What is the difference between a sole proprietorship vs LLC?
How do you choose between one or the other?
What are their advantages and disadvantages?
In this article, we will break down the notion of “sole proprietorship vs LLC” so you know all there is to know about it.
We will look at the LLC vs sole proprietorship differences, their benefits, drawbacks, tax benefits, how to choose between a sole proprietor vs LLC, how each structure can impact personal liability, business credibility, business financing options and more.
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Table of Contents
What is a sole proprietorship and LLC
A sole proprietorship is the simplest form of business structure that you can operate.
A sole proprietorship is an unregistered business that you can operate without having to file any paperwork with the state.
If you wake up today and start doing business, you are automatically a sole proprietor.
In essence, your business is not a separate entity and apart from your personal affairs.
Your personal creditors can come after your business assets and your business creditors can come after your personal assets like your house, car, savings, investments, savings account and others.
A limited liability company or LLC is one of the most common types of small businesses operated in the United States.
Typically, you will have a single-member LLC (or single-owner) or multi-owner LLC.
When you operate a business under an LLC, you are essentially running the business as a separate legal entity.
To do that, however, you’ll need to legally register the LLC by filing its articles of organization and paying the required filing fees.
A well-managed LLC can provide you with limited liability protection whereby the LLC creditors or business creditors cannot come after your personal assets.
Similarly, your personal creditors cannot seize the assets of the LLC.
The limited liability protection, in many cases, is the main reason why someone chooses an LLC over a sole proprietorship.
With an LLC, the idea is to shield your personal assets from business liability.
To sum up:
A sole proprietorship is an unincorporated business owned and managed by one person (the “sole proprietor” or “proprietor”) under his or her name or fictitious name (DBA) whereas an LLC is a legal entity that is separate and distinct from the business owner (the “member”) and can be owned and managed by one or more people.
Difference between sole proprietorship and LLC
The most common forms of business structure in the United States is the sole proprietorship and a limited liability company (LLC).
Most small businesses are either operated under a sole proprietorship structure or LLC structure.
Whether you are looking to start an online business, rental property business, consulting company, open a restaurant, sell food or other goods, you need to select the most appropriate business structure for your business.
To give you a quick bird’s eye view of the differences between a sole proprietor vs LLC, we have compiled a table outlining the main aspects to consider.
Here is a snapshot of what you need to know when dealing with a sole proprietorship and LLC:
|Business formation||No formal action is required unless you register for a DBA||A legal entity must be formed at the state level by filing articles of organization|
|Business income||Taxed in the hands of the proprietor (pass-through taxation)||An LLC offers the flexibility to be taxed like a sole proprietor, partnership or corporation (offers pass-through taxation)|
|Personal liability protection||No protection offered to the business owner. The sole proprietor is responsible for business debt and liability||Limited liability protection afforded to the members. The LLC members are not personally responsible for LLC debt and liabilities|
|Start-up cost||None unless you register a DBA||Formation fees of $50 to $500 are to be expected|
|Ongoing costs||None unless you have registered a DBA||Yearly or periodic fees required to be paid to the State. May also need to pay Franchise Tax|
|Compliance||No annual state filings unless you need to renew a DBA registration||Annual report, biennial report or periodic reports required to be filed with the State|
|Business ownership||The business owner and the business are the same. Sole proprietor owns 100% of the business.||The LLC operates as a separate legal entity and is distinct from its members. One member can own 100% of ownership or many members with varying percentage ownership|
|Management||The sole proprietor makes all business decisions and operates the business||The business can be owned by one or more members who can appoint managers to run the business|
|Governance||No formality in managing the sole proprietorship||An operating agreement is needed laying out the LLC internal governing rules|
|Business funds||Sole proprietor can mix business funds with personal funds||Members must keep separate records for LLC funds from personal records|
|Business name||Sole proprietor can operate under his or her personal name or DBA (doing business as)||Members must operate under the registered LLC name and must always include “LLC” or “Limited Liability Company” in legal paperwork|
|Business financing||Difficult to get financing to grow the business||Better than sole proprietorship to get business financing|
|Business credit||Difficult to build a business credit score||Can create a separate business credit score|
|Registered agent||Not required||Required|
At the end of the day, choosing the right business structure in business is a critical decision and should not be taken lightly.
You should look at your overall business objectives, risk and needs so you can make the right decision in setting up the right business structure.
If you think about it, setting up your business structure may very well be your first important “business decision”!
Benefits of LLC vs sole proprietorship
Entrepreneurs electing to operate their business as sole proprietors are looking for a simple business structure setup.
However, a sole proprietorship setup may not be optimal in providing the business owner legal and tax benefits that other types of business structures can offer such as an LLC.
An LLC, on the other hand, requires more formality to form as compared to a sole proprietorship.
The additional effort and cost may be worth it as the LLC will provide its members (the business owners) the limited liability protection of a corporation and the tax advantages of a partnership.
Let’s look at some of the main aspects of operating an LLC vs proprietorship.
Limited liability protection
An important benefit in operating a business as an LLC instead of a sole proprietorship is with regard to the limited liability protection.
