I used to always advise clients to start with a sole proprietorship and then upgrade to an LLC if they wanted to, with no real tax implications. After all, LLCs are disregarded entities, meaning the IRS will tax you as a sole proprietor (1-person LLC) or partnership / corporation (2+ person LLC) whether you've registered or not. However, there are some benefits to deciding to present as your business as an LLC.
1. You can elect S-Corp treatment.
While an LLC takes a few extra steps than entering the scene as a sole proprietor, a major perk to doing so is the option to elect s-corp status for your business. This means that your company is a legally independent entity, with the ability to pay the owner as an employee, avoiding the self-employment taxes that sole proprietors and members of an LLC must pay. An S corporation also provides additional protections since your personal assets are not responsible for the obligations of the business, and personal assets cannot be seized to satisfy business liabilities. However, none of these options are available to you as a sole proprietor, since you must be a corporation or LLC to elect this status.
2. You can take advantage of the pass-through deduction.
With the new tax law, a 20% deduction (with some restrictions) of qualified business income (QBI) is available for pass through entities on their net income. Pass through simply means the business is not taxed, and instead passes any income or loss to shareholders who report it on their personal tax returns, where business losses may offset other income. This deduction does not lower your taxable income and has nothing to do with whether or not you itemize. Although sole proprietorships are also considered pass through entities for the sake of QBI, the deduction only affects federal income tax, not the self-employment tax you are responsible for as a sole proprietor or partnership.
3. You can build business credit.
You have credit, why shouldn't your business have credit too? The ability to build and maintain business credit allows a separate financial identity from you, the owner(s). By demonstrating that the business is separate from the owner, you can minimize the negative affects that the credit of one may have on the other. This option is especially helpful if you have poor personal credit, as having good business credit can allow you to position yourself for more favorable payment terms and obtain better interest rates. Business credit also extends the first pillar of entrepreneurial success: completely separating the business finances from your personal.
There may be additional costs and requirements associated with forming an LLC over a sole proprietorship, and the truth is, the choice is not right for everyone. But these options make LLC's a more advantageous business structure, despite the seemingly identical tax treatment. Talk to your accountant to determine whether this is the right choice for you.
DISCLAIMER: I am an accountant, not your accountant. Please speak with a professional about your specific accounting and tax needs before putting any of the aforementioned tips into practice.