Incorporator The Journal of U.S. Formation
Start Free Quiz
Editorial 8 MIN READ

Sole prop vs single-member LLC, 2019

The 20% pass-through deduction arrives, treats both forms the same, and leaves the liability shield doing all of the work

The Editors
Staff, Incorporator.org
8 min read Updated
Contents 7 sections
  1. The federal tax treatment is identical
  2. Where the two forms stop looking alike
  3. What the 199A field looks like one year in
  4. The S-corp election is available to both, and that is still the real tax lever
  5. State filing, annual fees, and the actual cost delta
  6. Rule of thumb
  7. Sources

or 2019, the choice between a sole proprietorship and a single-member LLC is not a tax choice. The 20% Section 199A qualified business income deduction, now in its second filing year, applies identically to a Schedule C sole prop and to a disregarded-entity SMLLC. Whatever moves the needle between the two forms, it is the liability shield, not the tax return.

That was true in our 2016 piece on when to switch, and it is more clearly true now that 199A has had a year in the field and a round of proposed regulations to sharpen the edges. What follows is the comparison as a founder signing contracts in January 2019 should read it.

The federal tax treatment is identical

A single-member LLC is, by default, a disregarded entity under Treas. Reg. § 301.7701-3(b)(1)(ii). That means the IRS looks through the entity and taxes the owner directly, as if the LLC did not exist. Income and expenses land on the same Schedule C a sole proprietor files. There is no separate entity return, no Form 1065, no Form 1120. The owner pays income tax at ordinary rates and self-employment tax on net earnings under IRC § 1401. The 2019 self-employment-tax rate is 15.3% on the first $132,900 of net earnings from self-employment (Social Security wage base for 2019, per the Social Security Administration's October 2018 announcement) and 2.9% above that, with the 0.9% Additional Medicare Tax layered on high-earning filers per IRC § 1401(b)(2).

The same is true of the 20% pass-through deduction enacted by the Tax Cuts and Jobs Act in December 2017 and codified at IRC § 199A. The deduction applies to "qualified business income" of a "qualified trade or business" carried on through a sole proprietorship, a partnership, an S-corporation, or a disregarded entity. Proposed regulations REG-107892-18, published in the Federal Register on August 16, 2018 (83 Fed. Reg. 40884), confirm the point at § 1.199A-1(a)(2): a trade or business "includes a trade or business conducted by the individual directly as well as through a disregarded entity." Treasury has not yet issued final regulations as of this writing; the final package is expected soon, but the proposed version is the governing guidance a return filed for 2018 or 2019 must track.

For a freelance designer clearing $80,000 of net profit, the 199A math is the same on a sole prop and on a single-member LLC. Below the taxable-income thresholds (2019: $160,700 single, $321,400 married filing jointly, per Rev. Proc. 2018-57, § 3.27), the deduction is a flat 20% of qualified business income, subject to the overall taxable-income-minus-net-capital-gain limit. Above the thresholds, the W-2 wage and unadjusted basis limitations in § 199A(b)(2) kick in and specified-service-trade-or-business (SSTB) status starts to phase the deduction out. None of those mechanics care whether the business is titled "John Smith" or "John Smith LLC."

The 2018 Form 1040 has moved most of the Schedule C mechanics onto Schedule 1, but the bottom line is unchanged. An SMLLC owner writes the same number on the same line as a sole proprietor with the same gross receipts and the same expenses. If anyone on the internet is telling you the LLC cuts your federal income tax, they are either confusing you with an S-corp election (available to both forms) or selling something.

Where the two forms stop looking alike

The separation begins the moment a third party has a claim. A sole proprietor is the business, personally, for every purpose that matters to a plaintiff. Contracts run to the individual. Vendor judgments run to the individual. Commercial leases run to the individual. Employees sue the individual. Tort judgments arising from business activity run through the individual's personal balance sheet unless insurance caps them. The sole prop is a fiction of accounting; it is not a legal entity.

An SMLLC is a legal entity, organized under state statute, with a separate existence from its owner for non-tax purposes. Properly formed and maintained, it is the contracting party, the defendant of first instance, and the obligor of record. A vendor with a six-figure claim against the LLC must get a judgment against the LLC and then try to collect from the LLC's assets. Reaching the owner requires either a personal guarantee signed up front (common for leases and lines of credit, rarer for trade credit) or a successful veil-piercing argument that the entity was a sham.

