Sole Proprietorship vs. LLC

If you're starting a business, you’ll need to decide on a business entity type.

Two popular options among new business owners are sole proprietorships and limited liability corporations (LLC). Which one you choose will impact the steps you need to take to start your business and the ongoing requirements for running it. It will also affect the extent of your personal liability and your business’s tax treatment.

See below for all you need to know about starting a sole proprietorship versus an LLC to determine which best fits your needs.

Sole proprietorship vs. LLC explained

A sole proprietorship refers to a single-owner business where the owner isn't treated as a separate legal entity from the business. Under this structure, the owner keeps all business profits, but is also completely responsible for its debts.

Sole proprietorship is perhaps the simplest structure you can have, and you can get started immediately without many formalities.

So, what is an LLC, on the other hand? This type of business provides limited liability protections for your personal assets like a corporation. This means its accounts and debts are separate from your own and, if the LLC could not pay its expenses, creditors could only go after the LLC's assets, not your personal ones.

Starting an LLC requires registering with the state and designating the members who will run it.

Both sole proprietorships and limited liability companies make suitable structures for single-owner businesses, and, before making a decision, it’s important to understand the pros and cons to both.

Sole proprietorship

A sole proprietorship is a business you own and don't have to formally register with the government in a particular way.

This popular choice for single-owner businesses offers simplicity in starting and operating the business. You’ll control all aspects so you can make daily business decisions, keep all profits and even change the business' direction as you'd like. In addition, you can still hire workers like you could with a more formal structure.

Formation documents needed

A sole proprietorship doesn't require any state document to start the business. Instead, you start the business by simply providing work for clients.

However, if you plan to use a trade name, your county or state may require filing a fictitious business name statement with your desired business name. You'll first have to confirm availability for the name and check any restrictions on allowed business names. For example, your business name can't include "corporation," "LLC" or similar terms implying a different business entity type. You can consult your state or county for the list of disallowed terms.

You'll also want to know if you need any licenses or permits for your type of work. For example, running a food service business might require licenses from the health department, food handling safety certifications, among other requirements. Obtaining these means meeting all requirements, submitting paperwork and, of course, paying fees.

Registration and filing fees

You usually don't have to register with your state to operate as a sole proprietor. However, you'll pay a nominal fee if you register a fictitious business name. The amount of the fee depends on the state. For example, the state of Washington charges a $5 filing fee for fictitious business names, while the state of Florida charges $50.

Depending on your line of work, you may also need to pay for business license and permits. These can include occupational licenses, operational licenses, zoning permits and sales tax permits. You'll want to check with local, state and federal authorities to determine your requirements and costs.

Taxes and business expenses

As a sole proprietor, you wouldn't need to file a separate business tax return; instead, you'd list your business income and deduct business expenses on your state and federal personal tax returns. Your business income gets taxed at your usual individual income tax rate. You'd also pay self-employment tax, which covers the employee and employer shares of Medicare and Social Security taxes.

You'd also need to pay estimated taxes to the tax authorities each quarter. This means estimating your annual income, so you don't come up short. Otherwise, you could owe taxes and penalties when you file your return.

You can use your Social Security number as your tax ID as a sole proprietor. However, consider getting an Employer Identification Number (EIN) from the IRS if you want a business-specific number. An EIN offers more privacy than your Social Security number, boosts your business’s credibility and is required if you hire workers.

Impact on personal assets and protection

A sole proprietorship and LLC differ, especially in terms of liability protection. As a sole proprietor, you face full personal responsibility for any debts and legal issues your business might face. You could lose your personal assets if you get sued or need to cover business debts.

However, business liability insurance can help provide personal financial protection if legal issues arise. For example, if someone gets injured at your business or accuses you of negligence, liability coverage could help pay for the damages.

Reasons business entities choose sole proprietorships

There are quite a few reasons many business owners prefer a sole proprietorship over an LLC. These include:

• Simple formation: You won't need to fill out detailed paperwork such as the articles of organization that an LLC requires. Instead, you just need to register your business name, if you have one, and get any required permits and licenses.

• Fewer operating requirements: With an LLC, the owner must file an annual report. However, you won’t have this obligation running a sole proprietorship.

• Lower costs: You won't have to pay the annual filing fees or state fees that an LLC can require.

• Fewer tax requirements: You won't need to do a separate business tax return or file special paperwork with the IRS to change your tax status from an individual to a business.

Limited Liability Company (LLC)

Unlike a sole proprietorship, an LLC is a state-registered business structure characterized by owners not having personal liability for the business's debts. Since an owner gets legally treated as a separate entity from the LLC, their personal assets aren't at risk if the business defaults. Additionally, the LLC's profits are passed down to owners so that the company doesn't pay taxes on them.

You can choose to run the LLC alone or with others with whom you share profits and decisions. Each owner is called a member, and both individuals and some companies can become members.

Setting up and running an LLC comes with more requirements, including filing the articles of organization with the state. Otherwise, it operates a lot like a sole proprietorship if you have a single-owner business.

