If you are thinking of starting your own business in California and trying to figure out the appropriate structure and accounting costs, then this blog is for you.
The two most popular options for solo business owners in the US are the Sole Proprietorship and the Single Member LLC (Limited Liability Company). I will explain the difference so that you feel confident in your choice. But please note, this blog pertains only to California businesses. Each state has its own LLC rules and filings costs and we won’t be covering them here.
Understanding Sole Proprietorships: A Sole Proprietorship is the simplest form of a business entity. It is an unincorporated business owned and operated by a single individual. This structure is popular among freelancers, Uber drivers, and small business owners who are just starting out due to its simplicity.
Key Characteristics of a Solo Proprietorship:
- Ease of Formation: There is no actual written requirement to establish a solo proprietorship. You can start operating as a Sole Proprietor from day one without filing any specific paperwork. For example, you don’t need to do anything extra if you started a side gig as a nutritionist or an IT consultant. You are by default a sole proprietor and you would account for this income on Schedule C (this is how this form looks) of your Federal personal tax return (form 1040). You may still need a Business License or a Doing Business As (DBA) name if you use a name other than your legal name. The business license won’t have any impact on the status of a sole proprietor on the federal level. A DBA also does not change anything with the exception that there is a line on Schedule C where you would enter your DBA name. The mere fact of having a DBA does not change your filing status or tax entity. For tax purposes, DBA means a sole proprietor, or in other words, a Schedule C filer.
- Taxation: As I’ve mentioned before, sole proprietor income and expenses get reconciled on Schedule C of your personal tax return. There is no need for an additional tax return, and a DIY tax software such as TurboTax does a great job filing this schedule. To keep track of your income or expenses, you may get accounting software like TurboTax Self-Employed. For non-tech people, paper and pencil should work just fine. Most accountants like to see Schedule C numbers on an Excel document. Gross receipts are shown on top, followed by expenses, and then arriving at net income from that schedule. Sole proprietorships are subject to regular income rates and also roughly 15% for self-employment taxes. Self-employment taxes are calculated on the net profit amount on Schedule C and are usually an unpleasant surprise for new business owners.cal For example, if you make $10K in net income, you will have to pay regular tax plus $1,500 in self-employment taxes. Here is a simple calculator of self employment tax. That’s why many people start looking into S Corps, as those entities allow you to cut self-employment taxes. But this blog is not about S Corps, and we should go back to discussing the sole proprietorship status.
- Liability: One of the most significant drawbacks of a Sole Proprietorship is that it does not provide liability protection. The owner is personally responsible for all business debts and legal obligations. This means personal assets, such as your home and savings, could be at risk if the business faces legal issues or financial difficulties. But in our experience not every business owner needs this protection. And even if they want to, they can always buy liability insurance. And the bonus is that the insurance is tax-deductible on the same Schedule C.
Understanding Single Member LLCs A Single Member LLC (SMLLC) is a limited liability company with one owner. In simple terms, an LLC is a legal entity that allows you to separate your business and personal assets. The LLC itself does not change your federal tax status of sole proprietor, but it adds a layer of legal protection for which you need to pay a minimum of $800 a year in California. Filing LLC tax documents and paying fees does not automatically constitutes division of personal and business assets. There are many legal nuances that may still prevent that division.
Key Characteristics of a Single Member LLC:
- Formation: Creating an SMLLC requires filing Articles of Organization (Form LLC-1) with the California Secretary of State and paying the necessary filing fee. Additionally, an Operating Agreement, although not mandatory, is highly recommended to outline the management structure and operational procedures of the LLC. You can set up an SMLLC yourself on the California SOS website or use CorpNet or other similar services that will do it for you. If you have a complicated legal situation and need to get serious legal advice before setting up your LLC, I suggest you talk to a business attorney. We usually refer clients to San Diego Corporate Lawyers.
- Taxation: As I mentioned earlier, by default an SMLLC is treated as a disregarded entity for tax purposes, which means that the owner simply files the same Schedule C as a sole proprietor. The only difference is that now the business owner needs to attach Form 568 to their California return. Form 568 is confusing, but for a SMLLC, there is no requirement to fill out all pages. In most cases, the SMLLC is required to fill out sides 1, 2, 3, and 7 (Schedule IW). Here are instructions to the form 568 if you want to take a stab at it. Essentially, with form 568 for SMLLCs, the FTB only wants to know that a) you exist and owe them $800 in yearly tax, and b) your receipts didn’t exceed a specific threshold, for which you would need to pay additional fees. Yes yes. $800 is not the only fee. If your California LLC has significant gross receipts, your yearly tax won’t be only $800; you would have to pay more. For example, on $350,000 of gross receipts, you would have to pay $900, and on $2,000,000 of gross receipts, you would have to pay $6,000. For more details, you can read here. And an additional twist: An LLC can become an S Corp on the federal level if it chooses to. We talked about it here. (In comparison, a solo proprietor can not become an S-Corp unless they establish an LLC or a corporation on the California level first). But without those additional steps, an SMLLC is just a tiny form attached to your personal return for which you need to prepay $800 at the beginning of each tax year. Yes, not at the end of the year. The due date of $800 for SMLLCs owned by individuals is April 15th, and it is a prepayment for the upcoming year. They don’t want you to use the LLC protection without being paid upfront.
- Legal Protection: An LLC provides legal protection to the business owner. The owner’s personal assets are protected from business debts and legal actions. And as I have mentioned before, just because you pay the $800 fee and file the return does not guarantee that you have that protection. There is a concept known as piercing the corporate veil, and California has several other rules that may negate LLC protection. So, if you are setting up an LLC for legal protection, we suggest researching these legal rules first and understanding what needs to be done to maintain that protection.
Now let’s compare key aspects of LLC and sole proprietorship:
a. Liability Protection:
- Sole Proprietorship: No personal liability protection. Owners are personally liable for all business debts and legal claims. But there is always an option to buy liability insurance.
- Single Member LLC: Provides liability protection, shielding personal assets from business liabilities. But one needs to carefully research LLC laws because paying mere tax and filing forms does not automatically grant you this protection. This is a legal question, not a tax one.
b. Taxation:
- Sole Proprietorship: Income is reported on the owner’s personal tax return and is taxed by personal tax rates. On top of that, it is subject to self-employment taxes (roughly 15%).
- Single Member LLC: The same tax treatment and tax filing requirements as a sole proprietor, but the owner also needs to attach California Form 568 to their personal return to keep the LLC active. SMLLCs have to pay a minimum of $800, plus, if the LLC generates significant gross receipts, there will be additional tax in addition to the $800. Additionally, the LLC has the option to be an S Corp at the federal level.
c. Cost Considerations:
- Sole Proprietorship: Generally incurs minimal costs. Accounting can be done on a piece of paper or Excel. The Schedule C form can be handled in a DIY software such as TurboTax.
- Single Member LLC: Involves formation fees and ongoing costs such as the $800 annual Franchise Tax in California. To file a simple Form 568 should cost $200–$300. So, the total additional cost of an LLC is around $1,000.
Additional note: Many professions in California are not allowed to operate as LLCs. These professionals only have two options: either operate as sole proprietors with good liability insurance or become a corporation at the California state level. That corporation can elect to be taxed as an S Corp if needed for tax purposes. Here is the list of all professions that are barred from operating as LLCs. We suggest you check the list before establishing an LLC in California.
And now a shameless plug: If you ever need help with your business taxes, please keep us in mind. Our CPA firm works with businesses all over California and we have helped hundreds of business owners save on taxes. You can read about our services here.