Are you wondering if you should form a limited liability company (LLC) or a sole proprietorship for your small business? Forming a sole proprietorship vs. an LLC is one of the first questions a small business owner must ask themselves when establishing any type of business.
Read on to learn the differences between these two business entity types so you can make the right choice for your business.
Sole Proprietorships vs. LLCs: An Overview
What type of business structure is best for you: an LLC or a sole proprietorship? This article examines several key factors and how they relate to each of these entity types to help you make the best decision for your situation.
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 a corporation or a partnership and you must report your business income and expenses on Schedule C as part of your personal income tax return (Form 1040).
What is an LLC?
If you want to do business and protect yourself and your personal assets from any negative consequences as a result of running your business, you can complete paperwork to form an LLC. Creating an LLC is like creating another person — on paper, of course — because the LLC is held responsible for anything and everything that happens instead of the LLC’s owner.
An LLC is a legal entity formed according to the laws of each state. You can create an LLC by filing documents known as the Articles of Organization with your state’s business department (sometimes called the office of the Secretary of State). An LLC can be owned by one person (i.e., a single-member LLC or SMLLC) or by more than one person (i.e., a multi-member LLC or MMLLC).
Sole Proprietorship vs. LLC Comparison Chart
Ownership and Management
Costs To Renew and Maintain
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.
The most important formation document for an LLC is called the Articles of Organization. This document establishes your LLC’s existence, and you must file it with the state in which you’re operating your business. The cost to file Articles of Organization varies by state.
Ownership and Management
A sole proprietorship has just one person managing the business. That owner can make all business decisions as they see fit without input from any 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.
An LLC’s operational and management structure is typically outlined in its Operating Agreement. Although only a handful of states require an Operating Agreement, most LLCs have one — particularly those with multiple members. The 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.
A sole proprietorship doesn’t provide this type of protection. It offers no legal separation between the business and the sole owner. That means the owner is responsible for covering any debts, such as if the business 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 aren’t financially responsible for the debts or obligations of the business. That means a court can’t seize those owners’ personal assets to pay for such debts or obligations.
A sole proprietorship must pay a self-employment tax of 13.3 percent. Part of this tax goes toward Social Security and part goes toward Medicare.
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. No matter which business structure you adopt, you’ll need to pay payroll taxes if you have employees. You’ll also need to collect state and local sales taxes if you sell taxable goods or services. Finally, as a self-employed business owner, you’re responsible for paying self-employment taxes to the IRS. These taxes cover your Social Security and Medicare tax obligations.
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.
LLCs Can Choose Corporate Tax Status
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.
Sole Proprietorship vs. LLC: Advantages and Disadvantages
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 proprietorships have five main 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.
Some of the disadvantages of a sole proprietorship include:
- It offers no personal protection.
- It isn’t considered a business entity.
- It doesn’t enable you to build business credit
- If your business goes bankrupt, so do you.
LLC Advantages and Disadvantages
LLCs are easy to start, provide a layer of liability protection for their owner(s), are considered a credible business, and can be used to build business credit.
But, LLC owners still need to pay self-employment (Social Security and Medicare) as well as employment taxes if they hire employees.
Sole Proprietorship vs. LLC FAQ
Which is better, an LLC or a sole proprietorship?
If you want to build a business, an LLC is your best bet. It provides personal liability protection and tax benefits, which you can’t get from a sole proprietorship.
Should I change my business from a sole proprietor to an LLC?
Changing from a sole proprietorship to an LLC is an advisable move to build credibility and trust for your business as well as to protect your personal assets.
Do LLCs pay more taxes than sole proprietorships?
LLC owners are required to pay self-employment taxes. Costs for completing the annual tax return of an LLC may be higher than that of a sole proprietorship.
Is a single-member LLC the same as a sole proprietorship?
No. A sole proprietorship doesn’t provide personal liability protection, but an LLC does. In addition, sole proprietorships are considered informal businesses whereas an LLC is a formal, legal type of business entity.
When should a sole proprietor become an LLC?
The sole owner is open to liability and should create an LLC to provide legal protection. The LLC business structure provides a separation between the company’s assets and an owner’s personal assets.
Do sole proprietors pay taxes?
Sole proprietors must report all business income or losses on their personal income tax returns. The business itself isn’t taxed separately.
What are the advantages of changing from a sole proprietorship to an LLC?
Transitioning from a sole proprietorship to an LLC will protect your personal assets by setting them apart from your business assets. In the event of bankruptcy or a lawsuit filed against your company, your personal assets will no longer be at risk.
What are the disadvantages of changing from a sole proprietorship to an LLC?
LLCs are still subject to self-employment taxes. An LLC’s profits won’t be taxed at the corporate level, but will pass through to its members who must account for their share of those profits on their personal income tax returns.