Sole Proprietorship vs. LLC

Are you wondering if you should form a limited liability company (LLC) or a sole proprietorship for your small business? If you’re looking at getting started, this is likely one of the first questions you’ll ask yourself before establishing your business.

This Sole Proprietorship vs LLC article will cover the differences between these two business entity types, as well as the situations in which each one is better suited, to help make the right choice for your business.

Sole Proprietorships vs LLCs: An Overview

LLCs and sole proprietorships are perhaps the two most frequently seen business structures among many small business owners and startups.

Before walking you through the key differences between these two common business structures, we’ve quickly explained what they are and how they work in the sections below.

What is a Sole Proprietorship

Anytime you register a business under your name — even if you do business using a different name — the Internal Revenue Service (IRS) and your state will consider you a sole proprietor. That means you’re responsible for anything and everything that happens as a result of running your business.

A sole proprietorship is an unincorporated business owned by one person. As a sole proprietor, your business isn’t treated as a separate legal entity for tax purposes, meaning you’ll need to report your business income and expenses on Schedule C as part of your personal tax return (Form 1040).

What is an LLC

If you want to test a business idea and protect yourself and your personal assets from any of the debts or liabilities that may arise as a result of running your business, creating an LLC is a great option.

This process organizes your business as a separate legal entity in the eyes of the law, meaning you can’t be that you cannot be held personally responsible for any sticky financial situations your LLC may find itself in, as long as it remains compliant.

Each state will have its own specific laws regarding the formation of an LLC, though it generally involves selecting an appropriate and available name, appointing a registered agent, and filing documents known as the Articles of Organization with your Secretary of State (or equivalent). 

LLC and Sole Proprietorship Differences

	LLC	Sole Proprietorship
Formation	Requires registration of an available name Owners must file Articles of Organization Must get relevant business licenses and permits	Must get relevant business licenses and permits
Ownership and Management	Owners/members can either make business decisions themselves or appoint managers to handle the daily operations Good practice for the LLC to create an Operating Agreement	The sole owner makes all the business decisions
Liability Protection	Owners/members aren’t held personally liable for business debts	The sole owner is liable for business debts
Taxes	LLCs have ”pass-through” taxation by default Option to elect C corporation or S corporation tax designation	Sole proprietorships have pass-through taxation
Costs To Renew and Maintain	File annual reports Renew business licenses and permits Pay necessary taxes	Renew business licenses and permits Pay necessary taxes

Formation

Any person selling goods and services without a partner is a sole proprietor by default. Depending on the location of your business, you might need to apply for business licenses or zoning permits to legally operate your sole proprietorship. That’s it as far as formation paperwork goes, making sole proprietorships the easiest and least expensive type of business to start.

By contrast, LLCs are required to file a document called the Articles of Organization with their Secretary of State — though this may be referred to a Certificate of Formation/Organization in your state.

All this document does is officially establish your LLC’s existence within your state by providing the government with essential pieces of information regarding your LLC, such as its legal name, primary business address, management structure, and registered agent details.

Ownership and Management

In a sole proprietorship, one person is responsible for running the business and making all important decisions as they see fit — without any input from a third party.

Of course, most sole proprietors decide to hire employees, legal experts, accounting professionals, and other individuals to help with the daily management of their business. But, a sole proprietor only has to ensure their business operates safely and legally and that there’s enough profit to cover business debts.

In contrast to this, LLCs can have a range of different operational and management structures according to their needs (e.g., single/multi-member, and member/manager managed LLCs). This will typically be outlined in an operating agreement — even though this is only a requirement in a handful of states, most LLCs have one.

The LLC operating agreement outlines each member’s ownership stake in the business, voting rights, and profit share. An LLC can be managed by its members or managed by an appointed manager. Usually, LLC members decide on company matters in proportion to their ownership stake — called membership units — in the business.

Liability Protection

A sole proprietorship doesn’t provide this type of protection as it doesn’t offer any legal separation between the business and its owner. As a result, this means that the owner is responsible for covering any liabilities or debts the business may accumulate (e.g., if it defaults on a loan or loses a lawsuit).

