Choosing the right business structure when starting a new business is an important decision. Many small business owners prefer two popular business structures for flexibility and simplicity, limited liability companies (LLCs) and sole proprietorships. Unless you are a lawyer or a tax professional, the differences between each type of business entity can be difficult to understand in real-life terms.
However, your type of business entity has implications for the real world; For example, how much you pay in taxes, how much time you spend on paperwork, and what if someone sues your company.
Sole Proprietorships vs. LLC: Key Differences
Key Takeaways From Both Structures:
Here’s an at-a-glance run-down of some highlights to compare a sole proprietorship vs. LLC business structure:
- Sole proprietorships are usually cheaper to set up and administratively easier to maintain.
- In a sole proprietorship, owners are taxed at the applicable individual income tax rates on the profits made by the business.
- LLCs legally protect their owners and provide personal liability protection against the business debts.
- LLCs must complete formation documents, register with the state, and pay a filing fee.
- LLCs must follow their state’s laws that govern the LLC entity type. You may have to pay annual fees, file annual reports, and hold annual meetings.
- LLCs must keep their company records and funds separate from those of their owners.
- LLCs have tax flexibility – they can choose to be taxed as sole proprietorship (or partnership if multiple owners), C Corporation, or S Corporation.
As you can see, there are potential advantages and disadvantages to any business structure. The best option for you will depend on your specific circumstances and goals.
Forming a Sole Proprietorship vs. LLC
Forming a sole proprietorship can be as easy as getting to work. No business registrations are required to set up a sole proprietorship. Regardless of the state in which a sole proprietorship operates, it is considered a sole proprietorship unless the owner files paperwork to register the company as a different type of business entity (e.g. LLC or corporation).
Note that the requirements for the legal operation of the business may vary depending on where the business is located and what type of business activities it will be conducting. You may need to obtain licenses, permits, zoning, or other approvals from your local government. If you wish, you can set up a legal entity and register an assumed company name and, in order to make the tax season more bearable, receive an EIN (Employer Identification Number).
Limited Liability Company
In order to form an LLC, states require the filing of documents known as the ” Articles of Organization ” (sometimes called a “Certificate of Organization” or “Certificate of Formation”). The paperwork is usually neither extensive nor expensive. Requirements and costs vary by state.
The information required for filing the articles of Organization may include: the name of the business, statement of purpose, whether the LLC will be perpetual or expire on a specific date, principal place of business, registered agent, the management structure of the LLC.
You must choose a legal name for your LLC and review your proposed name before submitting the file. You should be sure to choose a name that is unique to your business and consult an attorney before using a name that others have trademarked. You must also select a registered agent. This can be you yourself if you are a single-member LLC, or one of your business partners in the case of a multi-member LLC.
Although most states do not require one, it is helpful for an LLC to draw up an LLC operating agreement and keep it at the LLC’s principal place of business. An Operating Agreement describes the roles, responsibilities, and powers of LLC members and managers to make decisions on behalf of the LLC. Some states require you to obtain your EIN for tax reasons.
What About Personal Liability Protection?
Sole Proprietorship: A sole proprietorship and its owner are considered to be the same unit. There is no legal separation between them. The entrepreneur takes personal responsibility for all debts and legal concerns of the company. So if someone sues the business or the business can’t pay their bills or loans, the owner is liable. This means the owner’s personal assets and property are at risk of being used in a refund or payment.
Limited Liability Company: An LLC is considered a separate legal entity from its owner. A member’s personal liability for business debts is limited to the amount of their investment in the LLC. This means that LLC members are, for the most part, protected from the LLC’s creditors and also from any lawsuits that may arise against the LLC. This is considered to be one of the main advantages of the LLC Enterprise Type over operating as a sole proprietorship.
Financing a Sole Proprietorship vs LLC
Regardless of the type of legal entity you choose, funding is likely to be a hot topic and challenge. Seasoned small business owners are likely to suggest that you keep your full-time job while you get your business off the ground; That personal income can be a steady stream of capital as you get your business up and running. In any case, you should get a business bank account and credit card whenever possible.
Getting a start-up loan can be difficult for a new business, but there are other funding options. You can consider crowdfunding, where you can give donors a gift for their contribution, turn them into shareholders, or simply rely on the goodness of their hearts. There are also a number of nonprofit lenders who offer microcredit to new or disadvantaged businesses.
Can You Mix Business Funds and Personal Finances?
Sole proprietorship: There is no legal obligation to keep the personal and business assets of a sole proprietorship separate. However, this makes it easier to keep accurate accounting records.
