As a small business proprietor, one of the most important and complex choices you’ll make is determining the structure of your company. Many small business owners favor two famous business structures for flexibility and simplicity – Sole proprietorship vs. LLC.
The actual implications of a company structure are difficult to calculate if you’re not a lawyer or tax specialist. You have to consider how much time you spend on paperwork, how much you pay in taxes, and what happens if someone sues your company if you form your company as a corporation, LLC, or sole proprietorship.
In this guide, we’ll look closely at Sole Proprietorship vs. LLC and explain how they differ in terms of formation, taxes, legal considerations, and more.
- What is a Sole Proprietorship?
- What is an LLC?
- The Difference Between Sole Proprietorship vs. LLC
- Sole Proprietorship vs. LLC: Formation
- Sole Proprietorship vs. LLC: Operations and Management
- Sole Proprietorship vs. LLC: Taxes
- Sole Proprietorship vs. LLC: Tax Flexibility
- Sole Proprietorship vs. LLC: Personal Liability Protection
- Sole Proprietorship vs. LLC: Employing Staff
- Sole Proprietorship vs. LLC: Paperwork and Compliance
- Single-Member LLC vs. Sole Proprietorship
- Mixing Business Funds and Personal Funds
- Sole Proprietorship vs. LLC: Which is best for you?
- Wrapping Up
What is a Sole Proprietorship?
Sole proprietorships are simple and inexpensive to create and the least complicated. Everyone who runs their own business is a sole proprietor unless they have formed another business structure. Sole proprietorships are easy to identify because the owner’s name is the enterprise’s name, but they may also operate under a business name or trade name.
A sole proprietorship is a company that has no legal barrier between the company and the owner. Since there is no barrier between a sole proprietorship and the proprietor, the owner is personally liable for any financial debts.
What is an LLC?
An LLC is a separate company that’s created under state law. It includes characteristics of a sole proprietorship, partnership, and corporation and allows owners a lot of flexibility. LLC owners can decide on a management structure, operational procedures, and tax treatment.
One person can create a single-member LLC, or a group can create a multi-person LLC. An LLC is a limited liability company identified by its legal name, ending with ‘limited liability company’ or ‘LLC.’
An LLC protects its owners from liability from the company’s debts and obligations. Creditors and plaintiffs who come after the business’s assets can’t pursue the owners’ assets in an ordinary course of business.
The Difference Between Sole Proprietorship vs. LLC
An LLC member’s liability is limited to their investment in the company, unlike a sole proprietorship, so the member is not responsible for the LLC’s debt. A sole proprietor would be accountable for the obligations of the enterprise. However, if you operate your business as a sole proprietorship, you will lose the liability protections.
Because an LLC must adhere to specific rules, a sole proprietor may be held personally responsible for the enterprise’s debts. Creditors may seize a sole proprietor’s home, car, and other personal assets to pay their debts. Still, an LLC owner can protect his assets if he operates the company properly and maintains it properly.
Here is an in-depth difference between LLC vs. Sole proprietorship.
Sole Proprietorship vs. LLC: Formation
Understanding the formation process of both business structures is essential to comprehend the difference between LLC vs. Sole Proprietorship.
No precise method exists to create a sole proprietorship; you may unknowingly operate one. Selling products and services without a partner is the default for a sole proprietor, regardless of whether your enterprise is located in a location where you must obtain business licenses, zoning permits, or both.
Sole proprietorships must apply for fictitious business names, DBA or “doing business as” certificates, and any company that operates under a trading name. Forming a sole proprietorship reasonably quickly and cheaply is possible since it requires the least amount of paperwork.
On the other hand, the procedure for forming an LLC is more involved than forming a Sole proprietorship, but it is still reasonably straightforward. Before you file, you must choose a suitable name for your company and be confident it is not used by anyone else. You must also select a registered agent. You may act as your single-member LLC’s registered agent or one of your corporation’s partners if it is a multi-member LLC.
A business plan is essential in advancing this phase of forming an LLC. You must file Articles of Incorporation, draw up an operating contract, and pay a fee. You must obtain an EIN if you live in a state where it is required for tax purposes.
