Sole Proprietorship vs. LLC: What’s the Difference? (2023)
Are you thinking about starting your own business?
With more than 580 million entrepreneurs worldwide, you certainly won’t be alone in your venture.
One of the first business decisions you’ll need to make is what type of business entity to establish.
Sole proprietorships and LLCs (limited liability companies) are two of the most straightforward entities to consider.
In this article, I compare and contrast sole proprietorships and LLCs, so you can decide which business entity is the right one for you.
What Is A Sole Proprietorship?
Starting a new business as a sole proprietor has some significant advantages.
For starters, it’s relatively simple and inexpensive to set up.
This type of business is also easy to maintain and gives the owner complete control over decision-making.
As a startup, sole proprietorships can be a great way to test your business idea without making a significant commitment.
Moreover, owners generally register a sole proprietorship in their name.
However, you can also get a DBA (or “doing business as”), which allows you to operate under a different name.
What Is An LLC?
A limited liability company (LLC) is a business entity offering personal liability protection to its owners.
LLC formation happens through several steps and requirements, which vary from state to state.
Owners create an LLC with its articles of organization, a governing document similar to a partnership agreement or corporate bylaws.
Moreover, the LLC operating agreement is another crucial document.
This document outlines the ownership and management rules for the company.
There’s also the concept of a registered agent.
This concept refers to a person or business that agrees to receive legal documents on behalf of the LLC.
One can also opt for a multi-member LLC, which more than one person owns.
Finally, there are also various state fees one needs to pay to form an LLC.
The right LLC formation service can help you with all the steps of this process and ensure you comply with your state’s requirements.
LLC vs. Sole Proprietorship
Let’s now compare sole proprietorship vs. LLC in more detail.
As entrepreneurs, knowing which business entity to choose is crucial to minimize personal risk and liability.
In terms of liability protection, an LLC owner has limited liability for the debts and obligations of the business.
The owner’s assets are protected if the LLC is sued or can’t pay its bills.
There are also tax advantages to choosing an LLC over a sole proprietorship.
Such advantages include the ability to deduct business expenses and to choose how the business will be taxed.
When it comes to the IRS and social security, the state taxes a sole proprietorship as a disregarded entity.
The business owners report their social security and Medicare taxes on their tax returns.
On the other hand, the state can consider an LLC as a partnership, S corporation, or C corporation for tax purposes.
Due to all these reasons, many people opt for a sole proprietorship when looking for a low-risk business structure.
However, there are some disadvantages to this type of business entity.
For starters, the sole proprietor has a personal liability regarding all debts and obligations of the business.
Said differently, the owner’s business assets are at risk if the business is sued or can’t pay its bills.
This distinction makes a big difference when it comes to personal liability protection.
Depending on their business structure, business owners must pay taxes differently.
LLCs offer tax advantages and liability protection that sole proprietorships don’t.
An LLC allows for pass-through taxation.
As pass-through entities, this type of taxation means the business owners can report their share of the LLC’s profits or losses on their personal tax returns.
LLC owners’ personal income tax rate is usually lower than corporate tax.
This tax rate is generally the same if one registers their business as a sole proprietorship.
Compared to corporate tax, the self-employment tax rate is lower for these two types of businesses.
Paperwork And Compliance
Business owners must fill in different forms depending on whether they register as a sole proprietorship or LLC.
Business owners must file Articles of Organization with the state as an LLC.
On the other hand, setting up a sole proprietorship is much simpler.
Then, when reporting taxes, LLC owners need to file business tax information with their income tax returns.
As a sole proprietor, Schedule C’s form declares profits and losses from the business.
As a business owner, your LLC makes you a separate legal entity from your business.
Such an arrangement provides various benefits, including limited liability protection.
In terms of personal assets, LLCs protect them if one’s business is sued or can’t pay its debts.
As a sole proprietor, personal liability protection doesn’t exist, and your assets are at risk if something goes wrong with your business.
Ease Of Formation And Operation
As a business entity, an LLC is more complex to form than a sole proprietorship.
This process includes filing paperwork with the state and paying fees.
Both of these make incorporation more complex and expensive than forming an LLC.
During their operation, not much difference exists between LLCs and sole proprietorships.
However, an LLC is a separate legal entity from small business owners.
The business will continue to exist even if the owner dies or leaves the company.
This only changes if the owner has set specific measures to dissolve the company.
Sole proprietorships don’t have this level of permanence and will usually end when the owner dies or leaves the business.
A business license is required depending on the type of business you’re running.
Businesses require such licenses irrespective of whether the company is a sole proprietorship or LLC.
For example, you’ll need a liquor license if you’re running and selling alcohol.
You’ll need to get a food handler’s license while running a restaurant.
Businesses that deal with hazardous materials or sell alcohol might need to obtain a special license or permit.
Having a bank account that is separate from your account is a good idea for any business owner.
You want your assets to be safe if you have business debts.
