Once your self-employment income grows, the legal structure of your business starts to matter — for taxes, for liability, and for how much it costs to run. The three most common structures for solo workers are sole proprietorship, Limited Liability Company (LLC), and S-Corporation (S-Corp).
Sole Proprietorship: The Default
If you freelance or run a business without filing any formation paperwork, you're a sole proprietor. It's the simplest structure — no separate legal entity, no state filings, no annual fees.
- Taxes: All net profit flows to your personal return (Schedule C). You pay income tax + self-employment tax (15.3%) on the full amount.
- Liability: None. Your personal assets (home, savings, car) are exposed to business lawsuits and debts.
- Cost: $0 in most states (some require a local business license).
- Paperwork: Minimal — just your personal tax return with Schedule C.
LLC: Liability Protection Without Tax Complexity
An LLC creates a legal separation between you and your business. If someone sues the business or the business takes on debt, your personal assets are generally protected — as long as you maintain the separation (don't mix personal and business finances).
- Taxes: Identical to a sole proprietorship — "disregarded entity" for tax purposes. Full net profit is subject to income tax + SE tax.
- Liability: Limited liability — personal assets are generally protected.
- Cost: State filing fees ($50–$500/year depending on state), plus any registered agent fees.
- Paperwork: Articles of organization, operating agreement, annual state filings.
Myth: "Forming an LLC will lower my taxes."
Reality: A single-member LLC is taxed exactly like a sole proprietorship. The LLC provides liability protection, not tax savings. To get the tax benefit, you'd need to make an S-Corp election on top of the LLC — and that only makes sense at higher income levels.
S-Corp: The Tax Optimization Play
An S-Corp isn't a type of business — it's a tax election. You can form an LLC and then elect S-Corp tax treatment with IRS Form 2553. The key benefit: you can split your business income between a salary and distributions, and only the salary portion is subject to FICA/payroll taxes.
- Salary: You pay yourself a W-2 wage. FICA (7.65% employer + 7.65% employee) applies to this amount.
- Distributions: Remaining profit is distributed to you. Subject to income tax but NOT FICA/SE tax.
- Net effect: At higher incomes, the FICA savings on distributions can be thousands of dollars per year.
Taylor earns $150,000 net profit. As a sole proprietor, SE tax on the full amount (after the 92.35% adjustment) is about $19,350.
As an S-Corp with a $90,000 reasonable salary, FICA on the salary is $13,770 (both halves). The remaining $60,000 in distributions has no FICA — saving Taylor roughly $5,580 per year.
But the S-Corp has costs: payroll processing ($500–$2,000/year), a separate S-Corp tax return ($500–$1,500 in CPA fees), and potentially higher state fees. Net savings: ~$2,000–$4,500/year.
The "Reasonable Salary" Rule
The IRS requires S-Corp owner-employees to pay themselves a "reasonable" salary before taking distributions. There's no fixed percentage or formula — reasonable means what you'd earn doing the same work for an unrelated employer.
Factors the IRS considers: industry norms, your experience and skills, time and effort devoted to the business, comparable W-2 salaries for similar roles, and the company's revenue and profitability.
Myth: "I can set my S-Corp salary to $10,000 and take the rest as distributions."
Reality: An unreasonably low salary is one of the most common S-Corp audit triggers. If you earn $150,000 doing specialized consulting, a $10,000 salary wouldn't pass the reasonable compensation test. Most tax professionals recommend 40–60% of net profit as salary, depending on the industry and role.
When Does Each Structure Make Sense?
| Net Profit Range | Recommended Structure | Why |
|---|---|---|
| Under $40,000 | Sole proprietorship | Low income = low SE tax. Admin costs of LLC/S-Corp not justified. |
| $40,000–$80,000 | LLC (no S-Corp election) | Liability protection is worth the state fees. S-Corp savings don't yet outweigh costs. |
| $80,000–$150,000 | LLC with S-Corp election | FICA savings on distributions start exceeding S-Corp administrative costs. |
| $150,000+ | LLC with S-Corp election | Significant FICA savings. Potentially $5,000–$15,000+/year in tax reduction. |
These ranges are rules of thumb — your specific situation depends on state fees, industry, and whether you have employees. Always model the numbers before making an election.
Open the Business Entity Comparison Calculator and enter your net profit. Compare the total tax burden across all three structures and find the crossover point where an S-Corp election starts saving money.
Beyond Taxes: Other Factors
Liability Protection
Both LLCs and S-Corps protect personal assets from business liabilities. But protection isn't automatic — you must maintain separation: separate bank accounts, proper contracts, adequate insurance, and no "commingling" of personal and business funds. Courts can "pierce the veil" if you treat the business as a personal piggy bank.
State-Specific Costs
LLC and S-Corp costs vary dramatically by state. California charges an $800/year minimum franchise tax for LLCs. Wyoming and Delaware have minimal fees but may not be practical if you operate elsewhere. Check your state's Secretary of State website for current fee schedules.
Future Flexibility
An LLC is the most flexible starting point. You can elect S-Corp treatment later (Form 2553) if income grows. You can also elect C-Corp treatment if you take outside investment or plan to retain earnings in the business. It's much harder to "downgrade" from a corporation back to a sole proprietorship.
- A sole proprietorship is free and simple but offers no liability protection and full SE tax on all profit.
- An LLC adds liability protection without changing your tax situation (unless you elect S-Corp treatment).
- An S-Corp election splits income into salary (FICA-taxable) and distributions (no FICA), saving money above roughly $80K net profit.
- The "reasonable salary" requirement is IRS-enforced — setting it too low is a common audit trigger.
- Always model the actual numbers including admin costs before choosing a structure.
If you run (or plan to run) a business, what's your current structure — and does it still fit your income level? Use the Business Entity Comparison Calculator to check whether a different structure would save you money after accounting for administrative costs.