When deciding on a business entity type, you need to consider whether you’ll own the business with a partner or run your business solo. In such cases, a limited liability company [LLC] or sole proprietorship would be a good choice; however, you need to be aware of the advantages and disadvantages of each. The following guide will outline the differences between sole proprietorships and LLCs to help you make an informed decision.
What is a sole proprietorship?
When an individual (or legally married couple) creates a business, it is considered a sole proprietorship by default. One of the advantages of sole proprietorships is that no formation documents are required to be filed with the state. The owner (sole proprietor) and the small business are regarded as the same legal entity and tax-paying entity.
Sole proprietorship benefits
- Less stringent filing requirements: When starting a sole proprietorship, you won’t have to fill out a ton of paperwork as compared to starting a corporation, limited liability company, or limited liability partnership. This is because you won’t need to register with the state, and you can form your business entity by virtue of doing business. However, you may have to obtain certain licenses and permits depending on the requirements laid down by the state or local government.
- Low filing fees: Many business structures need to register with the state and pay annual filing fees to maintain the registration. Sole proprietorships do not have the same ongoing legal requirements, which allows them to save on filing fees and time.
- Easy tax setup: Sole proprietorships have straightforward tax requirements compared to other entity types. You won’t need to apply for an EIN because you will be allowed to use your Social Security number like you would for any other financial transaction that requires it. Sole proprietors are taxed as pass-through entities, so you are taxed on a personal or individual level and don’t have to worry about submitting separate taxes for the business.
- Simple ownership structure: As the sole owner of your business, you have total control over the finances and decision-making process.
- Straightforward banking: When you start a sole prop, you won’t need to open up a separate or corporate bank account to operate. You can accept payments straight to your personal bank account.
Sole proprietorship drawbacks
- Hard to sell the business: While it is not impossible to sell a sole proprietorship, you’ll need to sell the business differently. This means selling your business assets rather than the business itself since the sole prop is attached to an individual by nature. This also means that if you no longer want to run the company or you pass on, the business comes to an end.
- Hard to obtain credit and financing: It can be challenging for sole proprietors to build business credit in the same way as other business entities that are well established and have a larger revenue. In terms of securing credit, it’s completely dependent on the sole proprietor’s initial investments, credit history, and finances.
- No liability protection: Since sole proprietors do not register their business with the state, they are also not afforded any type of liability protection. So in terms of business debts and obligations, personal assets will most likely be used to pay off creditors.
Check out our guide to sole proprietorships.
What is an LLC?
Limited liability companies are legal business entities formed under state laws and require formal registration. LLCs with only one member, known as single-member LLCs, can be compared to sole proprietorships. This is because the owners are known as members.
When more than one member is involved, it’s called a multi-member LLC. Multi-member LLCs can be managed by the company’s members or by a manager hired outside the company and designated by the LLC members.
LLCs are also considered separate legal entities from their owners and, by default, are considered the same tax-paying entity.
- Lenient ongoing compliance: When creating and maintaining an LLC in the long run, fewer requirements are involved compared to other business structures like corporations.
- Personal liability protection: The LLC business structure is appealing to many small business owners and entrepreneurs due to the personal liability that it offers to all members. So in the event of debt, obligations, and lawsuits, the owner’s personal assets cannot be used to pay off what the company owes.
- Flexible ownership: LLCs can be owned by partnerships, trusts, corporations, foreign entities, and individuals. There are also no restrictions on the number of members or owners an LLC can have.
- Credibility: LLCs are seen as a more formal business entity when compared to partnerships and sole proprietorships. Therefore they have much more credibility with clients, financial institutions, and suppliers.
- Management flexibility: LLCs may choose to be managed by the members or by nominating an individual from outside the company to manage the LLC’s day-to-day operations.
- Pass-through taxation: Another benefit of LLCs is that members enjoy pass-through taxation. They will submit personal income tax returns on the incomes and losses of the company. LLCs are not liable for corporate taxes.