The veil-piercing standard varies by state but converges on two conditions: a unity of interest and ownership such that the separate personalities of the member and the LLC no longer exist, and an inequitable result if the acts are treated as those of the LLC alone. The language is from Walkovszky v. Carlton, 18 N.Y.2d 414 (N.Y. 1966), decided under a corporate standard that most states have imported into the LLC context with minor modifications. In practice, the founders who get pierced are the ones who commingled funds, paid personal expenses from the LLC account, failed to capitalize the entity for its stated business, or signed contracts in their personal names and then claimed the LLC was liable. None of that is about the $90 filing fee. It is about whether the owner treated the entity as real.

What the 199A field looks like one year in

The 2018 filing season (returns due April 15, 2019) will be the first time Schedule C filers and SMLLC owners calculate a 199A deduction. For most single-member businesses under the threshold, the calculation is mechanical. You add up qualified business income, multiply by 20%, compare to 20% of taxable income minus net capital gain, and take the lesser. The IRS released draft Form 8995 (simplified deduction worksheet) and Form 8995-A (the full computation including W-2 wages and UBIA) in 2018 to cover the two populations.

The complications live above the threshold and in SSTB territory. Section 199A(d)(2) defines a specified service trade or business to include the fields of health, law, accounting, actuarial science, performing arts, consulting, athletics, financial services, brokerage services, and any trade or business where the principal asset is the reputation or skill of one or more of its employees or owners. For a single-member consultant crossing $160,700 of taxable income, the SSTB phase-out kicks in; by $210,700, the deduction is gone. The proposed regulations at § 1.199A-5 define the SSTB categories narrowly in some places (consulting, for instance, is distinguished from services "ancillary to the sale of goods") and broadly in others (the reputation-or-skill catch-all is limited to endorsements, appearances, and licensing of name or likeness). None of this mechanics-level guidance distinguishes between the sole prop and the SMLLC. A disregarded entity is the owner, and the owner's trade or business is what the rules address.

The practical consequence is that for a 2018 or 2019 return in the under-threshold zone, a founder who forms an SMLLC on January 2 will file substantively the same return as if they had kept the sole prop. The LLC filing fee and the registered-agent bill buy liability posture, not deduction.

The S-corp election is available to both, and that is still the real tax lever

Both a sole proprietor (by forming and electing) and a single-member LLC owner (by electing directly) can ask the IRS to treat the business as an S-corporation under IRC § 1362. The election form is Form 2553, filed under the rules in Rev. Proc. 2013-30 for late relief. An S-corporation pays the owner a reasonable salary subject to FICA, and the remaining profit flows through on a K-1 not subject to self-employment tax. This is the lever that actually reduces tax, and it has nothing to do with whether the underlying entity is an LLC or a sole prop that incorporated.

The 199A interaction is worth noting. An S-corporation's qualified business income is the K-1 income net of reasonable compensation. Paying yourself a higher salary increases W-2 wages (helpful above the threshold, where wages are part of the limitation) but lowers QBI (which the deduction is calculated from). Treasury addressed some of this in Notice 2018-64 and the proposed regulations. Practically, for owners in the under-threshold zone, the S-corp election still saves self-employment tax; the 199A deduction is preserved in roughly the same dollar amount on either side of the election, because the reduction in QBI is close to offset by the reduction in self-employment tax base. Above the threshold, the math gets tighter and requires modeling.

The point for the sole-prop-versus-SMLLC question is that the S-corp decision is separable. It is an election layered on top of whichever default entity form you pick. The LLC does not unlock the S-corp; the S-corp is available to any eligible domestic business whose owners are eligible shareholders.

State filing, annual fees, and the actual cost delta

The SMLLC costs more than the sole prop to operate, and that cost is real even if it is small. Formation fees in 2019 range from $40 (Kentucky) to $500 (Massachusetts), with most states clustered in the $75 to $150 band. Annual report fees run from $0 in a handful of states (Arizona, Missouri, New Mexico, Ohio for standard LLCs, Texas if under the no-tax-due threshold) to $800 minimum in California per R&TC § 17941. A registered-agent subscription adds $50 to $300 a year if you use a commercial provider rather than listing yourself.

A separate bank account is effectively mandatory for veil-piercing hygiene. Most banks do not charge a small business account holder monthly fees if minimum balances are met, but the cost of the second account is the cognitive overhead of keeping business and personal transactions separated.

The tax-preparation delta is small in the disregarded-entity case: the Schedule C is the same document. Where founders get surprised is in states like California that require an LLC return (Form 568) and the $800 annual tax even for a disregarded entity, or in Tennessee and New Hampshire, which impose entity-level taxes on SMLLCs that would not reach a sole prop. Check your state before forming. The federal neutrality of the disregarded-entity treatment does not carry through to every state income tax system.

Rule of thumb

For 2019: if you sign contracts that a plaintiff could reach your house over, form the SMLLC. The 199A deduction will look the same either way; the liability shield will not.

Sources

Keep reading

More from the journal.