LLC Kits & More

When should a limited liability company be treated as a sole proprietorship?

By default, a one-owner, or single-member, limited liability company that operates an active trade or business is treated as a sole proprietorship. And that's an option most business owners should consider--at least in passing. While an LLC owner can choose to treat an LLC as a corporation for tax purposes, sole proprietorship tax treatment provides some noteworthy benefits:

"LLC" sole proprietorship benefit #1: Simpler bookkeeping and tax accounting

Here's the first benefit about going with the sole proprietorship option. A sole proprietorship allows for simpler accounting.

For example, a sole proprietorship only needs to prepare a simple profit and loss statement in order to file its tax return. A sole proprietorship doesn't need to prepare a balance sheet or other financial statements.

What's more, a sole proprietor LLC will report its income and deductions inside its owner's tax return on a simple Schedule C form. In comparison, an LLC treated as a corporation for tax purposes will need to prepare a separate 10-20 page corporate tax return.

"LLC" sole proprietorship benefit #2: Skipping payroll

If a single-member LLC has no employees and only the proprietor works in the business, the "LLC" sole proprietorship doesn't have to do a payroll. And skipping payroll amounts to a second big benefit.

Here's why I say this. Payroll processing often causes big headaches for a small business. Payroll means you have to deal with quarterly and annual payroll tax returns. Payroll means that you need to regularly calculate wages and prepare payroll checks. And payroll automatically increases your taxes: For every employee your business hires, for example, the federal government levies a federal unemployment tax that will typically equal several hundred dollars annually. And the states also often levy payroll taxes.

"LLC" sole proprietorship benefit #3: Hiring minor children

Another benefit of an "LLC" sole proprietorship: If a sole proprietor hires his or her minor children, the proprietor can write off the children's wages as business deductions and in the process save his or her family substantial income and self employment taxes.

Here's why: If the proprietor keeps the money, he or she will typically pay both income and self-employment taxes on the money.

If the proprietor pays the money out to his or her children as wages, however, the children probably will avoid paying both income taxes and employment taxes on the money. A proprietor doesn't have to pay payroll taxes on wages paid to minor children. And minor children can typically earn several thousand dollars a year before they have to pay income taxes.

Note: You can't pay your kids wages for "fake" jobs. The job needs to be real.

"LLC" sole proprietorship benefit #4: Full deductibility of healthcare expenses

One other huge tax loophole becomes available when an LLC uses the sole proprietor tax accounting classification and hires only one other employee in the business--the proprietor's spouse.

In this special situation, the sole proprietorship can save lots of taxes by setting up a healthcare reimbursement arrangement, or HRA, plan. This HRA plan allows the sole proprietorship to deduct as business expenses amounts paid to reimburse employees for their healthcare expenses.

So here's the weird part of an HRA plan. While the HRA can't deduct amounts paid for the proprietor's healthcare expenses (that would be you of course), the HRA can deduct amounts paid for your spouse and his or her family. In other words, you, the proprietor, don't qualify as the proprietor. But you do qualify as the spouse of an employee.

This is a big opportunity. You may know that a sole proprietor can often deduct health insurance as an income tax deduction as long as the business makes money.

With an HRA plan, however, the sole proprietor gets to deduct not only health insurance costs but also any other uninsured healthcare costs such as co-pays and deductibles. And it gets better... The reimbursements are just deductions for income tax purposes but deductions for both for income tax purposes and for self-employment tax purposes. Furthermore, the HRA deduction doesn't depend on the sole proprietorship being profitable. (The self-employed health insurance deduction does.)

Two quick notes in closing if you're interested in exploring in greater detail the HRA option: Your spouse's total compensation needs to make sense--in other words, your spouse needs to have a real job with reasonable compensation. And you need a good accountant's help in correctly setting up one of these plans. An HRA can be tricky to setup correctly.