- Transfer of ownership: Unless an operating agreement is drawn up stating that new members can be brought into the company without prior consent from all members, this task will become a challenge if everyone in the company is not on board.
- High formation and maintenance costs: It costs far more to form and maintain an LLC when compared to a sole proprietorship or partnership. Additionally, LLCs, like corporations, will have to fork out formation fees, annual reporting fees, ongoing filing fees, and the necessary fees for renewing licenses and permits and submitting taxes.
At a glance: How is a sole proprietorship different from an LLC?
Both sole proprietorships and LLCs have their similarities as well as their differences.
- Sole proprietorships are more cost-effective in terms of formation and also much easier to maintain.
- Owners are also taxed at the relevant individual personal income tax rates on profits the company makes in the sole proprietorship business structure.
- LLC owners are protected as LLCs provide personal liability protection against the debts, judgments, or lawsuits brought against the business. It’s, therefore, a form of legal protection.
- A few additional steps are also involved in forming an LLC instead of a sole proprietorship.
- LLCs must complete formation documents, register with the state, pay filing fees, and follow state laws governing this type of business.
- They are responsible for filing annual reports, paying state fees, and holding annual meetings.
- LLCs must also ensure that the company’s records and funds are separated from individual or personal bank accounts.
- In terms of taxes, LLCs can choose to be taxed as partnerships or sole proprietorships, as well as S corps and C corporations.
Should I start a sole proprietorship or LLC?
You are not alone if you’re unsure whether to start a sole proprietorship or an LLC. The best way to decide is to know what each business structure requires and how each business structure may restrict you. If you plan on expanding the business and having more than one owner sometime in the future, you’re safer with an LLC.
Additionally, an LLC is a way to go if you want your personal assets protected from potential legal and financial liability. Forming an LLC is highly recommended if you want to enjoy the business tax benefits that come with limited liability companies, be it on the local, state, or federal level.
While the startup costs when starting a sole proprietorship are low, and you maintain maximum privacy, as the company owner, you are regarded as the company itself and 100% responsible for any business debts, judgments, or lawsuits brought against your company. So let’s take a closer look at how sole proprietorship and LLC taxes differ.
Read more about LLC types.
Sole proprietorship vs. LLC taxes
Regarding LLC vs. sole proprietorship, there are differences in how these business entities operate and pay taxes. Let’s examine how taxes are paid for both business structures.
Sole proprietorship taxes
- Sole proprietorships are not seen as corporate tax-paying entities. A sole proprietor’s taxable business income is subject to tax rates for individuals.
- Its losses and income are passed-through to the owner’s personal tax return via IRS or Internal Revenue Service Schedule C.
- The income generated by the sole proprietorship is also subject to self-employment taxes such as Social security and Medicare.
- Sole proprietorships must make quarterly estimated tax payments to the state, U.S. Treasury, and in some instances, the local tax authority because Medicare, Social Security, and income tax are not deducted from a salary or paycheck from an employer.
- LLCs are seen as disregarded entities unless the LLC owner makes a special tax election.
- LLCs are not recognized as their own tax-paying entity. The business obligations of the company go through to the LLC owner.
- If an LLC meets the eligibility requirements, it may choose to opt for corporate tax treatment as either a C or S corporation.
- This significantly reduces the self-employment tax burden as Medicare and Social Security are only applied to the owners’ salary or wages rather than to taxable business income.
- If electing C Corp status, the business files its own income tax returns, and the profits of the business are taxed at the corporate tax rate.
- This can be a drawback for some LLCs because profits will get taxed twice, once at the corporate level and then again at the individual level.
- However, income tax obligations pass through to the owner’s personal tax returns when electing the S Corp status.
- Many LLC owners choose to elect the S Corp status as it is more favorable regarding tax purposes.