Considering the LLC operates as a separate legal entity, it will own its own assets and liabilities.
To the extent a business is profitable and making money, having an LLC or sole proprietor structure will not make much difference as things are going great.
However, in the event things do not go as planned and the business loses money or becomes insolvent, that’s when an LLC will shine compared to a sole proprietorship setup.
An LLC creditor will not be able to personally pursue the assets of the LLC members behind the LLC.
That’s what we mean by limited liability protection.
The members of the LLC are not personally responsible to pay the debts and liabilities of the LLC.
On the other hand, a sole proprietor will be fully responsible for all the debts and liabilities of the business.
The biggest risk assumed by a single proprietor is that he or she constantly assumes unlimited liability in operating the business.
In the unfortunate event of the business having debt or liability that it cannot cover, the sole proprietor’s personal assets are exposed in a potential lawsuit or seizure.
Another important distinction between an LLC vs sole proprietor is with regards to taxation.
If you operate a business under a sole proprietorship structure, the business income is taxed directly in the hands of the sole proprietor.
The sole proprietor will need to report the business income and expenses on its personal income tax.
However, an LLC can offer more flexible tax treatments as it can be taxed similarly as a sole proprietorship, partnership or corporation.
An LLC can elect to have business taxes taxed in the hands of the LLC or directly in the hands of its members.
It’s up to the members to decide how the LLC will be taxed.
In this context, the members can make the most suitable tax election based on their personal and business circumstances.
Sole proprietorship vs LLC advantages and disadvantages
In this section, we will provide you with the pros and cons of LLC vs sole proprietorship to help you in your decision-making process as to which structure may be the right one for you.
Operating a single-member LLC vs sole proprietorship can provide similar results but also important differences that may potentially impact your business in the future.
It’s best to consider the benefits and drawbacks of the sole proprietor and sole proprietor structures now before it’s too late.
|Business formation||No legal paperwork required to form a sole proprietorship|
|Business income||Does not have to pay business taxes or unemployment taxes. Must only file a personal income tax to pay federal, state, local and FICA taxes (Federal Insurance Contribution Act) – Pass-through taxation|
|Business expenses||Can turn some personal expenses into business expenses (use of home, car, home office)|
|Personal liability protection||Without a separate legal entity, the sole proprietor does not have liability protection against business debt, liability, lawsuits and losses|
|Start-up cost||No start-up costs|
|Ongoing costs||No ongoing costs|
|Compliance||No annual reports required to be filed with the State|
|Business ownership||One person owning the sole proprietorship|
|Management||One person managing the business|
|Governance||No internal governance rules required|
|Business funds||No major consequence for mixing personal funds with business funds|
|Business name||Does not have the protection of a business name unless a DBA is registered offering very limited business name protection|
|Business financing||Difficult to find equity financing as investors do not invest in sole proprietors and banks to offer “personal loan” for business|
|Business credit||Difficult to build business credit|
|Business credibility||Less business credibility than an LLC|
Limited liability company
|Business formation||Must legally form an LLC a the state level by filing articles of organization|
|Business income||Can elect to be taxed like an S-Corporation, C-Corporation, partnership or sole proprietorship||Can be required to pay State Business Taxes or Unemployment Taxes|
|Business expenses||Can elect to be taxed like an S-Corporation, C-Corporation, partnership or sole proprietorship||The cost of filing a tax return may be higher|
|Personal liability protection||With limited liability protection, LLC members have protection against business debt, liability, lawsuits and losses|
|Start-up cost||Between $50 to $500 depending on the state|
|Ongoing costs||Annual, biennial or periodic reports to be filed with the state (along with annual fees)|
|Compliance||Must remain in good standing with the state|
|Business ownership||Can be owned by one or more members|
|Management||Can be managed by the members or managers (non-owners)|
|Governance||An operating agreement is required to govern the internal operations between members (voting rights, entering and exiting rules, distributions etc)|
|Business funds||Must not commingle business funds with personal funds to preserve the limited liability protection|
|Business name||With the LLC registration, the business name is offered greater protection in the registered state||Must ensure to use “LLC” or “Limited Company” when dealing on behalf of the LLC to preserve limited liability protection|
|Business financing||Easier to find equity financing from investors and debt financing from banks, can get business credit cards, small business loans, get factoring services, trade credit and more|
|Business credit||Can establish a business credit score|
|Business credibility||Greater market credibility|
Sole proprietorship vs LLC taxes
A sole proprietorship will report business income on his or her personal income tax.
In other words, a sole proprietor will only have one income tax to file for personal income and business income.
As for an LLC, although it is a separate legal entity and provides its members with the liability protection of a corporation, the LLC will have its income taxed in the hands of its members.
Here is an overview of what you can expect from a tax point of view when looking at an LLC vs sole proprietorship:
|Income tax report||Schedule C (Form 1040)||Schedule C (Form 1040)|
|Net income taxation||Taxable no matter if you withdraw cash from business or not||Taxed as a C Corp, S Corp, partnership or sole proprietorship|
|Business expenses||Deductible from gross income||Deductible based on the tax election (can be similar to sole proprietorship or corporation)|
|Recordkeeping obligations||Must keep all income and expense records to show net income||Must keep all income and expense records|
|Tax ID number||Only needed if you hire an employee||Needed|
Choosing between LLC or sole proprietorship
How do you choose between an LLC or sole proprietorship?