For LLCs, the law requires this separation.
Opening a business bank account is a simple process that can be done online or in person at most banks.
Mixing Business Funds And Personal Finances
As a sole proprietor, there isn’t much difference between your business and personal finances.
That said, doing your best to separate things is a good idea.
On the other hand, this must happen in an LLC since there is a legal division between the two.
Does Your Business Name Need To Be Registered?
As an LLC, you must register your business name with the state.
In addition, the law requires that ‘limited liability company’ / ‘LLC’ be after your business’s legal name.
With a filing fee of around $100 – $500, depending on the state, this is a relatively simple and inexpensive process.
For sole proprietors, the need to register your business name with the state varies.
You might be required to do so if your business name includes certain restricted words or phrases.
If you’re using a fictitious name for your business that’s different from your personal name, then registering this name is usually required.
The process and fees for registering a business name as a sole proprietor are usually the same as when forming an LLC.
Pros And Cons
Pros And Cons Of A Sole Proprietorship
Here are some critical pros of being a sole proprietor:
- You’re in complete control of your business.
- You don’t have to file any special paperwork with the government to get started.
- It’s easy to set up and start operating.
- You can change your business structure at any time without any legal consequences.
- You only have to pay self-employment payroll taxes on your business income.
However, there are also some cons to consider:
- You’re personally liable for all debts and obligations of the business.
- It can be harder to raise capital since you’re the only owner.
- There’s no separation between your finances and business finances.
The Pros & Cons Of Forming An LLC
Here are the pros of forming an LLC:
- As its legal entity, a multi-member or a single-member LLC offers limited liability protection to its owners. The owner’s assets are protected if the business is sued or incurs debt.
- Having its legal protection can make it easier to raise capital since investors will be more willing to invest in a business that has some level of asset protection.
- An LLC can be taxed as an S corporation, meaning the business income is only taxed once at the owner level. An S corp can save on taxes compared to a sole proprietorship or partnership, where the business income is taxed twice.
However, there are also some cons to consider:
- Depending on the state, you’ll need to file an annual report with the state and pay a filing fee.
- LLCs don’t usually qualify for Medicare or Medicaid, which means that the owners will need to obtain health insurance through other means.
- If you want to change your business structure, you’ll need to dissolve your LLC and start a new one. This process can be time-consuming and expensive.
Sole Proprietorship vs. LLC – FAQ
What Is An S Corp?
In the United States, an S corporation is a corporation that has elected the state to tax it under the Subchapter S of the Internal Revenue Code.
This arrangement allows the corporation to avoid double taxation of corporate income.
All shareholders must make the election for the business to qualify as an S corporation.
What Does The Secretary Of State Do?
The Secretary of State is responsible for maintaining public records and ensuring compliance with state laws.
The office also handles elections, business registrations, and public notary applications.
Is An LLC Or Sole Proprietorship Better For New Business Owners?
There is no one-size-fits-all answer to this question, as the best business structure for a new owner will depend on a variety of factors, including the type of business, the owner’s goals and objectives, and the owner’s financial situation.
However, in general, LLCs offer more flexibility and protection for owners than sole proprietorships.
Do Business Owners Pay Personal Income Tax As An LLC?
No, business owners do not pay personal income tax as an LLC.
Instead, the state taxes them on their share of the LLC’s profits.
Does A Personal Tax Return Need To Be Filed For An LLC?
No, one doesn’t have to file a personal tax return for an LLC.
The LLC will file its tax return, and the owners will report their share of the profits (or losses) on their tax returns.
Are Personal And Business Assets Separate In An LLC?
Yes, personal and business assets are separate in an LLC.
If the LLC is sued or goes bankrupt, the owner’s assets will not be at risk.
What Are Tax Benefits For An LLC?
LLCs offer several tax benefits, including pass-through taxation and the ability to deduct business expenses.
LLC owners also have the option of electing to be taxed as a corporation, which can provide additional tax advantages.
Is Getting Business Credit Easier With An LLC?
Business credit is generally more accessible with an LLC than a sole proprietorship.
Lenders view LLCs as separate legal entities and see them as less risky.
As a result, LLCs often have an easier time securing loans and other forms of financing.
Knowing the differences between a sole proprietorship and an LLC can help you decide which business structure is suitable for your company.
Going into business as a sole proprietor may be the most straightforward option, but you’ll be personally liable for all debts and obligations of the company.
Forming an LLC can offer some protection for your assets, but it’s important to note that additional costs and paperwork are involved.
Ultimately, the decision should come down to what will work best for your business.
Further reading on AdamEnfroy.com: If you’re going with an LLC setup, the right registered agent service can save you a lot of time and hassle.
Moreover, hiring an LLC setup and maintenance provider to help with the paperwork can give you peace of mind and help ensure that your company complies with state laws.
Check out my post on the best LLC services to see some of my top picks.
In addition, a business checking account for LLCs can help you keep your personal and business finances separate.