Looking to understand the differences between a sole proprietorship and a Limited Liability Company (LLC)? You’ve come to the right place.
When establishing a small firm, setting up a web store, or starting a freelancing side activity, you must decide if a sole proprietorship or limited liability company will be the better legal structure for you and your needs.
These two operating models can have a substantial impact on just how you operate your firm in terms of legal, tax, and management. Here’s what you should know.
What is a Sole Proprietorship
A sole proprietorship is an unincorporated business owned and run by one person. This option is the simplest, no muss, no fuss structure out there. You are entitled to all the profits of the business. However, unlike an LLC, you are also responsible for all of the liability.
What is an LLC?
A limited liability company (LLC) is a legal entity formed at the state level. An LLC exists separately from its owners—known as members. However, members are not personally responsible for business debts and liabilities. Instead, the LLC is responsible.
LLC vs. Sole Proprietorship
Choosing the right business structure when you start a new venture is a critical decision. Many small business owners favor these two popular setups for their flexibility and simplicity—limited liability companies (LLCs) and sole proprietorships.
Which one you decide on will depend on your situation, but some things you should consider when choosing your business structure are:
- Start-up costs
- Government regulation and how it could impact you
- Liability protection
- Tax implications
LLC vs. Sole Proprietorship differences
The following is a comparison of the key differences:
|Personal liability||Not liable for business debts and liabilities||Personally liable for business debts and liabilities|
|Management structure||1 or more members||One member|
|Mixing business funds and personal finances||Not permitted||Permitted|
|Business name registration||LLC required in company name (most states)||Operate under own name or DBA (“doing business as”)|
|Taxation||Profits taxed once via pass-through taxation on the owner’s personal returns||Profits taxed once via pass-through taxation. No option to file as a corp|
|Formation||Straight forward. File your Articles of Org & file forms with your Sec. of State||No formal action required to form Sole Prop. if operating under your own name|
|Fees||Pay a filing fee of between $50-$500||No costs. Register a DBA for $10-$120|
LLC vs. Sole Proprietorship management structures
In an LLC, the business can be owned by one or more members. Its members usually manage an LLC, but they can also appoint a manager to handle the day-to-day operation.
The membership of an LLC and the way it will be run are laid out in a legal document known as an operating agreement.
Personal Liability Protection differences
With an LLC, your individual assets are considered hands-off when it comes to business debt collection or other claims if your company is sued. In most cases, creditors can’t touch your home, car, or personal bank accounts.
In a sole proprietorship, there is no separation between you and the business. You are entitled to all of the profits, along with all of the debts and obligations. You can even be held responsible for liabilities caused by your employees.
Mixing business funds and personal finances
Sole proprietors don’t have to worry about mixing business and personal accounts from a legal standpoint. In the eyes of the law, they’re regarded as one and the same. However, the practice is still discouraged by most experts.
In an LLC, you must be careful to keep banking records and funds separate from your own personal records and funds. Violating this rule can result in the loss of your limited liability protection.
Business name registration
State regulation of LLCs include required words which must be included in an LLC name—for example, “LLC” or “limited liability company” might be required at the end of an LLC’s name. Registering your LLC does give your name protection within your state.
Sole proprietors don’t face the same requirements. However, if the business owner plans on operating under a company name, instead of under their own name, they will need to register for a “fictitious business name,” or DBA (“doing business as”), in their home state.
Tax Implications for Sole proprietorship vs LLCs
By default, all profits made by an LLC are only taxed once. This is known as pass-through taxation. As the owner, the tax liability belongs to you and passes through to your personal tax return.
To file taxes, you report your operating results, including profit or loss, by submitting Profit or Loss From Business (Sole Proprietorship) (Form 1040, Schedule C) with your personal 1040 tax return. An LLC is very flexible and can also be taxed as a sole proprietorship, a partnership, or a corporation.
A sole proprietor also benefits from pass-through taxation, so you’ll report your business’s income or loss in the same way. The difference is that you don’t have the option to file as a corporation.
You’re also not required to pay taxes on the full amount of your sole proprietorship’s income. Instead, you’ll only pay taxes on the profit of your business.
An LLC has many benefits including tax advantages that aren’t available to sole proprietors, but any benefits will depend on your specific situation and it isn’t necessarily always the case, especially when you factor in the fees associated with operating an LLC.
Whether an LLC is better for taxes depends on multiple factors, including your profit, expenses, and the type of work you do.
Forming a Sole proprietorship vs LLC
Forming an LLC requires you to file articles of organization, sometimes called a certificate of organization, with the state. Requirements vary by state.
Typically, an LLC operating agreement is drawn up to document the members’ and managers’ rights and duties. You should also expect to file certain forms with your state agency, usually the Secretary of State, and pay an initial filing fee that can range from $50 to $500.
LLCs also have to file annual or periodic reports and pay a required filing fee in most states.
For sole proprietorships, no formal action is required to form your sole proprietorship if you are operating under your own name. If you want to use a different name, you will need to file for a DBA.
You may also need to acquire any mandatory licenses or permits, and these requirements vary by region, state, and industry.
Whether you’re looking for the liability protection and flexibility of an LLC or the less formal, unlimited control of a sole proprietorship, now you have the tools to make a more informed decision for your business and your future.
Which one should I choose?
Many business owners, particularly freelancers or consultants, start out as sole proprietors because it’s easy. Minimal paperwork is required at the outset, and there’s no big outlay of cost, which is attractive for new entrepreneurs, particularly those testing a business idea.
Taxes are also simple for sole proprietors, since a separate business tax return need not be filed. However, as your business starts to grow, a sole proprietorship structure offers no legal protection for your personal assets, so you could end up personally bankrupt if your business doesn’t succeed as planned, or faces an unexpected challenge.
Individuals that start an LLC on the other hand aren’t personally liable for business debts, so you get more protection in the event of a business bankruptcy or business lawsuit.
On top of this, LLCs offer tax flexibility. Most LLC owners stick with pass-through taxation, which is how sole proprietors are taxed. However, you can elect corporate tax status for your LLC if doing so will save you more money.
All 50 states recognize the LLC structure to encourage small business growth. The best business structure for you will depend on many factors, and it’s best to consult a business lawyer before making this important decision.
However, due to the combination of liability protection and tax flexibility, an LLC is often a great fit for a small business owner.
For LLC owner information, check out our article on who can start an LLC.
Changing a sole proprietorship into a Limited Liability Company
A single proprietorship can be converted into an LLC. This usually entails filing your LLC registration with your state’s Secretary of State, Trade Bureau, or Business Agency.
Converting an LLC to a sole proprietorship
The member(s) must first dissolve the LLC, which is termed a dissolution. Obtaining consent from all shareholders in your Business and filing your closure paperwork, notifying all lenders that you are folding the LLC, completing all tax forms, and shifting any assets to a sole proprietorship are all processes involved.
What is the biggest advantage of a sole proprietorship vs an LLC?
Sole proprietorships are business entities that are easy to set up and require fewer procedural steps than other entities. One-person companies benefit especially if their business doesn’t require a complex legal or financial setup.
What is the advantage of a LLC?
The main advantage to an LLC is in the name: limited liability protection. Owners’ personal assets can be protected from business debts and lawsuits against the business when an owner uses an LLC to do business.
What are the disadvantages of a sole proprietorship?
The disadvantages of sole proprietorship include the lack of certain protections that you’d otherwise get through an LLC or incorporated business entity. It’s also harder to get financing and business credit as well as the fact that it is harder to sell your business.
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