When you're starting a new business, it's important to set up the right business structure. Most small business owners favor either a sole proprietorship or a limited liability company (LLC). But how do you know which one is the right choice for you? This guide will break down the differences between each entity to help you find the right option for your venture.
What's the difference between sole proprietorships and LLCs?
A sole proprietorship is an unincorporated business run by one person. It is one of the most common business structures in the United States, probably because it's also the simplest type of business to start and run.
If you want to operate as a sole proprietor, you do not need to take any action beyond the normal process of launching a new venture. Assuming you're the sole owner, you're automatically classified as a sole proprietor.
However, there is no legal distinction between you and the business. There are no liability protections separating your personal assets from your business assets. If something goes wrong in the business — you incur significant debts or you’re sued — you will personally be held responsible. And since the business is considered an extension of you, it's not taxed separately.
Consider setting up an LLC to protect your personal assets. An LLC is a legal entity formed at the state level. As an LLC, there's a separation between you and the business. This separation shields you from any debt or lawsuits incurred by the business.
To set up an LLC, you must register your business with the secretary of state in your region. Every state has different criteria for establishing an LLC, so research the guidelines that apply to your area. Compared to a sole proprietorship, registering an LLC is time-consuming.
LLC taxes are also more complex. The IRS classifies LLCs as "pass-through entities," meaning that the LLC does not pay federal income taxes on business income. The income "passes through" to the individual members of the LLC, who pay taxes on income earned from the LLC on their individual returns.
Sole proprietorship: Pros and cons
Pro: Easy to set up
A sole proprietorship is the fastest way to start a business. There's no state paperwork to fill out or fees to pay, which makes it a popular option for freelance contractors. It may be a good choice if you're looking to test a service-based business.
Pro: Full ownership
As a sole proprietor, you're the only business owner, and you are not required to hold shareholder meetings. You have complete control over the business, from operations to finances and anything else related to how your company functions. A sole proprietorship offers a level of freedom and flexibility that corporations and other business structures cannot.
Pro: Straightforward tax filing
Like LLCs, sole proprietors are considered pass-through entities by the IRS. Therefore, sole proprietors don't file separate tax returns for their businesses.
You report any income you earn on your personal tax returns. During tax time, submit a separate form for your sole proprietorship taxes, Schedule C, which you file along with your personal income tax form, Form 1040.
Pro: Simplified banking
Sole proprietorships benefit from straightforward, simple banking.
"No laws require sole proprietors to have a designated business bank account. But we always recommend using a dedicated account for your business,” wrote NerdWallet. “Doing so separates your business and personal finances, making it easier to track business income and expenses. That simplifies everything from tax filing to applying for a business loan or grant."
All you need to start your sole proprietorship is a personal checking account.
Operating as a sole proprietor can give you a lot of freedom, but there are drawbacks.
Con: No liability protection
Sole proprietors are personally responsible for any liabilities the business incurs. That means if you're sued for damages caused by the business, your personal assets will be at risk.
"If you default on a business loan, lenders can come after your personal assets (e.g., such as real estate, cars, and certain investments). Your personal property and money are also on the line in the event of a lawsuit," wrote NerdWallet.
Con: Difficulty accessing business credit
Lenders and financial institutions typically prefer to work with established businesses. This preference doesn't extend to sole proprietors, who are considered riskier investments than LLCs or corporations.
As a result, you could struggle to access business funding as a sole owner. To get funding for your venture, you may need to take out personal loans, which have their own pitfalls.
[Read more: How to Choose the Right Business Entity: Sole Proprietorship]
If you're looking to hit the ground running, operating as a sole proprietor is the quickest way to start. There's no paperwork to fill out, and you can focus solely on finding clients and generating revenue.
LLC: Pros and cons
Pro: Liability protection
Setting up an LLC creates a separate entity, limiting your personal liability regarding business operations. As an LLC, you're protected against lawsuits, debt, and other business obligations. You do, however, need to set up your LLC correctly and avoid mixing business and personal assets.
Pro: Credibility
LLCs are perceived as more credible by clients, lenders, and financial institutions. If you need access to funding, it's easier to do so as an established LLC. Banks and investors tend to view LLCs as less risky than sole proprietorships.
Pro: Flexible management options
One or more members can own an LLC.