Sole Proprietorship vs. LLC: Operations and Management
There is just one person at the helm in a sole proprietorship, so it has a simple operational and managerial structure. Sole proprietors may make any business decisions they want without the input of any third parties.
However, many sole proprietors employ lawyers, accountants, and other professionals to help run their businesses daily. The sole proprietor must ensure that their company operates safely and legally and generates enough income to cover business debts.
An LLC’s operational and administrative structure is more complicated and described in the LLC operating agreement. While only a handful of states require an operating agreement, most LLCs have one, particularly those with numerous members. The active contract includes the members’ positioning in the company, their voting rights, and their proportion of profits.
There are two ways to run an LLC. It may be managed by a member or a manager appointed by the members.
The members of an LLC usually determine firm issues in proportion to their ownership share—known as membership units— in the enterprise. As a result, profits are generally divided according to the percentage of ownership. For example, a 33 percent owner would have a one-third vote on issues, and a 25 percent owner would have a one-quarter vote. The 33 percent owner would keep one-third of the firm’s profits, while the 25 percent owner would keep one-quarter of them.
In LLC vs. Sole Proprietorship, the operation and management structure of a Sole Proprietorship business is more simple when compared to an LLC.
Sole Proprietorship vs. LLC: Taxes
A sole proprietorship and a single-member LLC are similar in tax consequences. A single-member LLC is a pass-through entity that does not pay corporate income taxes. The owner computes their business income on Schedule C, which is filed with their individual income tax return, and the profits are subsequently taxed at the owner’s income tax rate.
On the other hand, a multi-member LLC must file a Form 1065 with the IRS, U.S. Return of Partnership Income, showing its income. Each member must also file Schedule K-1s to show their portion of the business’s profits with the IRS and their tax return.
Your payroll taxes will increase if you have workers. LLCs and sole proprietorships might also have to pay additional income taxes. You’ll also have to charge sales taxes for any taxable goods or services you provide if you’re an independent entrepreneur.
Finally, you’ll have to pay self-employment taxes to the IRS and payroll taxes. As a self-employed entrepreneur, you’ll have to pay social security and Medicare taxes. State and local jurisdictions may also charge an additional tax on LLCs. This tax is known as an LLC tax, franchise, or business tax.
Sole Proprietorship vs. LLC: Tax Flexibility
In LLC vs. Sole Proprietorship, an LLC is more tax-efficient than a sole proprietorship due to its flexibility in paying taxes. Those who own an LLC can decide whether to keep the default—pass-through taxation—or to tax their business as either C-corporation or S-corporation.
An S-corporation is a pass-through entity. When taxed as a C-corporation, the LLC will be subject to corporate income taxes at the federal level (in some states and municipalities).
In certain situations, electing corporate tax status benefits the corporation. In addition to lower corporate tax rates on dividends, corporate income is not subject to income tax. LLC members cannot treat income as dividends, so they must pay taxes on all profits of the business, whether they are retained in the company. In contrast, corporations can claim more tax deductions and credits.
Sole Proprietorship vs. LLC: Personal Liability Protection
In LLC vs. Sole Proprietorship, when your LLC is sued, your assets are protected from business debt collection or other claims. Creditors are usually prevented from seizing your home, car, or personal bank accounts.
On the other hand, in a sole proprietorship, there is no separation between you and the business. You are entitled to all of the profits, as well as all of the debts and obligations. You may even be held liable for the debts incurred by your employees.
Many business owners form LLCs because they provide excellent asset protection without personal liability. Although personal liability protection is not always guaranteed, there are a few things you can do to stay protected.
You may want to obtain business insurance, establish business credit without relying on a personal guarantee, keep business and private finances separate, open a business bank account, and convert your business into a single-member LLC to maintain liability protection.
Sole Proprietorship vs. LLC: Employing Staff
Starting and growing a business may lead to employing workers or bringing on business partners. The mode of using workers or signing on partners, whether operating a sole proprietorship vs. LLC, varies slightly.
A sole proprietor can employ as many people as they want, but the same liability applies: If one of your workers is injured or incurs expenses while on the job, you as a sole proprietor will be personally liable.