Limited Liability Company: LLC members’ personal funds and transactions must be segregated from those of the company. Violation of this rule, for example by paying personal expenses with LLC funds or vice versa, could result in LLC members losing their personal liability protection. This is why it is so important for LLCs to have dedicated commercial banking and credit accounts.
Business Growth Potential
Sole proprietorship: Sole proprietorships are not allowed to sell stocks to raise capital to promote business expansion. In addition, outside investors typically do not fund companies that are not officially registered as legal entities (e.g. LLC or corporation).
Limited Liability Company: LLCs are not allowed to sell stocks to raise capital, but they can add additional members who can invest their money in the company to support its initiatives.
Ongoing Business Compliance Requirements
Sole proprietorship: Since the state does not recognize a sole proprietorship is an independent legal entity, there are no compliance requirements for companies. However, other ongoing requirements may apply to the legal operation of the business, such as: renewing business licenses, permits, and DBAs may apply to legally operate the business.
Limited Liability Company: LLC compliance requirements vary by state. These may include: filing an initial report (sometimes called a “statement of information”) with the government; Filing an annual report with the state (sometimes this is every two years or at a different interval), keeping business funds and transactions entirely from those of the owner, filing amendments when there are major changes to the LLC that need to be updated in the LLC’s Articles of Organization.
LLC vs. Sole proprietorship: Taxes
A single-member LLC and a sole proprietorship are similar in terms of tax treatment. Both are run-through companies, which means that the company does not pay any income tax itself. The owner reports business income on Appendix C attached to their personal tax return and the income is taxed at the owner’s personal income tax rate.
Multi-member LLCs are also pass-through entities, where each owner reports their share of the business’s income and pays taxes. The only difference is that a multi-member LLC must file a business tax return with the IRS, Form 1065, U.S. Return of Partnership Income. In addition, each member must include an Appendix K-1 on their personal tax return showing their share of the business’s income.
In addition to income taxes, both LLCs and sole proprietorships can have additional tax obligations. Regardless of the business structure, you will have to pay payroll taxes if you have employees. You must also collect state and local sales taxes when selling taxable goods or services. Finally, as a self-employed business owner, you are responsible for paying self-employment taxes to the IRS. These taxes cover your Social Security and Medicare tax obligations.
Some states and local jurisdictions impose additional taxes on LLCs. Depending on the state, this can be referred to as franchise tax, LLC tax, or business tax. You must also pay state and local income and wage taxes.
Only LLCs can choose a corporate tax status
A key difference between LLCs and sole proprietorships is tax flexibility. Only LLC owners can choose how their business should be taxed. You can either stick with standard pass-through taxation or choose to have the LLC taxed as an S corporation or a C corporation.
An S corporation is a pass-through entity. When taxed as a C-Corporation, the LLC pays a flat 21% federal corporate tax (most states and some municipalities also levy corporate tax).
LLCs can sometimes save money by electing corporate tax status. When a company is taxed as a corporation, dividends from the business are typically taxed at a lower rate than normal business income. In addition, a corporation’s retained earnings are not subject to income tax.
In contrast, LLC members cannot treat income as dividends and must pay tax on all profits in the company, whether or not they are withheld by the company. A company is also entitled to more tax deductions and credits.
If you have a sole proprietorship, when should you form an LLC?
The decision is ultimately yours. However, keep in mind that legal protection for your new business can be important to your well-being and the longevity of your business. Forming an LLC early on can help protect you personally from business liability. It can also make your business appear more stable to lenders and vendors, as well as customers and business partners. With that in mind, it can be an investment in your success.
Running a sole prop is as easy as getting to work and tracking your income and the breakup. You are the owner and the company, so all decisions are yours. This makes it easy for you to get started, but as your business grows, you take more risks.
LLC vs. sole proprietorship: Which should you choose?
Many owners, especially freelancers or consultants, start out as sole proprietorships because it’s easy. Minimal paperwork is required in the beginning and there is no huge expense involved, which is appealing to start-ups, especially those trying out a business idea. Taxes are also easy for sole proprietors, as no separate business tax return has to be submitted.
The rubber hits the streets as your business grows. A sole proprietorship structure does not provide legal protection for your personal assets, so you can personally go bankrupt if your business does not perform as planned or is faced with an unexpected challenge. LLC owners, on the other hand, are not personally liable for business debts, so you have more protection in the event of a business bankruptcy or business lawsuit.
In addition, LLCs offer tax flexibility. Most LLC owners stick to pass-through taxation like sole proprietorships are taxed. However, you can choose corporate tax status for your LLC if it will save you more money. All 50 states recognize the LLC structure to encourage small business growth.
Which company structure is best for you depends on many factors and it is best to consult a business lawyer before making this important decision. However, because of the combination of liability protection and tax flexibility, an LLC is often a great fit for a small business owner.