TABLE OF CONTENTS
One of the first steps to starting a business is choosing under which formal structure your business will operate. Your business structure impacts your day-to-day operations, your amount owed in taxes, and your options when things go awry. That said, it is important to choose the right business structure to ensure your business succeeds to the best of its abilities. And as you weigh two of the best structures for small businesses—a sole proprietorship vs LLC—there’s a lot of dense information to sift through, which can be confusing.
To guide you through the sole proprietorship vs LLC conundrum we’ll break down the definitions, similarities, and differences. Let’s get started!
What’s the Difference Between a Sole Proprietorship and LLC?
A sole proprietorship and an LLC are both business structures, but what exactly is the difference between the two?
In a nutshell, an LLC protects a business owner’s personal assets by the legal separation between business and owner. If your LLC is sued or suffers losses, your personal assets are protected. Meanwhile, with a sole proprietorship, the business owner (or “sole proprietor”) assumes all of the risks and debts of the business. As a result, it’s best to only consider a sole proprietorship if your business is low risk.
A sole proprietorship is the most common business structure among small businesses. Yet, due to its added benefits, an LLC is often a better option.U.S. Small Business Administration. “Sole Proprietorship“. Accessed March 17, 2022.
Is an LLC a sole proprietorship?
An LLC is not a sole proprietorship. An LLC may consist of just one person. This structure is called a single-member LLC. However, this is not the same structure as a sole proprietorship.
Single-member LLC vs sole proprietorship
If you own a single-member LLC, it has some similarities to a sole proprietorship. However, they’re not quite the same thing.
A single-member LLC and a sole proprietorship both have the same employer identification number (EIN) requirements. This allows you to open a bank account, hire employees, and pay taxes. Both also have the same pass-through taxation and payroll tax withholding processes.
The main distinction between the two is that a single-member LLC has personal liability protection, while a sole proprietorship has none.
What is a Sole Proprietorship?
A sole proprietorship is an unincorporated business with just one owner. It is the easiest type of business to form. Often, a sole proprietorship is known by the owner’s name, though you can also set up your own brand or business name.
This owner, the sole proprietor, is personally responsible for everything that happens to the business. The responsibility of a sole proprietor includes both the management of the business, as well as financial responsibilities. Without any legal separation between the business and the owner, the owner is responsible for all the debts of their business.
The advantage of a sole proprietorship is that it takes the least time and money to set up. If you’re looking to establish your business structure quickly, a sole proprietorship is the simplest option. It doesn’t require state paperwork or annual state filings, and you report your business profits and losses on your personal tax return.
Under a sole proprietorship, you enjoy self-employment benefits, through which you may be able to deduct business expenses.
There are more disadvantages than advantages to a sole proprietorship. In general, because the structure is so simple, it comes with risks. Namely, it doesn’t offer liability protection for your personal assets. This means that if your business faces a lawsuit or defaults on its debts, you may lose your personal assets. This can include your car, house, and more.
Secondly, sole proprietorships don’t give you the tax benefits of other structures. As a sole proprietor, you pay taxes on your business profits as well as FICA taxes, like Medicaid and Social Security. These taxes increase as your business becomes profitable. Moreover, as your sole proprietorship’s profits grow, you face more risk. More formal business structures mitigate these risks.
Lastly, a sole proprietorship doesn’t carry the same credibility or marketability as other structures. Sole proprietors must carry out all business functions under their own name unless you can file a “doing business as” (DBA) name in your state. As a result, all your invoices, bank accounts, and documents include your surname instead of a more official brand name, which can limit your opportunities to brand your business. Additionally, it can also be difficult to establish a business line of credit or obtain other debt financing options under a sole proprietorship.
When to use a sole proprietorship
A sole proprietorship may be a good option for a small business that’s just starting out. Because it’s a less formal business structure, it’s straightforward to set up. Moreover, if your business doesn’t take on much risk and you expect a low chance of financial loss or liability, a sole proprietorship might be right for you.
What is an LLC?
LLC stands for “limited liability company.” A limited liability company is one that is legally separate from the business owner. Its structure combines elements of a sole proprietorship, corporation, and partnership. Additionally, individuals can form a single-member LLC or multiple people can form a multi-member LLC. Due to the LLC’s hybrid nature, it gives the LLC owner(s) the flexibility to choose their tax treatment and operational processes.
You usually know an LLC when you see one because the law requires that its legal name ends with some form of “LLC.”
As a business structure, an LLC offers advantages in the areas where a sole proprietorship lacks. LLCs give you personal liability protection, taxation benefits, and added credibility. This means that your assets are protected in case your business is in trouble. You also have options that allow you to customize your tax structure and strategy.
Furthermore, under an LLC, your business is viewed as more trustworthy by banks and consumers, which may improve your odds of taking out loans and expanding your customer base. The characteristics of an LLC also make it easier for you to scale your business in terms of profit and risk.
The main disadvantage of an LLC is that it’s a bit more complicated and costly to establish than a sole proprietorship. (Though it’s not as involved as, say, a corporation.) The formation process can take longer and compliance is more involved, especially when multiple people are involved in the LLC.
Under an LLC, you’ll have to file state paperwork and annual state filings. Also, the costs of completing your LLC tax return may be higher.
When to use an LLC
LLCs are a great option for any business owner to consider. An LLC is a particularly attractive option when you’re starting out with lots of customers, profits, or risk of loss. An LLC can also help a business that’s looking for a unique set of tax options, which isn’t possible with a sole proprietorship.
Should I Form an LLC or Sole Proprietorship?
Now that you have a better idea of the nuts and bolts of these two business structures, it’s up to you to consider a sole proprietorship vs LLC. Ultimately, both structures have their comparative pros and cons, so depending on your situation, one may clearly be a better option than the other. However, it’s generally recommended most businesses opt for an LLC over a sole proprietorship as the added level of protection serves most entrepreneurs well.