An LLC must have an Employer Identification Number (EIN) issued by the Internal Revenue Service (IRS). The IRS considers members of an LLC to be self-employed and responsible for their taxes to hire employees. However, the IRS requires an EIN to file tax returns and pay payroll taxes.
Sole Proprietorship vs. LLC: Paperwork and Compliance
In LLC vs. Sole proprietorship, Sole proprietorships have the least amount of initial paperwork required at the start. After launch, a sole proprietor is accountable for federal, state, and local taxes only. In addition, a sole proprietor may need to renew a business permit.
An LLC has more compliance responsibilities in addition to filing its initial articles of incorporation. Every year, an LLC must submit an annual report in different states of operation. An LLC multiple-member LLC has even more requirements, such as creating an operating agreement, issuing membership units, recording ownership transfers, and holding member meetings.
While none of these activities are legally required, they are highly recommended for LLCs to preserve member liability. Moreover, LLCs must be dissolved appropriately, which takes additional paperwork.
Single-Member LLC vs. Sole Proprietorship
Small businesses may prefer to set up a single-member limited liability company (SMLLC) rather than a sole proprietorship. An SMLLC is similar to a limited liability company (LLC), aside from having only one member. Small businesses frequently default to a sole proprietorship when they do not register with the state.
An SMLLC gives its owner personal protection from the company’s liability from obligations, debts, actions, and taxes. The SMLLC can be taxed as a disregarded entity or as a corporation. The corporation status is beneficial if the owner receives the income directly and then pays the tax.
In addition to FICA and Medicare taxes, self-employment tax is imposed on self-employed individuals. The government treats an SMLLC as a sole proprietorship for tax purposes. An SMLLC owner is self-employed and is therefore subject to self-employment tax.
Here’s how you can convert Sole proprietorship to LLC:
Mixing Business Funds and Personal Funds
Many companies have difficulty getting off the ground due to the amount of data they must gather to function, leaving other areas open to errors. Entrepreneurs frequently make two mistakes: mixing personal and business finances or keeping their funds in one account to file taxes.
This habit may make it difficult for potential investors to assess the company’s business discipline, generate personal or business debt, or accumulate debt on one account. The most efficient way to establish an LLC or sole proprietorship is to open a business checking account or an additional account to keep business and personal funds separate.
In LLC vs. Sole Proprietorship, a sole proprietor is regarded as a single entity, so mixing business and personal accounts is not an issue. When operating an LLC, you must keep banking records and funds separate from your records and funds. If you violate this rule, you may lose your limited liability protection. Despite this, most experts still feel it is a bad practice.
Sole Proprietorship vs. LLC: Which is best for you?
Many small business owners are sole proprietors because establishing is easy and inexpensive. Setting up as a sole proprietor requires minimal paperwork, and it is appealing to new entrepreneurs because there’s no large outlay at the beginning. Taxes are simple for sole proprietors since a separate business tax return is not required.
However, as your company grows, you may be personally bankrupt if your company fails or faces an unexpected challenge. If you are an LLC owner, you will be protected if your company goes bankrupt or faces a business lawsuit because you won’t be personally responsible for the business’s debts.
An LLC provides additional advantages in addition to pass-through tax status. You can choose corporate tax status for your LLC if it saves you more money. LLC owners typically pay pass-through taxes, the same as sole proprietors. Every state recognizes the LLC structure to encourage small business growth.
When establishing a small business, you should consult a corporate lawyer to determine the most suitable structure. An LLC is often a good choice for a small enterprise proprietor due to its liability protection and tax flexibility.
Here’s an overview of Sole Proprietorship vs. LLC:
Remember your business goals and what you want to achieve when deciding which business structure is most suitable for you. The most common route when starting a business is to open as a Sole Proprietorship. An LLC is formed later on to support the company as it develops. People begin an LLC to safeguard their assets from potential legal problems.
A Limited Liability Corporation (LLC) provides liability protection that is not accessible in a Sole Proprietorship. While obtaining funding or financing might be difficult for any business, the advantages and safeguards an LLC can offer should not be underestimated. Hopefully, this guide on LLC vs. Sole Proprietorship provides helpful information on both business structures.