Sole Proprietorship vs. LLC: What Changes and How to Choose

Starting your own business is exciting. Initially, it may evolve around you: your skills and your drive to make things happen. But as your business thrives, you might need some help. If you're a sole proprietor (the default setup when you start selling goods or services), you're probably wondering: Can I actually hire people?

The short answer is yes. Sole proprietors can hire employees just like any other business. That said, bringing on your first employee means taking on new responsibilities related to taxes and compliance. Many business owners at this stage also consider forming an LLC for additional legal protection and flexibility. Let's explore everything you need to know to make the best decision for your growing business.

What is a Sole Proprietorship?

A sole proprietorship is one of the simplest ways to run a business. You and your business are the same thing in the eyes of the law. When you start freelancing or selling products without filing any special paperwork, you're automatically a sole proprietor. It doesn't require any forms or fees. This simplicity is helpful when you're first starting out. You report your business income and expenses on your personal tax return using Schedule C. The tradeoff is that you're personally responsible for all business debts and legal issues.

Can a Sole Proprietor Have Employees?

Yes, sole proprietors can hire W-2 employees just like corporations and LLCs do. It requires specific steps and payroll setup (see below). Some small businesses hire independent contractors to fill temporary gaps. They require less paperwork, but when you need dedicated team members with regular schedules who you'll supervise directly, employees are the way to go.

Legal and Tax Requirements for Hiring Employees as a Sole Proprietor

The process of hiring employees requires attention to detail from day one. That's because when you hire your first employee, several federal and state requirements kick in right away. Missing any of them can result in penalties and retroactive obligations. Here's what you'll need to handle:

Federal Requirements

• Get an Employer Identification Number (EIN): You can apply online through the IRS. You need one for reporting employment taxes.

• Complete Form I-9: Verify employment eligibility for every hire.

• Collect Form W-4: Gather withholding information from each employee.

• Set up Payroll: You need a system or payroll service for tax withholding, deposits, payments, and reporting.

State Requirements

• Register with Your State: Set up accounts for unemployment insurance and tax withholding.

• Get Workers' Compensation Coverage: Remember that most states mandate coverage once you have employees, although specific requirements differ.

• Establish a State Tax Withholding Account: Set this up before your first payroll.

• Report New Hires: Submit information to your state within 20 days. It's a state requirement with federal oversight(opens in a new tab).

Understanding Payroll Taxes

As a sole proprietor who is also an employer, you'll handle payroll taxes just like any other business. For Social Security and Medicare (known as FICA taxes), you need to withhold 7.65% from each employee's paycheck and match it. For federal income tax, you need to withhold the amount your employee indicates on their W-4 form. When it comes to federal unemployment tax (FUTA), you pay 6% on the first $7,000 of each employee's wages, though state credits usually reduce this. State unemployment tax usually runs between 2% and 5%, but the exact rate depends on your business location.

Beyond collecting these taxes, you also need to file regular reports. Form 941 goes out every quarter for federal payroll taxes, Form 940 is due annually for unemployment, and you'll prepare W-2s for your employees at year-end. New employers often deposit their payroll taxes monthly.

Employment Laws for Sole Proprietors

Once you hire employees, specific federal and state labor laws apply to your business. Remember to classify team members as employees or independent contractors correctly. Here are some key employment laws to know about:

• Wage and Hour Requirements: Follow minimum wage and overtime rules under the Fair Labor Standards Act (FLSA).

• Anti-Discrimination Protections: Create a fair workplace (specific laws kick in at different employee counts).

• Safety Standards: Meet Occupational Safety and Health Administration (OSHA) requirements and post required workplace notices.

• Leave Policies: The Family and Medical Leave Act (FMLA) applies to businesses with at least 50 employees, though your state might have different rules.

Can a Sole Proprietor Be an LLC?

Technically, no. You can't be both a sole proprietor and an LLC at the same time because they're different business structures. But you can form an LLC and operate it as the sole member. Many sole proprietors do exactly this when they're ready to take their business to the next level. The most significant difference is that an LLC creates a legal wall between you and your business. With a sole proprietorship, there's no separation.

Understanding Single-Member LLCs and Sole Proprietorship Taxation

For federal tax purposes, a single-member LLC is usually treated as a disregarded entity, meaning the IRS treats it like a sole proprietorship. You'll still file Schedule C with your personal tax return. However, when you form an LLC, most states require you to file annual reports and pay fees. You'll also likely need to get a new EIN specifically for your LLC. You can choose to have your LLC taxed as an S-corporation or C-corporation, which changes how you pay yourself. Discuss it with a tax professional to see what makes sense for your situation.

Sole Proprietor vs. Single-Member LLC: Key Differences

When you compare these two structures, the liability protection stands out as the main advantage of an LLC. It's something to consider when choosing the best business entity for your growing business. Here's a side-by-side comparison:

Should You Form an LLC?

If you're planning to hire employees, forming an LLC can be worthwhile. Here are some pros and cons:

Advantages

• Liability Protection: Your personal assets stay separate from business debts and lawsuits.

• Professional Image: Many businesses prefer working with LLCs.

• Tax Options: You get to choose different tax treatments as your business grows.

• Financing Opportunities: Banks often prefer lending to LLCs over sole proprietorships.

Things to Keep in Mind

• Formation Costs: You may have to pay between $40 and $500, depending on your state.

• Ongoing Expenses: Annual reports and registered agent fees can add up.

• More Recordkeeping: You'll need to maintain separate business records.

• State-Specific Taxes: Some states charge additional LLC taxes or fees.

Hiring Employees as a Single-Member LLC

The hiring process for a single-member LLC is similar to hiring as a sole proprietor, with a few key differences. First, you need to use the LLC's EIN for payroll and tax purposes. You should register everything under the business name. It's essential to maintain clear boundaries between your business and personal finances to preserve that legal separation the LLC provides. You'll still have employer responsibilities, such as workers' compensation and unemployment insurance.

Run Your Business Confidently with Justworks

Regardless of your business entity, managing employees involves handling multiple responsibilities. From calculating payroll taxes to staying current with employment laws, the administrative burden can pull you away from growing your business.

Justworks' HR services support your business through every stage of growth. Our platform simplifies payroll and helps you maintain compliance. It can grow with you, whether you operate as a sole proprietorship, transition to an LLC, hire across state lines, or expand internationally. Get started with Justworks today.