An LLC, on the other hand, provides liability protection to its owners. If the business defaults on a loan, but obeyed all local, state, and federal rules and regulations and acted properly, the owners can’t be held financially responsible for the business’s debts or obligations. This means that a court can’t seize those owners’ personal assets to pay for the LLC’s liabilities (only business assets can be used).

Taxes

A single-member LLC and a sole proprietorship resemble each other in terms of tax treatment. Both are “pass-through entities,” which means the business itself doesn’t pay income taxes. The owner must report business income on Schedule C attached to their personal income tax return, and that income gets taxed at the owner’s personal income tax rate.

Multi-member LLCs also are “pass-through entities” with each owner reporting and paying taxes on their share of the business’s income. The only difference is that a multi-member LLC must file a business tax return with the IRS: Form 1065, U.S. Return of Partnership Income. In addition, each member must attach Schedule K-1 to their personal income tax return, which shows their share of the business’s income.

Beyond income taxes, both LLCs and sole proprietorships might have additional tax responsibilities, including:

• Payroll Taxes: No matter which business structure you adopt, you’ll need to pay payroll taxes if you have employees
• Sales Tax: You’ll also need to collect state and local sales taxes if you sell taxable goods or services
• Self-employment Tax: Finally, as a self-employed business owner, you’re responsible for paying self-employment taxes to the IRS (e.g., Social Security and Medicare)

Understanding these tax responsibilities is extremely important because choosing the wrong organizational structure for your business can negatively impact your bottom line. It’s always best to discuss your business structure options with an attorney or legal advisor.

LLC Tax Flexibility

A key difference between LLCs and sole proprietorships is tax flexibility. They can either choose the default status — “pass-through” taxation — or elect for their LLC to have an S corporation (S corp) or C corporation (C corp) tax designation. If taxed as a C corp, an LLC will pay a 21 percent corporate income tax at the federal level. But, most states and some localities also levy corporate taxes.

LLCs can sometimes save money by electing corporate tax status. When a company is taxed as a corporation, for example, dividends from the business are usually taxed at a lower rate than ordinary business income. In contrast, LLC members can’t treat income as dividends and must pay taxes on all profits of the business.

Check out StateRequirement’s guide to LLC Taxes for more information.

Costs to Renew and Maintain

A sole proprietorship requires the least amount of paperwork prior to launch. After launch, a sole proprietor only needs to keep up with federal, state, and local taxes. In addition, a sole proprietor might need to renew relevant business licenses and permits.

LLCs have more compliance responsibilities. After filing initial Articles of Organization, an LLC must file an annual report in many states. LLCs with multiple members have even more responsibilities, such as drafting an Operating Agreement, issuing membership units, recording transfers of ownership, and holding member meetings.

While none of these steps are legally required, they’re all highly advisable to help LLCs preserve their members’ liability protection. Since an LLC is a registered business entity, dissolving an LLC takes additional paperwork. An LLC with a corporate tax status also is eligible for more tax deductions and credits.

Pros and Cons of LLC vs Sole Proprietorship

Both sole proprietorship and LLCs have their own advantages and disadvantages. As with every business decision, it’s best to consult with your legal advisor before making a final choice so you know you’ve considered all of the key factors.

Sole Proprietorship Advantages and Disadvantages

Sole Proprietorship Advantages

• They’re easy to start
• They require no filing fees
• They have no annual fees
• They have simple tax filings
• As the owner, you’re your own boss and decision-maker

Sole Proprietorship Disadvantages

• They don’t offers any personal protection
• They aren’t considered a separate business entity
• They don’t enable you to build business credit
• If your business goes bankrupt, so do you

LLC Advantages and Disadvantages

LLC Advantages

• They provide personal liability protection, which keeps your personal assets safe
• They offer flexibility in terms of management and profit distribution
• They enjoy pass-through taxation and avoid the double taxation of corporations
• They can build business credit, enhancing financing opportunities
• They are relatively straightforward to form

LLC Disadvantages

• They have higher formation and annual maintenance fees
• They require more paperwork and formalities
• The self-employment taxes they may face could be higher than corporate tax rates
• They can be tricky to raise capital from investors compared to corporations