Selecting a legal structure is an important step in starting a business. Understanding the various financial and legal aspects of selecting the entity that best meets your business and personal needs may save considerable time and money to fix later.
There are four primary business structures to choose from, including:
- Sole Proprietorship
- Limited Liability Company
The sole proprietorship and Limited Liability Company are two of the most popular entities, but each has its own pros and cons. For more information about the other two entities, click learn more about the partnership and corporation.
The low cost and ease of starting are appealing to many new entrepreneurs, but may not provide entrepreneurs the personal liability protection and tax advantages of a Limited Liability Company (LLC). The decision of whether or not you should form an LLC depends on several factors, including what your business sells, potential exposure to lawsuits, and business funding needs.
We will go into more detail on the advantages and disadvantages of the sole proprietorship and LLC to help provide some direction in making this decision. Keep in mind that while we have a lot of experience in this area, we are not attorneys or accountants. This information shouldn’t be used in place of professional advice.
What is a Sole Proprietorship?
A sole proprietorship is essentially a business operating through the owner. According to the SBA (Small Business Administration), over 70 percent of businesses form as a sole proprietorship. To establish this type of business, the owner doesn’t necessarily need to file any documents, unless they plan to operate under a fictitious name (known as an assumed name, doing business as or DBA in some states).
Advantages of the Sole Proprietorship
The reason sole proprietorships are so popular is they are easy to set up, inexpensive, and have comparatively little paperwork.
Setting Up – The sole proprietorship is the easiest business structure to form because there is no entity. Legally speaking, the sole proprietorship and the individual are the same.
Unless the sole proprietorship has employees, it won’t need to register for an EIN (Employer Identification Number). The business is identified by using the owner’s Social Security Number.
Managing funds as a sole proprietorship is more relaxed than the LLC, as there must be a separation between your business and personal accounts. Not separating funds may cause the LLC to risk losing limited liability protection. There is no such concern about commingling funds in a sole proprietorship.
Ease of Operation – The sole proprietorship is the easiest of the four entities to administer. While there are aspects all entities will encounter, the sole proprietorship “entity” doesn’t add complexities such as state registration and recurring reporting requirements that come with the LLC.
Cost to Form – Unlike the LLC, there are no formation filing fees or ongoing annual report fees that need to be paid for this type of entity. The only fee to legally operate a sole proprietorship in some states is a name registration. If the owner is doing business under a name that isn’t their full first and last name, they will need to obtain a Doing Business As (DBA) registration, which is sometimes known as an Assumed Name or Fictitious Name. Expect to spend from $0 – $100 to register the DBA.
Disadvantages of the sole proprietorship
Liability – The biggest disadvantage of a sole proprietorship is that it is not a separate entity, and there is no personal liability protection for the owner. The owner is personally responsible for all debts and financial obligations incurred by the business. If the business is sued, the sole proprietor’s personal assets (such as homes, cars, personal property, etc.) could potentially be used to satisfy any judgments.
Taxes – As a sole proprietor, you can only report net income or net losses on the owner’s personal tax return. In some cases, the owner will pay more in income taxes.
Investment – One of the downsides of operating a sole proprietorship is that there are limited options to raise capital. While it is always possible to convert a sole proprietorship into a different entity down the road, forming and operating as an LLC, partnership, or corporation from the beginning can make it easier for you to take on partners, and raise funds from investors.
A sole proprietorship is limited to loans and lines of credit to finance the venture.
What is a Limited Liability Company?
A Limited Liability Company (or “LLC”) is a separate business entity that is a distinct legal entity from its owners upon formation.
Limited Liability Companies are a popular business structure used by small businesses that want the ease of operation of the sole proprietorship but want to protect their personal assets. The Limited Liability Company provides the liability protection of a corporation without the administrative burdens that come with a corporation, such as having a board of directors and annual meetings.
An LLC can be owned and operated with a single owner.
Advantages of the LLC
Liability Protection – One of the main advantages of an LLC is the legal protection that is provided to the owners (referred to as “members”) personal and business assets. This protection is available since the LLC is a separate legal entity from the member(s), which allows the assets of the company and the personal assets of the member(s) to be independent. As long as the entity is formed correctly and maintained, LLC members are protected from the business’s creditors seeking compensation from personal assets and funds.
Something to note is this liability protection is often mistaken in thinking it will protect the members if the business defaults on a bank loan. In almost every case, when taking out a bank loan, the bank will require anyone owning 20% or more of the business to sign a personal guarantee stating the member(s) will repay the business debts.
Taxation – One crucial benefit of the LLC is that it has greater flexibility in how it can be taxed. The LLC can choose to be taxed like the other business entities (sole proprietorship, partnership, and corporation (both C corporation and S corporation). This election is made with the IRS (Internal Revenue Service) and allows the opportunity to select the most efficient tax treatment. Even better, the tax election can be changed, which can be useful as the business grows.
By default, the IRS considers a single-member LLC (SMLLC) to be taxed as a sole proprietorship, which is more commonly known as a “disregarded entity” for tax purposes. This means the LLC isn’t recognized as an entity by the IRS, and profits or losses from the business are transferred from the LLC to the member’s personal income tax return. This pass-through taxation is the simplest to file and is usually the lowest tax burden for smaller businesses.
Regardless of how the LLC is taxed, it is still a separate legal entity providing liability protection for the members.
Electing corporation tax status may allow higher profit businesses to save on taxes. Assuming a reasonable salary is being taken by the owner, the remaining profits can be distributed as dividends that aren’t subject to self-employment taxes. The downside of this benefit is that an owner-operator has to become an employee, and their wages are subject to payroll taxes and unemployment taxes. This also comes with the additional administrative tasks of filing payroll forms.
