Sole Proprietor vs. LLC: Liability, Taxes, and Which Makes Sense for You

The Default: You're Already a Sole Proprietor (And You Might Not Know It)

Here's the truth: If you've started making and selling handmade goods without formally creating a business entity, you're already operating as a sole proprietor. You didn't file anything. You didn't pay fees. It happened by default the moment you started earning income.

As a sole proprietor:

• You and your business are legally the same entity. There's no separation.
• Business income is personal income. Everything flows to your personal tax return (Schedule C).
• You pay self-employment tax. About 15.3% on all net profit (12.4% for Social Security + 2.9% for Medicare).
• Full personal liability. If someone sues the business or the business owes debts, they can come after your personal assets.

This is why the business structure question matters. As you scale, the liability risk increases. And that's where an LLC comes in.

What is an LLC? (And How Does It Actually Protect You?)

An LLC (Limited Liability Company) is a separate legal entity. Unlike a sole proprietorship where you ARE the business, an LLC is a distinct legal thing that owns your business.

Key features:

• Liability Protection: Business debts and lawsuits stay with the LLC. Your personal assets are generally protected (with some exceptions).
• Pass-Through Taxation: The LLC itself doesn't pay income tax. Profits pass through to your personal tax return (Schedule C), just like a sole proprietorship.
• Self-Employment Tax: You still pay self-employment tax on LLC profits (same as sole proprietor).
• More Paperwork: You need to file articles of organization, maintain records, and file annual reports (varies by state).

So here's the key distinction: An LLC is the liability protection of a corporation without the double taxation of a corporation. You get liability protection, but your taxes remain simple—profits still flow to your personal tax return.

The critical question: Is that protection worth the cost and complexity?

Liability Protection: The Real Stakes

The main reason to form an LLC is liability protection. But here's what people often misunderstand: the protection isn't absolute.

What an LLC Actually Protects

If your LLC is sued, the liability stays with the LLC. Example:

When an LLC Does NOT Protect You

Liability protection has important limits:

• Willful Misconduct: If you deliberately did something wrong, the LLC protection might not apply. If you knew your candles were defective and sold them anyway, an LLC won't protect you.
• Personal Guarantees: If you personally guarantee a business loan or lease, you're liable regardless of the LLC.
• Taxes: You still owe personal income taxes and payroll taxes. These aren't covered by LLC protection.
• Employee Lawsuits: Your LLC provides some protection, but employment laws can create personal liability.
• Piercing the Veil: In rare cases, courts can ignore the LLC protection if you're not maintaining proper business separation (mixing personal and business finances, etc.).

Bottom line: An LLC isn't a liability shield for everything. But it IS strong protection for product defects, accidents, and general business claims—which are the most common risks for handmade makers.

Taxes: The Surprising Truth

Most makers think an LLC saves them money on taxes. It doesn't. Here's why:

How LLC Taxation Works by Default

By default, a single-member LLC (just you) is treated as a "disregarded entity" for federal tax purposes. This means:

• • You file Schedule C (same as a sole proprietor)
• • All business income flows to your personal tax return
• • You pay self-employment tax on all profits (same as sole proprietor: 15.3%)
• • You get the same deductions as a sole proprietor

In other words: No tax difference between an LLC and a sole proprietor by default.

Can You Save Taxes as an LLC?

Yes, but only if you elect to be taxed as an S-Corp. This is more complex and usually only makes sense if you're earning $60K+ per year in profit. See Forming an LLC: Step-by-Step Without a Lawyer for details on S-Corp taxation.

For most makers below $60K revenue, there's no tax benefit to forming an LLC. The decision should be about liability protection, not tax savings.

The Real Costs: Startup and Ongoing

Forming an LLC: Startup Costs

Ongoing Annual Costs

• State Annual Report/Franchise Tax: $50-$500 (varies by state; some states like California charge $800+)
• Registered Agent (if using service): $75-$150/year
• Accounting/Tax Prep: $300-$800/year (depending on complexity)
• Business License Renewal: $20-$100 (varies by location)

Realistic ongoing cost per year: $150-$1,000+ depending on your state and whether you use a service.

Compare this to your actual risk. If you're earning $5K/year from a side hobby, that cost might outweigh the benefit. If you're earning $50K+ and selling high-risk products (food, cosmetics, children's items), the cost is easily justified.

Complexity: What You Actually Have to Do

Sole Proprietor: Minimal Admin

• • File Schedule C on your annual tax return (takes 30 minutes)
• • Get a Business License if your county requires one (~$50, one time renewal per year)
• • Keep business records and receipts for tax deductions
• • That's it

LLC: More Requirements (But Not Overwhelming)

• • File Articles of Organization with state (~1 week turnaround)
• • Get an EIN (free; takes 15 minutes online)
• • File annual report with state (every year; simple form)
• • Keep business records separate from personal finances
• • File an additional business license (same as sole proprietor)
• • Optionally file Form 8832 if electing S-Corp taxation (tax complexity increases significantly)

The biggest requirement: Keep your business finances separate from personal finances. If you mix them, you risk "piercing the veil" and losing liability protection.

This means: business checking account, separate credit card, clear records. It's not hard, but it requires discipline.

The Decision Framework: When Should You Form an LLC?

Here's a practical framework to help you decide:

Form an LLC If:

• You're earning $20K+ per year in gross revenue. The liability risk increases with scale.
• You're selling high-risk products (food, cosmetics, children's items, candles, anything that could cause injury).
• You have personal assets worth protecting (house, car, savings). If you have little to lose, liability protection is less critical.
• You're hiring employees or contractors. Employment-related liability becomes a real risk.
• You're earning $60K+ and want to explore S-Corp taxation for potential self-employment tax savings.

Stay as Sole Proprietor If:

• You're earning under $10K per year. The liability risk is lower, and the cost of an LLC outweighs the benefit.
• You're selling low-risk products (digital designs, art prints, crafts with minimal injury potential).
• You have liability insurance. Product liability insurance often provides comparable protection to an LLC (more on this below).
• You can't afford the ongoing annual fees. $100-500 per year might be critical cash flow for your business.
• You're risk-averse about admin. If the annual paperwork feels overwhelming, it's okay to wait until you scale.

Wait—What About Insurance Instead?

Here's something important that many makers miss: Product liability insurance provides similar protection to an LLC, often for less money.

Basic product liability insurance costs $200-500 per year and covers:

• • Customer injuries from defective products
• • Property damage caused by your products
• • Legal defense costs

If you can only choose one: Get insurance first. It covers the most common liability scenario (product defects) and is often cheaper than forming and maintaining an LLC. Then, as you scale, consider adding an LLC for broader liability protection and legal legitimacy.

Multi-State Selling: Does It Change the Equation?

Many Etsy and Shopify sellers ship to every state. Does that affect your business structure decision?

Short answer: Not really.

You only need to form an LLC in your home state (where you live/work). You don't need to register as an LLC in every state where you have customers. The LLC formed in your state provides liability protection even if you're selling nationally.

Exception: Some states require registration if you have employees or physical operations in that state. But for most handmade makers doing remote sales, your home state LLC is sufficient.

Ready to Form an LLC? Next Steps

If you've decided an LLC is right for you, the process is straightforward:

1. Choose a name that complies with your state's requirements
2. Check availability with your state's Secretary of State office
3. File Articles of Organization (DIY or use a service)
4. Get an EIN from the IRS (free; do this immediately after formation)
5. Open a business bank account (critical for separating finances)
6. File your annual reports and stay on top of renewal deadlines

For detailed step-by-step guidance, see Forming an LLC: Step-by-Step Without a Lawyer (Or Why You Might Need One).