LLC vs S-corp vs sole proprietorship

The confusing part is that these three are not the same kind of thing. Sole proprietorship and LLC are about legal structure and liability. S-corp is about taxes. An LLC can be taxed as an S-corp, which is why the choice is rarely "one of three" and more often "an LLC now, maybe the S-corp election later."

What is the difference between an LLC, an S-corp, and a sole proprietorship?

Sole proprietorship. The IRS defines a sole proprietor as "someone who owns an unincorporated business by themselves." You and the business are legally the same person. You report business profit on Schedule C attached to your personal Form 1040, and you pay self-employment tax on the profit using Schedule SE. Nothing separates your bank account from the company's, so the SBA warns "you can be held personally liable for the debts and obligations of the business." No formation, no state filing, no cost.

LLC. A limited liability company is, in the IRS's words, "a business structure allowed by state statute." You create it by filing articles of organization with your state and paying a fee. Its purpose is liability protection: the SBA says an LLC protects you "from personal liability in most instances," so your personal assets like your vehicle, house, and savings accounts are not at risk if the business is sued or owes money. Crucially, an LLC does not have its own tax rules by default. The IRS treats a single-member LLC as a "disregarded entity," meaning it is taxed exactly like a sole proprietorship, and a multi-member LLC as a partnership. So a one-owner LLC pays the same self-employment tax a sole proprietor pays. It buys you legal protection, not a tax break.

S-corp. An S corporation is a tax status, not a business you form. The IRS describes S corporations as ones that "elect to pass corporate income, losses, deductions, and credits through to their shareholders for federal tax purposes." An existing LLC or corporation makes the election by filing Form 2553. Income still passes through to your personal return, so there is no corporate-level tax. What changes is how you take the money: as an S-corp owner who works in the business, you must pay yourself a salary through payroll, and only that salary is subject to Social Security and Medicare tax. Profit taken beyond the salary, called a distribution, is not.

Is an LLC or S-corp better for taxes?

They are not competitors, so the honest answer is "it depends on your profit." A plain LLC and a sole proprietorship are taxed identically: all net profit is hit with self-employment tax, which the IRS sets at 15.3% (12.4% for Social Security up to an annual wage base, plus 2.9% for Medicare with no cap).

The S-corp election is the only one of the three that can lower that self-employment tax, and here is the mechanism. Once your LLC or corporation is taxed as an S-corp, you split your income into a reasonable salary and a distribution. Payroll taxes apply to the salary. The distribution avoids the 15.3%. If a business nets $120,000 and a reasonable salary for that work is $70,000, roughly $50,000 escapes self-employment tax. That is the entire appeal.

The catch is the "reasonable salary" rule, and the IRS enforces it. Owner-employees cannot pay themselves a tiny wage and call the rest a distribution. The IRS states that if a shareholder receives cash or property, "the S corporation must determine and report an appropriate and reasonable salary for that shareholder," and courts have repeatedly ruled that shareholder-employees owe employment taxes even when they take distributions instead of wages. Lowball the salary and you invite back taxes and penalties.

Sole proprietorship vs LLC vs S-corp: side by side

Source: IRS business-structures pages and SBA, Choose a Business Structure.

When does an S-corp election make sense?

It makes sense when the self-employment tax you save is bigger than the cost of running an S-corp, and not before. Being taxed as an S-corp is not free. You have to run formal payroll, file a separate business return (Form 1120-S), issue yourself a W-2, and usually pay an accountant to keep it clean. That is real money and admin every year, whether the business has a good year or not.

Below a certain profit, that cost eats the tax savings; above it, the math flips. There is no legal profit threshold in the tax code, but the rule of thumb most accountants use is that the election starts paying off somewhere around $60,000 to $80,000 of net profit, after you set a defensible salary. Under that, keep it simple.

Which should I choose?

For most new solo businesses, the sensible path is an LLC first, then add the S-corp election later once profit clears the payroll-cost threshold. The LLC gives you the thing you actually need on day one, which is liability protection, at a low cost and with almost no ongoing burden. It changes nothing about your taxes, so there is no downside to filing it early. Then, when your profit grows to the point where splitting salary and distributions saves more than payroll and accounting cost, you elect S-corp status on top of the LLC you already have. You do not have to dissolve anything or start over.

A sole proprietorship is fine for a true side hustle with little liability risk, because it costs nothing. But the moment there is real money or real risk, the LLC's protection is worth the filing fee, and the S-corp election is a later optimization, not a starting point.