LLC vs Sole Proprietorship: What’s Their Difference?

Last updated on: July 21, 2021

Starting a business is an important step. There are several crucial decisions you have to make in order to realize your dreams and ambitions. One of them is choosing your business structure.

Every aspiring entrepreneur must decide on either starting a business as a sole proprietorship or forming a Limited Liability Company, and what the consequences may be.

In fact, this is a really big decision for your business, because it determines factors like:

  • Type of management;
  • Tax implications;
  • The existence or not of a liability protections guaranteeing the inviolability of the owners’ personal assets;
  • Start-up costs.

Although both of these structures allow you to operate without partners or employees, the difference between them is significant.

Let’s talk about what an LLC and a sole proprietorship are, and compare the LLC vs. sole proprietorship. Also in this article, we will answer the question of whether the investment in the LLC pays off, and outline the advantages and disadvantages of both business structures.

What is a Sole Proprietorship?

A sole proprietorship is the easiest and cheapest way to do business.

If an individual or a married couple starts a business, they are considered to be a sole proprietorship by default in terms of legislation.

It is very easy to form one. Being an informal business structure, the state registration is not required. There are no mandatory state fees either. Actually, it is the easiest way to realize a dream of having your own business. 

However, before making the final decision on running a business as a sole proprietorship, you should take into account all the features of this type of business. Here are some of them:

  • No personal liability protection that guarantees the security of your personal assets;
  • No required paperwork apart from industry-specific licenses;
  • You don’t have to pay corporate taxes. You are only responsible for personal federal, state, local self employment tax and FICA taxes;
  • Tough to build business credit and difficult to obtain funding;
  • There is no need to file an annual report and comply with other formalities inherent in a registered business.

A sole proprietorship does not create a separate legal entity. The owner and the business are treated as one. Therefore, you can often distinguish a sole proprietorship from other forms by the fact that its name is the same as the owner’s name. 

If you want to operate under a different name, you can apply for a DBA. This abbreviation stands for ” doing business as” and allows you to operate under a fictitious name.

What is an LLC?

An LLC is a separate legal entity founded by one or more members in accordance with state law. 

Today, more and more people form an LLC to run a business. If you are thinking about this option, consider the features of an LLC such as:

  • Your personal assets safe from possible claims. In the case of debts or a lawsuit against the company, it will not affect the owners’ assets in any way;
  • Launching and maintaining an LLC requires plenty of paperwork, in comparison to informal business structures;
  • To avoid any possible legal consequences, it is necessary to submit annual state filings on time; 
  • An LLC has more market credibility than a sole proprietorship because of its official status and limited liability;
  • There are additional taxes to pay;
  • It is slightly easier to obtain financing because potential investors feel more comfortable and secure.

You can distinguish an LLC from other forms by the special “designator” in the name, which are words such as “limited liability company” or the abbreviation “LLC”.

What’s the Difference Between an LLC and a Sole Proprietorship?

Both options have advantages and disadvantages. There is no definite answer to the question of what is better, a limited liability company or a sole proprietorship. It all depends on the unique needs of each particular business.

We have prepared a comparison of an LLC versus the sole proprietorship to better demonstrate the peculiarities of these two forms.

Formation

If we compare sole proprietorship vs LLC in terms of formation features, the first one has a significant advantage regarding its simplicity and cost. 

There is no statutory registration procedure for the sole proprietorship, so you just have to get started. 

However, the lack of formal requirements for starting a business does not mean that there are none at all. Keep in mind that depending on your business activities and location, you may need to obtain a license or permit. You can also apply for a DBA, if you plan to run your business under a fictitious name.

Forming an LLC requires more formalities. Depending on the state, the requirements for formal incorporation may vary, but the basic steps generally include the following:

  • Name your LLC, which must be unique and contain words that clearly describe the business as LLC;
  • Designate a registered agent;
  • File the Articles of Organization (the main document of the company);
  • Create an Operating Agreement (an internal LLC document that describes the basic principles of its work, as well as the rights and duties of its participants);
  • Get an EIN;
  • Obtain certain licenses or permits.

The cost of the mandatory state fee depends on the state and ranges from $50 to $200.

Operations and management

With sole proprietorships, decision-making and management is performed directly by the owner of the business. This does not prevent him from hiring employees or other specialists, such as lawyers or accountants, but the owner is always at the head of the company.

The management structure of an LLC is determined by the number of its participants. Thus, a single-member LLC is managed by its owner. However, when it comes to a multi-member LLC, the difference between the sole proprietorship and an LLC is more obvious. There are two types of management available for such companies:

  • By the owners;
  • By one or more designated managers.

Voting procedures on the decision-making process and distribution of votes among the participants are usually established in the Operating Agreement.