If you are looking to start a business, you may be thinking about the need to register an LLC or not?
Sole proprietorships are good business structures:
- When you operate in a low-risk industry
- When you want to test your business idea on a small scale before going big
- For side-businesses that do not generate a lot of revenue to justify the additional cost of maintaining and LLC
- When you want to make 100% of the business decisions
- When you want to own 100% of the business
- When you want to be able to stop doing business without any formality or having to dissolve a legal entity
- When you don’t want to complicate your income tax filing obligations
Limited liability companies are ideal business structures:
- When you will operate in a medium or high-risk industry
- When you want to protect your personal assets from any recourse
- When you want to build a business credit score to get debt financing
- When you want to appear more credible before clients, vendors and investors
- When you want to attract equity investors
- When you want to have the option to be taxed like a corporation or benefit from pass-through taxation
Sole proprietorship vs LLC FAQ
Is an LLC a sole proprietorship
An LLC is not a sole proprietorship.
There are some significant differences between a sole proprietor vs single-member LLC.
In a nutshell, the first and most important difference is that a limited liability company offers its member or business owner protection against business risk.
We refer to this as “limited liability protection”.
What this means is that the LLC will shelter and shield the business owner’s personal assets from claims and lawsuits filed by the LLC creditors.
This is the case as the LLC is a business entity that is separate from its owner.
On the other hand, the sole proprietor is not legally protected from business debt claims, commercial lawsuits, business creditor actions.
The sole proprietor’s personal assets are exposed to being seized to cover any outstanding business debt, losses or liabilities.
The second most notable difference between an LLC and sole proprietor is with regards to how business income and expenses are taxed.
The sole proprietorship business income is taxed on the sole proprietor’s personal income tax (pass-through taxation).
On the other hand, an LLC offers greater flexibility to the member as it can choose to be taxed like a corporation, partnership or sole proprietor.
An LLC can choose to be taxed like a corporation as a separate entity or take advantage of pass-through taxation if it makes sense.
Can a sole proprietor be an LLC
Yes, a sole proprietor can operate as a single-member LLC.
As the sole member of the LLC, you are the only person making all the business decisions and calling all the shots.
The main consideration for a sole proprietor to operate a business under an LLC is that you’ll need to:
- Legally form your LLC with the state
- File annual reports, biennial reports or periodic reports with the state
- Pay annual fees or annual franchise tax
- Ensure you separate the bookkeeping of your business income and expenses to preserve your limited liability protection
Should I form an LLC or sole proprietorship
Forming an LLC or sole proprietorship will depend on the type of business you want to operate and your future goals.
If you are going to operate a small side-gig with very little risk, a sole proprietorship structure may work just fine.
However, if you are looking to start a business in a risky industry or you intend to take the commercial risk to grow the business, you will want to separate the business operation from your personal life by forming an LLC.
In most cases, the cost of forming an LLC, maintaining it in good standing and handling additional paperwork for tax purposes may be worth it.
Is a single-member LLC the same as a sole proprietorship
A single-member LLC is an LLC owned and operated by one person whereas a sole proprietorship is a business operated under an individual’s personal name or DBA.
They are very close in structure as the business is owned and operated by the same person.
However, they are different as a limited liability company is a legal entity formed under state laws whereas a sole proprietor does not need to form a business entity to operate as a sole proprietor.
Also, a single-member LLC is a disregarded entity by the IRS and is taxed the same way as a sole proprietorship.
As a result, income passes through to the LLC single member.
Is an LLC better for taxes
The LLC offers important tax advantages, benefits and flexibilities that may not be available to a sole proprietor.
What are the tax benefits of LLC vs sole proprietorship?
Here is how the sole proprietorship versus LLC tax differences:
- Both the LLC and sole proprietorship must file their income tax report on Schedule C (Form 1040)
- You can make a tax election to be taxed as a C Corp, S Corp, partnership or sole proprietor if you operate an LLC, this offers additional tax flexibility than a sole proprietor setup
- Both the sole proprietor and LLC offer the possibility of pass-through taxation
You’ll need to consider the specific tax rules applicable to you as a sole proprietor or as a limited liability company to see what works best for the business you intend to operate.
How to choose between sole proprietorship and LLC
There is not a cookie-cutter answer to this question.
Choosing between a sole proprietorship or LLC should be done based on careful analysis and due diligence.
Although in many cases, operating a business under a separate legal entity such as an LLC can be beneficial in protecting personal assets, in some other cases operating a sole proprietorship can be simpler and more appropriate.
The most important considerations in choosing between a limited liability company vs sole proprietorship can be boiled down to the following aspects:
- Personal asset protection
- Pass-through taxation
- Set up costs
- Capital funding (debt or equity)
If the simplicity of the sole proprietorship set up is the driving force, then that’s what you need.
If personal asset protection from business creditors is your main concern, perhaps the LLC is a better option.
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