Forms needed

When you’re learning how to start a business as an LLC, it’s important to remember that it will involve a lot more paperwork than a sole proprietorship. You’ll need to formally register it with the state since the IRS won't automatically consider your business an LLC by default. The specific documents vary by location, but most places will require the following:

• Articles of organization: Comparable to the articles of incorporation for corporations, this document includes key details about your company. You obtain this form from your state, and it serves to establish the LLC. You'll provide information such as the company's name and contact information, the line of business, and the effective start and end dates and details for each member. You’ll also name a registered agent to handle your business's legal documents.

• Operating agreement: Certain states, including New York and California, require this document which discusses how members will run the LLC. It explains procedures for adding and removing members, clarifies member responsibilities and outlines decision-making processes. You'll also find basic business information along with details on meetings, financial and tax concerns and contractual duties.

• Initial report: A few states, including South Carolina and Nevada, ask for an initial business report when you register the LLC. This document should contain basic details such as the names of people running the business, your principal place of operations, your line of work and your designated registered agent. Every year, your state will likely require submitting an annual report containing similar details to this initial report.

Along with these specific documents, plan to complete paperwork to register your trade name. In addition, you will need to register with applicable tax agencies and obtain relevant permits and licenses.

Registration fees for an LLC

One difference between an LLC and a sole proprietorship includes the registration costs. Unlike a sole proprietorship, you'll need to pay a registration filing fee ranging from around $50 to $500, depending on your state. For example, the state of Indiana fees start at $95 to form an LLC, while New York State charges $200. You'll also have an annual filing fee.

In addition, don’t forget to consider other costs, such as a fee for registering your business's trade name and getting the appropriate licenses and permits. Your state or county can provide specific rates.

Taxes and expenses

How you handle your LLC’s taxes and expenses depends on how many members it has. Further, it depends on whether you elect for tax treatment as a corporation.

As a single-member LLC, you'd report your business income and expenses on your personal tax return since the IRS sees you as a sole proprietor. You'd also pay your individual income tax rate and the self-employment tax and make quarterly tax payments. By contrast, the IRS treats multiple-member LLCs as partnerships by default. This requires an additional partnership tax return alongside personal tax returns for the owners.

You can also opt for the IRS to treat your LLC as a corporation. This means you'll experience double taxation on the company's profits and distributions to owners and the corporate tax return requirement that C-corps have.

Whether you start an LLC or sole proprietorship, your potential tax savings remain the same. In either case, you can deduct your business expenses and qualify for business-related credits and deductions.

Liability protection and assets

An LLC offers liability protection benefits that a sole proprietorship doesn't. Since you and the LLC are considered separate entities, you don't face personal liability for business debts. Instead, you can only lose the money you've invested in the business. So, while your business can lose its assets, you usually won't lose personal assets if your LLC gets sued or you default on your business debts.

Reasons business owners choose LLCs

In contrast to a sole proprietorship, an LLC offers some benefits that can benefit many business owners. This business type is appealing due to its tax advantages, legal protections, flexibility and formality.

• Tax advantages: The IRS allows an LLC to receive tax treatment as a corporation if you choose it. Otherwise, pass-through taxation usually applies where only the LLC members pay taxes on profits and not the LLC itself. This means you’d report your business income on your personal tax return. You'll also list business expenses and claim other related credits and deductions there.

• Legal protections: Having an LLC protects owners from personal liability for business debts since the owners remain separate legal entities from the business itself. This provides peace of mind that guides many business owners on when to choose an LLC instead of a sole proprietorship.

• Flexibility: When comparing an LLC to a sole proprietorship, an LLC offers flexibility since you can have one or multiple owners and distribute profits as you’d like. If you'd like your LLC to receive tax treatment as a corporation, you also have this option through the IRS.

• Formality: Forming an LLC provides some authority that operating as a sole proprietor may not. This can help build credibility with clients and lenders and make it easier to get credit.

Can you change from one to the other?

Your sole proprietorship versus single-member LLC decision isn't permanent. If your needs change, you can select a new business structure. The process you’ll follow to do so will depend on the type of legal entity you currently have.

If you run a sole proprietorship, you’ll need to complete all the required state and tax paperwork to form the LLC and pay the relevant fees. You'll then need to follow the requirements for running your LLC.

Changing from an LLC to a sole proprietorship is more complex. You'll need to complete state dissolution paperwork to dissolve your LLC. You'll also need to alert other parties, such as creditors, tax agencies and licensing agencies. Finally, you'll need to pay off the LLC’s debts and distribute its assets.

What's your next step?

It’s always a good idea to meet with a business attorney and tax advisor before you make a long-term decision. They may ask about your business's complexity, line of work and future business plans. Your business structure needs may change as your business evolves.

After you make your LLC versus sole proprietorship decision, you can continue planning your business. Make sure you understand the market for your products and services so you can succeed. Lastly, consider funding and look for the best small business loans to meet your needs.