Sole Proprietorship vs. LLC

Every business owner has to make an important decision about the business structure they want for their company. This decision is crucial because it will shape how the business operates, its legal standing, and its tax obligations.

Sole proprietorship and LLCs (limited liability companies) are two of the most common options, and either choice can be a good one. However, there are some differences to understand before making a final decision.

Unless you’re a lawyer or a tax accountant, you may not be familiar with all the nuances of sole proprietorships vs. LLCs, so let’s break down some of the main differences between these two business structures. 

What Is a Sole Proprietorship?

A sole proprietorship is a business structure where the owner is the only person responsible for the company’s operation. The owner is also fully liable for the company’s debts, meaning their assets are on the line.

Anyone who runs a business alone operates a sole proprietorship by default. This is why sole proprietorships are the most common form of business, especially for small businesses and solo entrepreneurs. The company ceases to be a sole proprietorship if the individual decides to form a partnership.

What Is a Limited Liability Company?

An LLC, or limited liability company, is a business structure that combines elements of a corporation and sole proprietorship. It gives the business owners limited personal liability for their company’s debts but with fewer requirements than a corporation.

Unlike a sole proprietorship, an LLC is not automatically created when you start a business. Instead, you must register with your state and pay the required fees to form an LLC.

Sole Proprietorship vs. LLC: Critical Differences Between 

Here’s a deep dive into some key differences between sole proprietorships and LLCs.

Legal Liability

One of the biggest differences between a sole proprietorship and an LLC is how their owners are legally liable for the company’s debts.

As a sole proprietor, your assets are at risk if your business takes on debt or has to pay a lawsuit settlement. If the company goes bankrupt, it could jeopardize your home or savings accounts and other assets.

You can also be personally liable for any harm that your company causes. For example, if someone is injured due to an unsafe product you sold, they could sue you as the business owner for compensation.

In contrast, an LLC limits the personal liability of its owners. The company’s debts and legal issues are strictly the responsibility of the business itself, not the individual owners. If your LLC takes on debt or has to pay a lawsuit settlement, the business’s assets and earnings are on the line instead of your assets.

However, even though LLCs provide some legal protection for their owners, that doesn’t mean you’re completely shielded from liability. The extent of this protection varies by state. 

Tax Obligations

Another big difference between a sole proprietorship and an LLC is how they are taxed.

A sole proprietorship is generally treated as a “pass-through” business for tax purposes. The firm does not pay taxes; instead, the owner pays taxes on their share of the company’s profits (or losses).

The benefit of this system is that it makes the tax process simple and less expensive. But the downside is that you have to report your business income on your tax return, which means that your personal and business finances are combined.

On the other hand, an LLC may be taxed as either a “pass-through” entity, a partnership, or a corporation. The owners can decide how the LLC is treated for tax purposes when they file their initial paperwork. Here are the different ways an LLC may be taxed:

Single-member LLC

The IRS treats single-member LLC as a disregarded entity or sole proprietorship. In this case, the LLC is not separate from its owner for income tax purposes. Filing a single-member LLC income tax involves preparing a Schedule C form, and the company’s net income becomes a part of your tax return (Form 1040 or 1040-SR).

Multiple-member LLC

A multi-member LLC pays income tax as a partnership. The net profit of the LLC is allocated among its members, and each person pays taxes based on their share of the income.

There are a few steps to prepare this kind of tax return, including filing an information return, receiving a Schedule K-1 and transferring information to Schedule E, and finally, including the income from Schedule E in Form 1040 or 1040-SR.

Corporations or S Corporations

LLCs can also be taxed as a corporation or an S corporation. Companies that opt for this tax option (election) have high-income individuals who will benefit from lower individual tax rates. This election is submitted through the IRS Form 8832.

By having an LLC taxed as a corporation, the owner can keep their business income off their tax return and don’t have to pay self-employment taxes. However, double taxation may be an issue for some businesses due to this structure.

Operations and Control

Another critical difference between a sole proprietorship and an LLC is the owners’ level of control over the company.

As the owner of a sole proprietorship, you have complete control over the business. You can change company policy or day-to-day operations. There are no restrictions on who can make decisions, and there is little oversight from any other party.

Conversely, an LLC typically functions as a partnership, and everyone’s opinion counts unless it’s a single-member LLC. 

For example, an LLC may require a majority vote from members before making significant changes to the company. There may also be rules and protocols (an operating agreement) around decisions, such as requiring votes to approve company action.

Although there is less personal control over a business that operates as an LLC, you still have a say in the company’s decisions as a member.

Business Name

In a sole proprietorship, the default business name is the name of its owner. For privacy and security reasons, some people register a fictitious business name (“DBA” or “doing business as”) with the state. This process is relatively simple and involves submitting a form and paying a fee to the appropriate agency.

You do not need to register with the state if you use your legal name as the business name. However, you must acquire permits or licenses to legally operate your business in your city, county, or state.

In contrast, an LLC must register with the state where it does business and follow specific requirements for naming the business. Most states require an LLC to include “Limited Liability Company” or the abbreviation “LLC” in its name. Or a designation that indicates that it is a legal business entity.

There are benefits to having an LLC business name, including Increased credibility and professionalism when dealing with customers and vendors.

The difference between a DBA and an LLC is that having a fictitious business name is not the same as forming an LLC. A DBA is simply a way to identify your business with its main or “working” name, while an LLC is a formal business structure that offers legal protections to the company’s owners.

Formation and Legal Status

Sole proprietorships are easily formed by starting a business, usually without legal or formal paperwork. You can begin operating your business as soon as you open, with no legal requirements for compliance or management.

You only file with the state when you use a different name for your business. That’s where a DBA comes in; other than that, there are no complex starting requirements for a sole proprietorship. Remember to obtain business licenses and permits, and apply for an employer identification number (EIN) if you hire employees or file excise or pension plan tax returns. 

LLCs, however, must file a certificate of organization or articles of organization with the state (depending on your state’s laws) to operate legally. This document is an official notice to the public that the company exists and has been formally organized under state law. The certificate includes details such as the business name, registered address, and names of members or managers.

Forming an LLC also requires an operating agreement detailing how the company will be managed and operated. This document can include information like the percentage of ownership each member has, rules around major decisions, and the rules for conflict resolution.

In addition, all LLCs must comply with federal and state business laws and local regulations in their city or county, including filing an annual report and paying any taxes or fees owed to the state.

How to Decide Which Business Structure Is Right for You

Before deciding to form an LLC or operate as a sole proprietorship, there are some factors to consider.

A sole proprietorship may be the best option if you want a high degree of personal control and flexibility. You don’t have to deal with legal requirements or tedious paperwork, and you can operate your business however you want.

Conversely, an LLC can be a better choice if you want to limit your liability and are willing to comply with strict legal requirements. It provides a more formal and regulated structure, allowing you to take advantage of the legal protections offered by the LLC.

Ultimately, it comes down to your personal preferences and business needs. Whether you’re an entrepreneur just starting or a seasoned professional, carefully weigh the pros and cons of each business structure to find the best option for your situation.

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