Credibility – Having the LLC designator at the end of a business name may provide the perception to customers that the business is larger and more professional than those without.
Investment – LLCs do not necessarily have an easier time raising money from investors, but unlike the sole proprietorship, the LLC can sell a portion of the business. This investment allows the business owner to obtain funding without taking on debt.
Disadvantages of the LLC
Paperwork – Forming an LLC requires registering with a state (typically with the Secretary of State in most states) and annual reporting requirements. For a small business looking for liability protection and isn’t raising much money from investors, the LLC is often the better choice over the corporation because there are fewer administrative requirements.
Registered Agent – LLCs are required to assign a registered agent. The agent is someone who accepts legal documents and tax notices on the LLC’s behalf and can be the owner.
Cost – Forming an LLC requires paying an initial filing fee, an annual fee in some states, and in some states, a franchise tax. The franchise tax is a tax on the privilege of doing business in that state a sole proprietorship usually doesn’t have to pay.
Related: See what it costs to form an LLC in each state.
Additionally, there are ongoing costs with the annual report filing and franchise tax.
How to Choose Between the Sole Proprietorship and LLC
It’s hard to make a blanket statement as to what is the best business structure between the sole proprietorship vs. LLC. Every business has different levels of risk, and every person has a different level of risk they are willing to accept. There is also the cost of formation and administrative requirements to take into account.
Here are a few considerations in helping choose, but consider getting professional advice from an accountant and attorney before making your decision.
Setting Up the Business
As discussed above, forming a sole proprietorship is as simple as starting to conduct business. There are no required documents that need to be filed with the state, other than a DBA (“doing business as”) certificate if the business plans to operate under a fictitious name.
Forming an LLC may require the completion and filing of Articles of Organization and the associated state fees. LLCs should also have an LLC operating agreement in place, even if there is only a single member. The operating agreement helps establish the guidelines for business procedures and can demonstrate that you have complied with LLC formalities in case your liability protection is jeopardized later in litigation or collections. In addition to forming an LLC, you may also need to register for business licenses or permits, and these requirements vary depending on what the business sells and where it is located.
The liability protection of LLCs may be particularly attractive to owners of certain businesses in higher liability industries. Although there are specific instances, such as negligence or intentional misconduct, LLC owners are not usually personally liable if there legal actions against the company. As the LLC provides separation from the owner’s personal and business assets, it’s also important to set up a separate bank account.
Sole proprietorships do not offer any such protection. If the business is sued, the owner is at risk personally.
While the tax deductions are pretty much the same, regardless of the type of entity, there are some differences in how they are taxed.
Sole proprietors pay self-employment taxes on income earned by the business in addition to taxes on business profits. The owner and business are considered one tax-paying entity, and all business income is viewed as the personal income of the owner. At the end of the year, a Schedule C (Profit or Loss From Business) is filed along with the owner’s personal tax return.
LLCs can be taxed in a variety of ways. Single-member LLCs can be taxed as a sole proprietorship, meaning that the business tax obligations pass through to the individual tax returns of the LLC member. An LLC can also choose to be taxed as a corporation by filing an election with the IRS to be taxed either as a C Corp or S Corp, which may provide tax savings. Basically, all profits of a sole proprietorship are assessed self-employment taxes (Social Security and Medicare) which are 15.3%. As an LLC that elects to be taxed as a C Corp or S Corp can decide to distribute dividends after paying the owners a reasonable salary.
Tax savings are great, but shouldn’t be the primary reason to form an LLC. Having the liability protection of an LLC can be considered as insurance to protect your personal assets in case the business faces legal issues. In most cases, the tax savings won’t usually be realized until the business is making a minimum of $60,000 – $80,000 in annual profit.
While there is really only one way to operate a sole proprietorship, there are many options for how you can structure an LLC. Even as a single-member LLC, there can also be managers with different responsibilities within the company.
As a sole proprietor, the business owner makes all the business decisions unilaterally with fewer regulatory and administrative constraints on the business.
A single-member LLC can also provide the owner with control of the business. Still, the owner has the added responsibility of filing the initial paperwork and complying with annual reporting and maintenance fees.
Choosing between the LLC vs. sole proprietorship isn’t an easy one, but choosing a legal entity is one of the most critical decisions for new business owners. Weighing the risks and benefits unique to your business can help guide you to whether a sole proprietorship or LLC is the best structure.
What is the main difference between an LLC and a sole proprietorship?
The biggest difference between an LLC and a sole proprietorship is that the LLC provides a shield for the owner’s personal assets should the business face legal action. As a sole proprietor, the business and individual are legally the same.
Which is better, an LLC or sole proprietorship?
It depends. There are several factors when considering which entity is the best for your business. You will want to consider the need for liability protection, cost, and tax flexibility. For many, the low cost of an LLC, liability protection, and the potential to save on taxes makes it a better choice.
Which pays less taxes, a sole proprietorship or LLC?
In many cases the taxes for a sole proprietorship and LLC are going to be the same. Where the LLC comes out ahead is an LLC can provide its members a distribution that isn’t subject to self-employment or payroll taxes.
Can a sole proprietorship become an LLC?
Essentially Yes. The sole proprietorship will cease to exist and a new LLC entity would be formed. It is recommended to work with an accountant to make sure the transition is done correctly.
Choice of Organizational Form for the Start-Up Business: https://scholarship.law.umn.edu/cgi/viewcontent.cgi?article=1111&context=faculty_articles
IRS-Sole Proprietorships: https://www.irs.gov/businesses/small-businesses-self-employed/sole-proprietorships