If you are thinking of starting your own business in California and trying to figure out the appropriate structure and accounting costs, then this article is for you. The two most popular options for solo business owners are the Sole Proprietorship and the Single Member LLC (Limited Liability Company). We 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 we won’t be covering them here.

1. 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:

• Ease of Formation: There is no requirement to establish a solo proprietorship. You can start operating as a Sole Proprietor 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 of your Federal tax return. 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 your sole proprietor federal tax status. 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.
• Taxation: As we’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-techy 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. Self-employment tax migraines are mitigated by the QBI deduction and a deduction for half of the self-employment tax. These deductions are very useful bring down self employment tax liability.
• 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. Solution? Liability insurance. And the bonus is that it is tax-deductible on the same Schedule C.

2. 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 tax status, but it adds a layer of security for which you need to pay a minimum of $800 a year in California.

Key Characteristics:

• 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: 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 small 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). Essentially, 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 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. An additional twist: If the LLC needs it can ask the IRS to be taxed as an S Corp. 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 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.
• Liability Protection: One of the most significant benefits of an SMLLC is the limited liability protection it provides. The owner’s personal assets are protected from business debts and legal actions. Side note: just because you pay the $800 fee and file the return, it does not guarantee that you have that protection. There is such a notion as piercing the corporate veil, and California has a bunch of rules when LLC protection is not applied. So, if you are setting up an LLC for legal protection, we suggest researching legal rules first and seeing what needs to be done to keep that protection.

3. Comparing Key Aspects

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: Also reports income on the owner’s personal tax return (default tax treatment) but 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 applying for an LLC.