If you own your own business, you have likely tried to find answers online about a lot of questions, from employee issues to paying taxes. However, many resources are specifically tailored to medium to large businesses. Unfortunately, solutions that work for those bigger companies may not be the right option for you.
Perhaps one of the most pressing issues, if you are just starting out, is whether it makes sense for you to incorporate your business. In most cases, ultra-small businesses (those who may have just one employee (you) or have one or two employees) have just two business entity options that make sense. The other legal entities that you might create are simply too big and cumbersome to fit your needs.
Your focus should often be on just two choices: sole proprietorship or single-member LLC as a small business. Deciding on the right option for you will vary based on a variety of factors. Here, we walk through some of the most significant differences between these two choices so you can decide which option is right for you.
What is a Sole Proprietorship?
If you have been operating a business but have taken no steps to create a formal legal entity, then it is likely you are already operating as a sole proprietorship. These companies do not require any additional steps to form, and you report the income and expenses as part of your individual income tax return (Schedule C).
There is no difference between you as an individual and you operating as a business owner from a legal or tax standpoint. Sole proprietorships can still have employees and hire contract workers, but they often do not work with others.
What is a Single-Member LLC?
A single-member limited liability company (LLC) is a separate legal entity you can use to operate your company. The major advantage of creating this type of company is that you create limited liability for yourself. That means that if your company gets sued, for example, the potential liability that you may have is limited to whatever assets are held by the LLC.
The “single-member” designation is just as it sounds—you are the only owner of the company. You might have employees or others who work for you on contract, but you are the only owner.
Exploring the Differences Between a Sole Proprietorship and a Single-Member LLC
Perhaps the biggest difference between these two entities is related to the limited liability that a single-member LLC has simply because it is a separate legal entity. However, there are certainly other important differences as well.
State Fees and Taxes
A sole proprietorship requires no filing or formalities to be developed. However, a single-member LLC does. In general, you will incur the following fees if you create a single-member LLC in Connecticut.
- $120 filing fee for filing your Certificate of Organization
- $100 one-time registration fee with the Department of Revenue Services (if required)
- $80 annual filing fee for filing your annual report
Regardless of whether you create a single-member LLC or use a sole proprietorship, you will be required to register with the Department of Revenue Services (DRS) and pay sales and use taxes if you sell goods, provide a taxable service, or operate a hotel or other lodging house. Not all services are subject to sales and use taxes. You should review the DRS’s list of services if you are uncertain if these services should be taxed. If your service(s) are not subject to sales and use taxes you may not have to register for sales and use taxes.
Connecticut also has a pass-through entity tax, which is unlike many other states. Pass-through entities, including single-member LLCs, are subject to a Pass-Through-Enity-Tax (PTET) taxes of 6.99%. This tax is much higher than individual tax rates that would be used for a sole proprietorship, however, 87.5% of the PTET is credited back to the owner of the LLC on their individual income tax return similar to withholding from a W2.
For 2021, for example, the max tax rate for individuals is 6.99%–but that only applies to income over $500,001 for single filers ($1,000,000 for married filing jointly). Because the average household income in Connecticut is $79,444, the average tax rate is 5-6% for most Connecticut taxpayers. Give us a call if you have any questions related to the PTET and we can answer your questions.
It is also important to note that sole proprietorships do not have a separate tax form to report income. They use Schedule C to show their profits and losses from the business. They can have a separate tax identification number (EIN), but they are not required to have one.
A single-member LLC will file their taxes as part of their individual tax return, but there is an important caveat. A single-member LLC can choose to be taxed as a C-Corporation by filing Form 8832 and making that election or as an S-Corporation by filing form 2553.
A single-member LLC must have an EIN if it has employees. If it is treated as a disregarded entity and has no employees, it does not need to have one for federal tax purposes—you likely need one to file taxes in Connecticut.
You do not need a lawyer to form either of these entities. A sole proprietorship comes about automatically, so there is nothing an attorney would need to do to create this type of company. We, as your CPA, can help you with creating an LLC, however. While it is not necessary, it might be a good idea to get help with this process to ensure every step that is necessary to create your entity has been completed.
You also do not need a tax professional to assist with taxes for either of these entities. Again, however, it might be a good idea to use a tax professional to help you plan appropriately and ensure that you are complying with all of the federal and state tax requirements.
Our team can help you address your tax and business planning questions for your small business. Learn more by setting up an appointment with our Meriden office: 203-902-3937 or our Madison office: 203-909-6291.