"Member-owners can be as involved in the management of their business as they want since they can choose to be members or outsiders," wrote NerdWallet.
Bringing on additional partners can help lighten the workload of launching your business. It also allows you to access different skill sets that can help your company grow more quickly than if you were operating solo.
Pro: Simple tax filing
Like sole proprietors, LLCs are pass-through entities.
"As the owner, the tax liability belongs to you and passes through to your personal tax return. For multi-member LLCs, pass-through taxation occurs for all members according to the amount of profit they received from the company that year," explained LegalZoom.
An LLC can also be taxed as a sole proprietorship, a partnership, or a corporation. Speak to a tax professional to learn what options are available and suit your situation.
Con: More paperwork and fees
One downside of setting up an LLC is the paperwork that is involved. You'll have to complete any forms your state requires and pay the accompanying fees. Most states require that you file annually.
Con: Self-employment taxes
LLCs are subject to self-employment taxes, which means you are taxed at the individual level for profits made by your LLC. In practice, your LLC could push you into a higher tax bracket, triggering higher taxes than if you were taxed as a corporation.
[Read more: What Is a Limited Liability Company (LLC)?]
Which business structure is right for you?
Choosing a business structure is an important decision every entrepreneur must make. And the right choice for you depends on your goals and the type of business you envision operating.
If you're looking to hit the ground running, operating as a sole proprietor is the quickest way to start. There's no paperwork to fill out, and you can focus solely on finding clients and generating revenue. However, you lose the liability protections that LLC members enjoy.
If you're unsure, it can be helpful to talk to other business owners to learn which path they took when first getting started. It can be beneficial to seek the guidance of an attorney or a certified public accountant who have experience working with small businesses.
Tax differences between a sole proprietorship and an LLC
At a fundamental level, single-member LLCs and sole proprietorships are taxed almost identically. “A single-member LLC is taxed as a ‘disregarded entity,’ meaning you file Schedule C just like a sole proprietor. The IRS sees no difference until you make an election,” wrote SDO CPA. When you choose to operate as a partnership or corporation, your tax status will diverge from that of a sole proprietor.
Both single-member LLCs and sole proprietors qualify for the same pass-through benefits: Owners of either structure can claim the 20% Qualified Business Income deduction under Section 199A.
Where LLC taxation differs is that once the LLC elects to be taxed as an S corporation or C corp by filing Form 2553 or Form 8832. As an S corporation, your LLC can reduce self-employment taxes. LLC owners pay the full 15.3% self-employment tax, while S corp owners only pay it on their designated salary. The remaining funds can be withdrawn as distributions.
A C corporation election allows retained earnings and potential tax deferral, but it presents a double-taxation issue. “The profits of a C corporation are effectively taxed twice, first when the company files its income taxes and again when those profits are distributed as dividends. Shareholders in a C corporation can't deduct business losses on their tax returns, unlike an S corp,” wrote Investopedia.
LLCs may also have local and state tax obligations that don’t apply to sole proprietors, depending on where your business is located. For instance, California levies an $800 franchise tax. Other states may have an LLC tax or business tax. You’ll also have to pay state and local income taxes and payroll taxes.
How to switch from a sole proprietorship to an LLC
Each state has its own procedures for switching from a sole proprietorship to an LLC. The process is similar, if not identical, to creating a new LLC. It requires filing the paperwork to register your business, apply for an EIN, and get any applicable permits.
LLCs require what is known as a “registered agent.” This is an individual who is designated to receive legal notices on behalf of the business. Many business owners are their own registered agents; however, if you don’t live in the state in which you’re doing business, you may need to hire a registered agent to act on your behalf.
If you wish to carry the same brand name, bear in mind you may have to cancel your sole proprietorship’s trade name or DBA name before you can form an LLC. Look into your local laws to understand if there are restrictions on using the same business name.
Finally, sole proprietors usually don’t need an operating agreement, since they’re individuals. When you change to an LLC, an operating agreement is a standard practice.
“Even if you’re a single-member LLC, an operating agreement is an important legal document for you to create,” wrote ZenBusiness. “For example, many banks won’t let you get a business bank account without one. And, if someone sued your LLC, an operating agreement helps further demonstrate to the court that your LLC is a separate entity from you.”
Check if there are other local regulations you need to meet before you make the change to an LLC.
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