Sole proprietorship vs. LLC: Formal requirements
Sole proprietorships have far fewer formal requirements when compared to LLCs. Let’s take a look at the requirements below:
Formal requirements for sole proprietorships
- Sole proprietorships do not need to register with the state before transacting.
- Depending on the industry they are involved in, they may need to obtain specific licenses and permits before operating.
- No formal action is required if you are operating under your name. However, you will need to file a DBA (doing business as) if you plan on conducting business under a different business name from your legal name.
- In some cases, you may need to acquire the necessary permits and business licenses, which will vary based on your industry, state, or region.
Formal requirements for LLCs
- When starting an LLC, you’ll need to file Articles of Organization, also referred to as the Certificate of Organization, with your Secretary of State.
- It’s also a good idea to have your LLC operating agreement drawn up to ensure that the rights and duties of all members and managers are clearly outlined.
- LLCs also require you to file documentation with state agencies and pay initial filing fees.
Ongoing compliance requirements
When running a sole proprietorship, there are no registration or ongoing filing requirements, so there are no corporate formalities or paperwork requirements. Business begins when you start transacting. LLCs have quite a few compliance requirements when compared to sole proprietorships. This is because LLCs will need to file annual reports with the Secretary of State, make payments of state fees and franchise taxes, and file income taxes with the Internal Revenue Service.
Sole proprietorship vs. LLC: Management structure
The management structure for a sole proprietorship vs. LLC differs significantly. Let’s take a look at it below:
Sole proprietorship management structure
- When it comes to sole proprietorships, the owner is the company itself, and therefore the company owner manages day-to-day operations.
LLC management structure
- One or more members can own LLCs.
- Additionally, owners or members of the LLC are allowed to manage the day-to-day operations of the limited liability company, or they can choose to nominate a manager outside of the LLC to handle the company’s operations.
Sole proprietorship vs. LLC: Ownership structure
The ownership structure of a sole proprietorship differs significantly from that of an LLC. Let’s take a closer look at the differences below:
Sole proprietorship ownership
- Sole proprietorships are owned and maintained by one individual. So the ownership structure is very straightforward.
- In some instances, married couples may also run a sole proprietorship.
- While sole proprietorships are entitled to all the company profits, they are also liable for all the debts and judgments associated with the company.
- Partnerships, trusts, corporations, foreign entities, and individuals can own LLCs. There are also no restrictions on the number of members or owners an LLC can have.
- LLCs are considered separate entities or separate legal entities from their owners and are not held personally liable for the debts, judgments, or lawsuits brought against the business.
- So in the case of LLCs, personal and business assets are separate.
Depending on your new business goals and industry, and the benefits you are after, be it simplicity in formation, compliance, or liability protection, both sole proprietorships and LLCs have advantages and disadvantages.
For some business owners, the fact that they are personally or legally protected from financial claims against the company is more than enough reason to go with the limited liability company.
However, if you value the independence and privacy that comes with the sole proprietorship entity type, and the fact that it’s a fairly fast and simple structure to get up and running, then the choice is yours.
To make an informed decision, research the requirements and limitations associated with LLCs and sole proprietorships.
Sole proprietorships are regarded as common-law business entities, so they don’t have to file formal paperwork with the state or need a registered agent.
A sole proprietorship is regarded as an unincorporated business having only one owner. However, taking on a business partner in a sole proprietorship is possible, thereby altering your entity from an unincorporated business to a general partnership.
A sole proprietorship is ideal for entrepreneurs and low-risk businesses that simply want to test their business ideas before formal registration with the state. However, when it comes to the risks of remaining unincorporated, you will need to consult with an attorney.
Sole proprietorships do not need to undergo formal registration requirements with the state. However, depending on the services offered or the industry, you must acquire the necessary licenses and permits before operating.
The sole proprietor or owner of the sole proprietorship is responsible for all expenses associated with the business. This means creditors may attach both fixed and personal property if the business owes money. Sole proprietorships do not have a separate identity under the law.