Self Employed vs Sole Proprietorship: Tax and Legal Aspects in The US

A question that’s been hunting the business forums and threads for a while touches on what is a sole proprietorship and what is self-employed, if there is any difference between them, and how is the best to build the business. 

Sole proprietorship and self-employed are not the same. While sole proprietorship means owning a business and being the sole proprietor of it, self-employment means being hired at your own business. 

Key Properties of Sole Proprietorship

Let’s start with the definition of Sole Proprietorship given by the IRS: “A sole proprietor is someone who owns an unincorporated business by himself or herself. However, if you are the sole member of a domestic limited liability company (LLC), you are not a sole proprietor if you elect to treat the LLC as a corporation”

From a legal perspective, in the United States, a sole proprietor can also be self-employed. Both a sole proprietor and a self-employed are individuals who pay taxes. If you are both a sole proprietor and self-employed, then you have to pay the tax for individual income. In this way, you avoid double taxation.

For example, if you are self employed sole proprietor, and had a profit of  $500,000, the sum is declared as income, and you are being taxed once for the entire amount.

To avoid double taxation, and apply as a self employed sole proprietor, you have to fill in the Schedule SE (Form 1040 or 1040-SR), Self-Employment Tax available on the IRS website.

However, the downside of self employed sole proprietors is that the taxes go up to 15.3%, which includes both Social Security and Medicare taxes. At the same time, you can claim a tax deduction by filing a tax return electronically using FIRE. 

To be called a sole proprietor in the United States, you have to: 

• Be the only owner of the business

• Report income and expenses on your personal income tax

• Pay for the income as self-employment tax, if applicable. 

A sole proprietor is not necessarily a self-employed individual. As long as you continue to be the 100% owner of the business, and don’t treat the business as a corporation, employing staff is absolutely normal, and in some cases even recommended, depending on the business type. However, hiring other individuals into the business adds another level of complexity which includes but is not limited to paying wages, payroll taxes, social security, and medicare taxes which differ from self-employment taxes. 

At the same time, hiring siblings could change the tax structure, and by case reduce the tax value. 

Key Properties of Self-Employment

Self-employment is different from sole proprietorship due to the variety of business forms it can be applied. In other words, you can be self-employed not only in a sole proprietorship business but also in partnerships and Limited Liability Company (LLC). 

As I explained previously how does self-employment interact with sole proprietorship, let’s explore how self-employment can be arranged in Partnerships and LLCs. 

In the United States, you can establish a business based on a partnership and provide services to the business you co-own. In this case, you will be considered self-employed and not employed. The IRS also states that in case you are a general partner or equivalent of it an a LLC, the net earnings will include the share you hold from the partnership and you will be taxed per earnings of your share. 

However, even though self-employed, you will still have to pay the guaranteed tax as a shareholder. 

In the case of limited partnerships, only guaranteed payments for services you rendered to the partnership are considered net earnings from self-employment.  You don't pay self-employment tax on your share of partnership income but do pay self-employment tax on guaranteed payments.

To get a self-employed status in the US you must: 

• Be a sole proprietor, a general, or a limited partner.

• Identify yourself as self-employed in Sole Proprietorship, Partnership or LLC

• Pay the corresponding taxes that apply to the form of business you are self-employed

At the same time, being self-employed can be both part-time and full-time in the business form you choose, but this can also affect the income you are being taxed.

More tax information about being self-employed in partnerships and LLCs can be found on the Entities page on the IRS website. 

Note that self-employment taxes and tax deductions are federal-wide and are not specific to the state where the business is located. 

Legal and tax aspects of Sole Proprietorship and Self Employment

• Sole proprietorship, LP, LLP and specific types of LLP are allowed to self-employ because in all cases the self-employed individual is directly associated with and liable for the business. 

• You cannot be self-employed in a corporation regardless of its type (C, B, S, Close, or Non-profit) as the personal assets and business assets are two separate entities, and the owner is not liable for the business debts or liabilities.

• The Social Security tax for self-employed individuals is deducted from the first $106,800 income earned. It consists of 10.4%.

• The sole proprietorship is a recommended form of business for startups before they develop their business into a more formal entity. It is suitable for testing business hypotheses and strategies. 

• A Sole proprietorship cannot sell stocks but can get a trade name. 

• Considering the close association of the individual with the business model, banks are skeptical about offering loans to sole proprietors

• In a partnership, there is at least one person with unlimited liability and others with limited liability. Regularly the individual with unlimited liability has the highest share in the partnership.

• In LLCs (Limited Liability Companies), the business can have one or multiple owners, but the owners are not personally liable. LLCs in the United States pay among others personal tax or corporate, and by case, self-employment tax. 

• According to the Center for American Progress, self-employment is the most common form of entrepreneurship in the United States. 

• The Small Business Administration data states that in 2022, 82% of small businesses in the US have no employees. This means that they are self-employed sole proprietors.