. As I mentioned, you could choose to elect to have your C corporation taxed as an S corp, filing the same Form 2553 with the IRS, letting them know Let me be treated like an S corp. So there's some basics for you. That's the difference between a legal tax entity and tax structure. It does have a play in making sure you don't overpay in taxes based on the income you make, whether it's considered passive or ordinary. You want to have the right entity that matches that type of income to minimize self-employment tax. A lot of times these decrease your chance of being audited as well. So there you go. Remember, the IRS is not your friend. They just wrote me a letter to let me know. Sorry about that, but can't count on them to show up at your next party with a good gift. Like, share, comment, ask questions. We want to support you.
