Fact checked for accuracy by Janet Berry-Johnson, CPA.
Choosing the right business structure is a critical decision when starting a new venture. The two most common for flexibility and ease are limited liability corporations (LLC) and sole proprietorships. There are advantages and disadvantages to each business structure and knowing what those are will help you make the best decision for your company. Let’s dive into each one.
Main Differences Between an LLC and Sole Proprietorship
Tax flexibility is the first major difference between an LLC and a sole proprietorship. LLC owners can elect to be taxed as an S-corporation, a C-corporation, or stick with the default pass-through taxation. It’s important to speak with your accountant on these options to see what tax advantages each has and how to utilize them for your situation.
Another big difference is personal assets and legal protection. While there is no business structure that offers absolute protection, an LLC is a legally separate entity from the owner while a sole proprietor is personally responsible. The owner in a sole proprietorship is personally responsible for the business’s debts and there is no legal separation between the business and the owner but since an LLC is a legally separate entity from the owner, the owner isn’t personally liable for the business’s obligations.
The way each entity is operated and managed can look different too, especially with multiple-member LLCs. In a multi-member LLC, owners can share the responsibility of making key decisions for the company. They can also hire someone to make these important decisions as well. In a sole proprietorship, there is only one owner that has the final say on all decisions.
Main Similarities Between an LLC and a Sole Proprietorship
Despite the many differences, there are some similarities between an LLC and a sole proprietorship. In terms of the way each structure is taxed, unless an LLC elects another method, both entities are considered pass-through meaning that the business itself doesn’t pay income tax, it gets passed through to you as part of your income.
Obtaining a loan for any startup can be difficult so financing options for both entities vary greatly and can be difficult regardless of which entity you chose to set up. You should set up a business bank account and credit card to ensure you’re tracking finances properly.
Entity Formation and Startup Costs: Pros and Cons of LLC vs. Sole Proprietorship
A sole proprietorship is much easier to form than an LLC. There is no formal action required if you plan to operate your business as a sole proprietor under your own name. If you would like to use a different name, you may file a DBA (doing business as). Typically, the cost is very little, if any at all, to form a sole proprietorship. You can start your business right away and report the income on your taxes without any special certificates. Depending on the rules in your area, you may still need a business license.
In order to legally form an LLC, you have to file articles of organization and business permits where applicable. Depending on the state, these requirements vary and you’ll want to do some research on how to register with the proper authorities in the state you are forming in. Expect to pay $50 to $500 with your state agency to get your LLC formed. Furthermore, LLCs also have to file annual or periodic reports and pay the filings fees for these. Read our entire article on the cost to form an LLC for more details.
Taxes: Pros and Cons of LLC vs. Sole Proprietorship
In general, there are not substantial tax differences between an LLC and a sole proprietorship. Sole proprietorships are solely pass-through entities. Federal taxes are based on the company owner’s net business income and taxes must be filled out on the business owner’s tax return.
LLCs are taxed similar to sole proprietorships by default. The advantage to forming an LLC is having the option to elect a different tax classification. Depending on the elections made by the LLC and the number of members, the IRS will treat an LLC either as a corporation, partnership, or as part of the owner’s tax return. A domestic LLC with at least two members is classified as a partnership for federal income tax purposes unless it files Form 8832 and elects to be treated as a corporation. For income tax purposes, an LLC with only one member is treated as a disregarded entity as separate from its owner unless it files Form 8832 and elects to be treated as a corporation. However, for purposes of employment tax and certain excise taxes, an LLC with only one member is still considered a separate entity.
Liability Protection: Pros and Cons of LLC vs. Sole Proprietorship
Sole proprietorships absorb all risk for liabilities and legal encounters because it doesn’t offer liability protection as an LLC does. In a sole proprietorship, there’s no legal separation between the business and the owner. The owner is personally responsible for the business’s debts. It’s not a surprise that many businesses fail. In a sole proprietorship, if the business goes bankrupt, the sole proprietor has to file for personal bankruptcy, and both personal and business debts will be included. In addition, someone who sues a sole proprietorship can name the owner in the lawsuit and come after their personal assets such as their property and savings.
Though an LLC is taxed as a pass-through entity, it doesn’t act like a pass-through for liability protection. LLC owners are not personally liable for debts of the company. In the normal course of business, a business creditor or someone who sues the business can’t come after the personal assets of the owners, unless the business owner has personally guaranteed the loan.
One of the best ways to protect your personal assets is to form an LLC (one of the biggest advantages of creating an LLC). An LLC is a legally separate entity from the owner meaning the owner isn’t personally liable for the business’s obligations. If the business fails, the owners can file for business bankruptcy, and they don’t have to pay business creditors out of their own pockets.
Is a Single Member LLC The Same Thing as a Sole Proprietorship?
The two are different. The main distinction between the two is that a sole proprietorship and the owners are one and the same, while a single-member LLC provides a divide between the two for legal purposes.
How To Pick Which One Is Best For Your Business
Many business owners start out as sole proprietors because it’s simple and easy. Minimal paperwork and low start-up cost are appealing to new entrepreneurs, especially those testing a business idea. Since you don’t have to file a separate tax return, taxes are simple for sole proprietors. But when your business starts growing, not having legal protection for your personal assets can be a bit scary. You could end up personally bankrupt if your business doesn’t exactly succeed as you planned it to.
That’s where an LLC formation comes into thought. As an LLC owner, you aren’t personally liable for business debts, so you get more protection in the event of a business bankruptcy or business lawsuit. Start-up costs are a little higher and tax filing is more complex; however, most LLC owners stick with pass-through taxation, which is how sole proprietors are taxed.
If you’re struggling to figure out when to make the move, read our guide on the best time to form an LLC.
The Last Word
The best business structure for you will depend on many factors, and it’s best to consult a business lawyer and accountant before making this important decision.
Whether you’re looking for the liability protection and flexibility of an LLC or the less formal, unlimited control of a sole proprietorship, hopefully you have a better understanding to make a more informed decision for your business and your future.
Filed under: Advice Columns