Taxes

Due to the fact that the sole proprietorship is not a separate business entity, you are not required to pay taxes on its behalf. In this case, it is the owner’s responsibility. The owner must indicate all profits and losses in the Form 1040, which is enclosed with the personal tax return, and pay income tax on that amount.

There is also a self-employment tax. All sole proprietorships must pay it on time to avoid IRS penalties.

If you want to choose a tax treatment on your own, when thinking about an LLC or a sole proprietorship, the first one is the best option. Unlike a sole proprietorship, a limited liability company can be taxed as:

  • Single LLC (as a sole proprietor): this classification falls into the “pass-through” taxation category—the business doesn’t file any tax forms. As the owner of the LLC, you report business income or loss on your personal tax returns;
  • Multi LLC (as a partnership): each partner pays self-employment taxes on his share of the partnership profit on the Form 1040;
  • LLC as a C corporation: using this method of taxation, an LLC must pay a flat federal corporate income tax. At the time of this writing, the rate is 21%. In addition, similar taxes may be paid at the state or local level. Members pay income taxes when they distribute profits, by reporting their shares on their personal tax returns. Such “double taxation” is not beneficial to every company, but it does offer some advantages. For example, the right to additional tax deductions or loans;
  • LLC as an S corporation: when you choose this option, the IRS treats the LLC as a partnership. In other words, the company delegates tax liability to its owners. The company’s profits are distributed according to their shares of ownership and are subject to their personal income taxes.

When planning your expenses, it’s also important to keep in mind that income tax is not the only tax you have to pay. Depending on state requirements, both the LLC and sole proprietorship may be subject to:

  • Payroll tax, if you have hired employees;
  • Sales tax if you sell goods or services;
  • Sometimes the state or city imposes additional taxes. For example, a franchise tax.

Legal protection

When you choose the LLC or sole proprietorship for small business, the ability to protect your personal assets can be a strong argument.

Because sole proprietorships treat the business and the owner as one, their assets are not separated. The owner is fully liable for business debts and obligations, and, furthermore, risks personal assets.

Forming an LLC is one of the most reliable ways to secure your real estate, money, car and other personal assets from possible creditors. Since an LLC is a separate legal entity, it is responsible for its own debts. The owner’s property is untouchable.

There are some exceptions where the court may disregard the effect of limited liability, for example:

  • Fraud related to obtaining a loan;
  • Violation of the tax law;
  • Negligence;
  • Inflicting physical or mental harm on other people.

Paperwork and compliance

Due to the fact that a sole proprietorship is an informal business entity, it is not subject to compliance requirements.

For an LLC, there are different rules. You will need to provide:

  • Filing the Statement of Information and annual report on time;
  • Separation of the business assets from personal assets;
  • Having a valid registered agent, etc.

Depending on the needs and structure, a sole proprietorship or an LLC must:

  • Pay taxes;
  • Obtain  an EIN;
  • Renew licenses, permits and a DBA on time, etc.

Which Should You Choose?

There is no best business structure that perfectly fits every entrepreneur. That’s the truth.

However, based on the difference between an LLC and a sole proprietorship, it is possible to choose the type of enterprise that will be right for you.

You can’ t deny that at the initial stage a sole proprietorship does provide some benefits. Because of the lack of formal requirements, you can start making deals without wasting time and money on registration.

This option would work well for your small business if it:

  • Has a small number of clients;
  • Is associated with small financial risks.

On the other hand, the ability to protect personal assets, flexible taxation, and the credibility that an LLC provides cannot be overstated. Choose this legal structure if:

  • You have an extensive customer base;
  • The business has a substantial income;
  • You are focused on dynamic growth and development;
  • Your business activity involves a risk of liability or losses;
  • You want to use the opportunity to change your tax treatment.

Many aspiring entrepreneurs choose the form of their future company without having enough information about each of the available options. If you are not sure yet, or if you have any questions, a consultation with a professional can be very helpful. An experienced lawyer or accountant, who understands state law, will answer all your questions.


Frequently Asked Question


Does Your Business Name Need to Be Registered?

According to general rule, a sole proprietorship operates a business under the name of its owner. Registration is not required in this case. 

However, if you plan to operate under a different name, you must apply to the state for a DBA. 

The LLC name is automatically registered and assigned to the company upon approval of its Articles of Organization.

In case you are not ready to officially launch yet, but you want to reserve a certain variant of the name, you can apply for a reservation. This will protect your name from third parties for a certain period of time to give you time to complete preparations for company registration.

Senior Business Tax Writer, etc
Jean Wilson Murray
https://bestllcservices.co/
(323) 789-5289
Senior Business Tax Writer, etc
Jean Wilson Murray

In this IncFile vs ZenBusiness review, we're going to compare two of the most popular LLC formation services based on pricing, features, and drawing out differences and similarities to let you see which is most suitable for you and your business.

You can learn more about @Mike here.

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