As a small business owner, choosing your business structure is an exciting task, but it doesn’t come without its challenges. Many owners wonder about the differences between each business structure and when they should make the leap from a sole proprietorship to an LLC.
In this article, we’ll take a closer look at sole proprietorships and LLCs to find out what they are, how they differ, and how you can choose the proper business structure for your new endeavor.
What is a Sole Proprietorship?
A sole proprietorship is a simple business structure run by a single person. It refers to an unincorporated business with one owner entitled to all profits of their business. There is no separation of business and personal assets in a sole proprietorship, meaning that all the profits are taxed as the owner’s personal income. You are also responsible for any business debts or liabilities.
What is an LLC?
LLC stands for limited liability company. An LLC is a legal business entity formed at the state level. Unlike a sole proprietorship, the LLC’s legal identity exists separately from its owners. As a result, the owners are not personally responsible for any business debts or liabilities.
LLCs are generally taxed in the same way as sole proprietorships, but they can elect to be taxed as a corporation to choose a more cost-effective tax structure.
What’s the Difference Between an LLC and a Sole Proprietorship?
Unlike an LLC, no formal or legal action is required to operate as a sole proprietor. Because you are the only owner of your business, your sole proprietorship stems from your business activities.
Pros of Sole Proprietorship
- Inexpensive to form: There are few costs to becoming a sole proprietor. It’s an easy way to turn your hobby into a real profession.
- Simple tax filing: As a sole proprietor, you’ll report your business income and expenses on the Schedule C form of your personal income tax return. You pay federal and state income tax on any business profits and pay self-employment taxes.
Cons of Sole Proprietorship
- High risk of personal liability: As a sole proprietor, you’ll be entirely liable for any business debts and obligations. If you have employees, you’re also accountable for their actions. If your business fails or is sued, your personal assets could be at risk.
- Difficult to attract investors: Without an LLC, your business may lack legitimacy, making it difficult to attract or secure funding.
Pros of an LLC
- Tax flexibility: With an LLC, you have the option to file taxes as a sole proprietor, partnership, S corporation, or C corporation. Filing as an S Corporation or C corporation can result in significant tax savings for your company.
- Protected from liability: LLC members are protected from liability should the company run into financial trouble or be sued.
Cons of an LLC
- Expensive renewal fees: Depending on your state, renewal fees for your LLC can be rather expensive.
- Subject to state tax: Most states have a franchise or capital values tax on LLCs. These fees are either a flat rate or vary based on your yearly revenue.
Legal Protection and Personal Liability
With sole proprietorships, you are the business. There is no separation between your assets and the business assets. While it’s nice to enjoy all the profits from your business, you’re also responsible for any debts and obligations. Creditors can even go after your personal assets if your business assets aren’t enough to satisfy a claim.
On the other hand, LLCs offer their owners a measure of protection. If your business goes bankrupt, you aren’t on the hook for the business obligations. You can file for business bankruptcy and won’t need to pay out of your own pocket. If your company is hit with a claim, creditors can’t touch personal assets like your car or home.
As a sole proprietor, you are the boss of your business. You make all the decisions and don’t need to answer to anyone else.
On the other hand, an LLC can have multiple managers or owners. The membership of your LLC and management of daily operations will be outlined in an operating agreement.
Sole Proprietorship vs. LLC Taxes
With an LLC, all your profits are only taxed once. This is known as pass-through taxation since the tax liability belongs to the owner and passes through to your personal tax return. A single-member LLC and sole proprietor will report business income on their Schedule C, and the income is taxed at the owner’s personal income tax rate.
With a multi-member LLC, each member will report and pay taxes on their share of the business income. However, a multi-member LLC must also file a business tax return with the IRS. Each member of the LLC is also required to attach a Schedule K-1 to their personal tax return, which shows their cut of the business’ income.
If a sole proprietor has employees, they’ll have to pay payroll taxes and pay self-employment taxes to the IRS. These taxes include your social security and Medicare payments.
The main difference between sole proprietorships and LLCs with taxes is that an LLC can file as a corporation.LLCs can save money by choosing a corporate tax status, as business dividends are usually taxed at a lower rate than other business income.
Frequently Asked Questions
Can you mix your business and personal finances?
It’s not against the law for sole proprietors to mix business and personal finances, but the practice of mixing finances is discouraged. With an LLC, you’ll need to keep business finances completely separate from your personal finances. You’ll establish a separate business credit score unrelated to your personal credit.
To build business credit early on, LLC members should open a business bank account and pay all business expenses from this account. If you fail to do this, you could end up losing your limited liability status.
Does your business name need to be registered for both?
Generally, sole proprietors aren’t required to register a business name. However, if the business owner decides to operate under another company name, they’ll need to register for a DBA or a “doing business as” name.
LLC names are required to have “LLC” or “limited liability company” at the end of their names. In addition, registering your business name gives your additional protection in your state.
Do you need an EIN?
A sole proprietor without any employees doesn’t need an EIN, although they can apply for one if they desire. Instead of an EIN, the sole proprietor will use their personal social security number as their taxpayer identification number.
If you have an existing EIN as a sole proprietor and decide to become an LLC later on, you’ll need to apply for a separate EIN for your LLC to file employment taxes.
How much does it cost to set up an LLC vs. Sole Proprietorship?
By default, anyone who begins a business venture on their own is automatically a sole proprietor. As a result, there are no formation fees to start a sole proprietorship - you can start immediately with no paperwork.
You’ll first need to pay the state filing fee to form an LLC. Depending on where you live, this can range anywhere from $40 - $500. You may also need to pay business license fees, permit fees, or publication costs.
How do you set up an LLC vs. Sole Proprietorship?
A sole proprietorship begins once you start doing business. You don’t need to register your business with your state to exist. However, specific states may require sole proprietors to follow local registration, business licensing, or permit laws. Check the requirements within your state to ensure you are conducting business legally.
To set up an LLC, you’ll need to file a certificate of organization with your state. You will also need to draw up an LLC operating agreement to outline the company member's rights and responsibilities. Once you’ve drawn up this agreement, you’re expected to file forms with your state agency and pay the state filing fee.
LLC vs Sole Proprietorship: Which should you choose?
Ultimately, the decision to become an LLC or continue as a sole proprietor comes down to you and the nature of your business. However, for those looking to make a slow entry into the world of entrepreneurship, a sole proprietorship is a great start. There are little to no costs to start, and you’re only held accountable for the operation of the business.
If you’re a more seasoned business owner with a solid business plan, existing employees, and liability concerns, forming an LLC may be the right choice for you. With an LLC, you can protect yourself from potential financial risks and fast-track the growth of your business.
Can you convert a sole proprietorship into an LLC?
Yes, you can. All business owners start with a sole proprietorship status, which can change to an LLC in the future.
Secure Funding to Take Your Business to New Heights
Whether you choose to establish an LLC or sole proprietorship, all businesses will need funding to grow and thrive. Fundid is re-imagining how businesses get the funding they need to succeed. Join our Grant Match Program and search for grants in the Grant Marketplace.