Sole proprietorships and LLCs are two of the most popular types of business structures in the United States due to their low costs and set-up requirements. Your choice between a LLC or sole proprietorship will have major financial and operational consequences for your business. In this guide, we explain the differences, benefits, and drawbacks so you can decide which structure is best for you.
What’s the Difference Between a Sole Proprietorship and an LLC?
LLC stands for limited liability company, where limited liability means your personal assets can’t be used as collateral if your business is sued or goes bankrupt. Since an LLC is a separate legal entity from its owner(s), creditors can only go after the business assets in a dispute.
A sole proprietorship, on the other hand, is not legally separate from its owner. This means you have full personal liability for business losses. In other words, your car, house, and personal savings could be used to settle business debts.
As the name indicates, a sole proprietorship is owned by one person. Conversely, you can form a single-member LLC or a multi-member LLC depending on your needs.
Forming an LLC involves filing articles of organization with your state government. This document indicates the name, location, membership, and structure of your LLC. Filing fees vary depending on the state, but average about $150.
Sole proprietorships are formed when an individual operates a business without filing — no formal setup is required. Though forming a sole proprietorship couldn’t be simpler, doing business without legal protection might not be worth the risk.
LLC or Sole Proprietorship: Which Should I Choose?
|Consider a sole proprietorship if your business...||Consider an LLC if your business...|
|is low risk||is higher risk|
|has less start-up funding||has more start-up funding|
|is less likely to face lawsuits||has a possibility of facing lawsuits|
|is less likely to incur a large debt||is more likely to incur some debt|
|benefits from a simple tax structure||benefits from a flexible tax structure (multiple options)|
To fully understand the differences between limited liability companies and sole proprietorships, let’s examine some of their main features and drawbacks:
Pros and Cons of LLCs
LLCs are defined by their limited liability characteristic, which legally separates the owners’ business and personal assets without requiring separate taxation (no corporate double taxation). If you’ve considered forming an LLC to protect your personal assets, but wondered if it’s worth the fees, you’re not alone. Let’s assess:
Creating an LLC requires some effort and money up-front, but it may be well worth it. Here are a few benefits of LLCs:
Arguably the greatest advantage of forming an LLC is the protection it affords your personal assets so that if the worst happens — your business goes bankrupt or is sued — only the LLC’s assets can be used to settle debts, not your life savings or home. Operating with this legal protection minimizes your risks when you start a new business.
Flexible Tax Structure
Limited liability companies don’t have to be taxed separately from the owner(s), even though they’re legally a separate entity. Single-member LLCs are automatically taxed the same way as sole proprietorships — as a disregarded entity, meaning profits and losses are reported on the owner’s personal tax return (form 1040).
LLCs may also elect to file form 1120 to be taxed like a corporation. High-profit LLCs usually utilize this tax option. Over the course of an LLC’s lifespan, members may file to change their initial tax designation (form 8832 to elect corporate tax status) at most once every 5 years. Having several options for how LLCs are taxed makes them a great choice for a variety of businesses.
A professional limited liability company (PLLC), a type of LLC for licensed professionals, also offers limited liability and a flexible tax structure.
Flexible Management/Ownership Structure
An LLC can be owned by an individual, multiple members, or even another organization. It’s up to the LLC member(s) to decide if the organization is member-managed vs manager-managed, how profits are divided, and what routine responsibilities look like.
These terms are laid out in an LLC operating agreement or a single-member LLC operating agreement: useful tools for designating daily operations and decision-making protocols, as well as simplifying the process of opening business bank accounts or obtaining legal assistance.
LLCs may not be the best option for all business types. Let’s look at some of the drawbacks:
Start-up and Maintenance Fees
Because LLCs are registered with the state government, business owners have to pay initial filing fees, as well as possible annual fees or additional taxes. In many states these fees are minimal, especially when we compare LLCs vs corporations, which are pricier and have more filing requirements.
Because LLCs function at the state level, requirements vary along with formation costs. LLC owners need to file the correct documents with their Secretary of State’s office and pay the correct fees on time. Luckily, most state governments have online guides that make the paperwork more straightforward.
Sole Proprietorship Pros and Cons
Sole proprietorships are the easiest way to operate a business, and they allow businesses to get started without any bureaucracy or fees. Sole proprietorships are usually best for low-risk, small-scale businesses, but owners should consider whether the ease of formation is worth the potential risks.
Sole Proprietorship Advantages
Forming a sole proprietorship is a painless process. Here are some aspects of starting a business where sole proprietorships stand out:
No Formation Cost
Compared to other types of businesses, sole proprietorships don’t require any official formation documents or state registration, which means you don’t have to pay a filing fee or other annual fees. If you wish to operate your business under a name other than your own, however, you need to file a DBA (doing business as), which comes with a filing fee of between $10 and $100, depending on the state.
Minimal Formation Requirements
Not only is starting a sole proprietorship less costly than starting an LLC, but it’s also much more straightforward. A sole proprietor operating a business under their own name without employees can use their social security number instead of obtaining an employer identification number (EIN) for tax purposes. The only thing you need to legally operate is the appropriate business license for your profession, such as a building health permit for running a restaurant.
Simple Taxation Process
Sole proprietorship owners don’t have to worry about separate tax returns for their business since all profits and losses are accounted for on their personal tax returns.
Similar to a sole proprietorship, if two or more people conduct business together without forming a legal entity, they’re considered a partnership.
Sole Proprietorship Disadvantages
Sole proprietorships have their benefits, but they also put business owners in a risky position. Let’s take a look at some of the cons:
Personal Assets Not Protected
Sole proprietors operate their business under their own name, so personal and business assets are not legally separated. This is referred to as full personal liability, and it puts sole proprietors in a risky position when starting a new business. Unfortunately, sole proprietors could sustain serious personal losses in the event of bankruptcy or legal action being taken against the business.
Difficulty Raising Funds
If you plan on looking for investors for your business, you’ll have more trouble operating under a sole proprietorship because they’re widely perceived as high risk and low credibility. Forming a legal entity for your business gives potential investors confidence in your business plan.
LLC or Sole Proprietorship: Which is Best?
It’s always better to protect your assets when operating a business, but if you don’t have the funds to form an LLC, consider starting your business as a sole proprietorship and transitioning to an LLC once it becomes profitable. Doing so allows you to test your business idea — just remember to seek guidance from a financial advisor before starting your business to make sure you’re properly assessing the risks and planning ahead.
When you’re ready to form an LLC, take the next step and begin drafting your LLC operating agreement, which will help you define the scope of your business.