At the end of the day, you know your business and its needs best, so you’re the one best-equipped to make the right call in terms of an LLC vs sole proprietorship. Either way, carefully consider both options.
How to Start an LLC
When starting an LLC, you have two options: starting your LLC yourself or working with a service to establish it for you. If you opt to start your LLC on your own, there are plenty of online resources to guide you. But do be aware that the specifics of starting your LLC vary state by state, so it’s important to review your specific state’s guidelines.
Though the process varies by state, it generally consists of following steps across the board:
- Name your LLC
- Chose a registered agent (the person who accepts legal documents on your LLC’s behalf)
- File your Articles of Organization (also known as a Certificate of Formation or Certificate of Organization) with your state
After this, you have officially formed your LLC! To complete the process, you need to take two more steps:
- Get an EIN for your business (this tax ID number is used by the IRS to identify and tax your business)
- Create an operating agreement (a legal document specifying the details of ownership in your LLC)
As mentioned above, another option is to employ an LLC formation service to register your LLC for you. These companies can help you start your LLC online, as well as help you set up your EIN, operating agreement, and more.
Key Differences When Setting Up an LLC vs a Sole Proprietorship
On top of their differences in function, LLCs and sole proprietorships also differ in the set-up process. In this section, we examine the sole proprietorship vs LLC in terms of setting up the two types of business entities.
Forming an LLC vs sole proprietorship
Both LLCs and sole proprietorships require business registration basics like choosing a name and obtaining the required permits. Overall, setting up a sole proprietorship has fewer steps than setting up an LLC.
To establish your sole proprietorship, you need to get your appropriate business permits. If you plan to use a trade name, the only other step needed is to register your trade name.
On the other hand, to form an LLC, you need to file Articles of Organization with your state in addition to getting business permits and registering your trade name (if applicable).
Tax benefits of an LLC vs sole proprietorship
Both structures have pass-through taxation, which is when business owners pay business taxes on a Schedule C attached to their personal tax returns. With pass-through taxation, the income is taxed at the same rate as the owner’s personal income tax.
For a sole proprietorship, the above is the only option. Meanwhile, an LLC can elect to instead use corporate tax status. As a result, you can avoid paying a self-employment tax on your income as an owner of the LLC, thus avoiding double taxation. The current self-employment tax rate is 15.3 percent.Internal Revenue Service. “Self-Employment Tax (Social Security and Medicare Taxes“. Accessed March 17, 2022. Furthermore, a corporation can also be eligible for more credits and deductions. This can save you money. Note, however, that in some states and local jurisdictions, an LLC may have to pay an additional LLC tax.
Both LLCs and sole proprietorships are responsible for things like payroll taxes if they have employees, as well as state and local sales taxes.
Is managing an LLC and sole proprietorship the same?
When weighing a sole proprietorship vs LLC in terms of operations and management, these structures can look very similar. However, a sole proprietorship is always just one person at the top of the hierarchy. With a single-member LLC, the two might be virtually identical.
Generally, LLCs have the potential to be more complicated depending on the number of people involved. For example, with a multi-member LLC, multiple owners might share control and responsibility. Alternatively, owners might appoint a single manager to make the LLC’s management decisions. These details will be recorded in the LLC’s operating agreement. Whereas, with a sole proprietorship, one owner has the final say in all decisions.
How is financing an LLC vs a sole proprietorship different?
With both an LLC and sole proprietorship, you pay the fees associated with renewing your business license(s) and paying taxes. Since an LLC has more upkeep and paperwork, a sole proprietorship is less expensive to finance.
Additionally, LLCs also need to budget for the time and resources spent creating an operating agreement, holding and keeping records of meetings, and filing an annual report (a requirement in many states). The costs of filing articles of organization vary in each state, but it generally ranges from $50 to $200.
Do You Need to Change to an LLC if You Already Have a Sole Prop?
As sole proprietorships are best for low-risk or low-profit businesses, it’s can be a good idea to consider switching to an LLC. Making the upgrade can help you grow your business by increasing the amount of risk you’re able to take.
To change your sole proprietorship to an LLC, the IRS requires you to get a new EIN, which is free when you apply with the IRS.Internal Revenue Service. “Do You Need a New EIN?“. Accessed March 17, 2022. Afterward, you follow the steps of forming an LLC, which may be easier as you’ve already done the legwork of setting up a sole proprietorship.
Is an LLC Always a Better Choice than a Sole Proprietorship?
An LLC is a better option for many businesses due to the benefits and protections it offers. However, a sole proprietorship may be preferable in certain circumstances.
Mainly, you should consider a sole proprietorship if you’re just starting your business out small and testing the waters. Thus, you might not expect much risk or a large volume of profits, so you won’t need to worry about liability protection. Similarly, if you’re expecting your business to generally be low-risk or low-profit long term, a sole proprietorship may be the better, simpler choice.
Outside of these specific cases, an LLC is the stronger choice for most business needs.
Sole Proprietorship vs. LLC: Closing Thoughts
Many business owners begin with a sole proprietorship because it’s the easiest, no-fuss option with the least paperwork and costs. However, an LLC gives your business the most benefits in the long run, so it’s the recommended option for most businesses. Whichever kind of structure you choose, it’s important to make the decision that best aligns with your business needs. Soon enough, you’ll be accepting payments for the sole proprietorship or LLC you always dreamed of running.
- U.S. Small Business Administration. “Sole Proprietorship“. Accessed March 17, 2022.
- Internal Revenue Service. “Self-Employment Tax (Social Security and Medicare Taxes“. Accessed March 17, 2022.
- Internal Revenue Service. “Do You Need a New EIN?“. Accessed March 17, 2022.