LLC vs. Sole Proprietor for Contractors

This is one of the first real decisions a new contractor makes, and it’s easy to get sold a formation package before you understand the trade-offs. This guide lays out what the SBA, the IRS and state agencies say about each structure, what’s different for licensed contractors, and the questions worth asking a CPA or attorney. It doesn’t recommend a structure for you; that depends on your state, your trade, your income and your risks.

What is a sole proprietorship?

The SBA says you’re automatically considered a sole proprietorship if you do business activities but don’t register as any other kind of business. It’s easy to form and gives you complete control. The catch is in the SBA’s own words: sole proprietorships don’t produce a separate business entity, and You can be held personally liable for the debts and obligations of the business.

For taxes, the IRS says a sole proprietor reports business income and expenses on Schedule C with their Form 1040, pays self-employment tax on Schedule SE, and generally makes estimated tax payments with Form 1040-ES. California: the Franchise Tax Board says you can establish a sole proprietorship without registering with the Secretary of State, and the income goes on your individual return (Form 540).

What is an LLC?

The IRS describes a limited liability company as a business structure allowed by state statute, with rules that differ by state. Owners are called members, and most states allow single-member LLCs. The SBA says LLCs protect you from personal liability in most instances, meaning your personal assets, like your vehicle, house and savings, aren’t at risk if the LLC faces bankruptcy or lawsuits.

“In most instances” matters: the protection has limits, and they are set by state law and court decisions. Before you rely on it, ask an attorney in your state what can weaken it, for example signing personally for a loan, lease or supplier account, or mixing business and personal money.

How does the IRS tax each one?

Many people are surprised that the default federal tax treatment is similar for a one-owner business:

• Sole proprietor: profit is reported on Schedule C and taxed on your personal return, plus self-employment tax.
• Single-member LLC: for income tax, the IRS treats it as a disregarded entity separate from its owner unless it files Form 8832 to be taxed as a corporation. For employment tax and certain excise taxes, the IRS still treats the single-member LLC as a separate entity.
• LLC with two or more members: taxed as a partnership by default, unless it elects corporate treatment.
• S corporation election: an eligible corporation, or an LLC that has elected to be taxed as a corporation, can file Form 2553 to be taxed as an S corporation, which passes income through to owners’ personal returns.

Whether an election makes sense depends on your numbers and state, and it adds payroll and filing work. That’s a conversation for a CPA or enrolled agent. Our self-employment tax guide explains the tax that applies by default.

What does each cost to set up and keep?

A sole proprietorship has no state formation fee, though you may need a fictitious business name (DBA) filing if you use a name other than your own, and local business licenses still apply. An LLC has a state filing fee to form it and, in many states, an annual report or fee to keep it active. Fees vary widely by state; check your secretary of state’s fee schedule.

California: the Franchise Tax Board says every LLC doing business or organized in California must pay an annual tax of $800, due even if the LLC isn’t conducting business, until it is cancelled, plus an additional fee if the LLC makes more than $250,000. The first payment is due by the 15th day of the 4th month after filing with the Secretary of State.

Does your licensing board treat LLCs differently?

It can, and this is where contractors differ from other small businesses. Your license is often issued to the business, so changing structure later may mean a new license application. Some boards add requirements for LLCs. California: CSLB requires an LLC licensee to carry a $100,000 employee/worker bond on top of the $25,000 contractor bond, plus liability insurance with at least $1 million in coverage for five or fewer personnel (more for larger LLCs). See our California CSLB guide. Check your own state board before you form the entity, so the name and structure match what the license will need.

How do they compare side by side?

• Formation: sole proprietorship, none (DBA if needed); LLC, state filing.
• Personal liability: sole proprietorship, owner can be held personally liable; LLC, protection in most instances, with limits.
• Default federal tax: both report one-owner profit on the owner’s return; LLC can elect corporate or S corporation treatment.
• Ongoing state costs: sole proprietorship, usually minimal; LLC, annual fees or taxes in many states.
• Licensing: sole proprietorship, license in your name; LLC, license in the LLC’s name, possibly with extra bond or insurance rules.
• EIN: the IRS lists hiring employees and operating a partnership or corporation among the reasons you generally need one, and banks often ask for one. It’s free either way. See our EIN guide.

Is an LLC a substitute for insurance?

No. An LLC is a legal structure; insurance is a contract that pays certain claims. Many contractors use both, and some licensing boards or customers require insurance either way. Our insurance basics guide explains the common coverage types as education only.

What should you ask a professional?

• How does liability protection work in my state, and what would weaken it?
• What will the LLC cost each year in my state, including fees and taxes?
• Does my licensing board require anything extra for an LLC?
• At my expected profit, is any tax election worth the extra payroll and filing work?
• If I start as a sole proprietor, what does switching later involve for my license, bond and contracts?

Formation services are optional. The state filing itself can be done directly with your secretary of state, and the EIN is free from the IRS.