Sole Proprietorship vs. LLC: How to Choose
Define Sole Proprietorship
Pros/Cons of Both Entities
Making a Decision
So, you’ve started a small business. You know what you’re going to do and how to do it. But have you determined your business entity structure? Not sure what to register?
New business owners are often confused about the difference between a limited liability company (LLC) and a sole proprietorship. Both have advantages and disadvantages. Let’s explore the differences.
What is a Sole Proprietorship?
A sole proprietorship is an unincorporated business with one owner, and it’s the simplest and least expensive type of business to form.
As a sole proprietorship, the owner’s name is the business’s name, though sole proprietorships can also operate under a brand name or trade name. The main characteristic of a sole proprietorship is that there’s no legal separation between the business and business owner, so the owner is personally responsible for the business’s debts.
Here are some key takeaways to think about when considering a sole proprietorship:
- No required paperwork apart from industry-specific licenses
- No annual state filings
- Simplified tax filing
- No liability protection
- Difficult to obtain financing in the business name
- Harder to build business credit
What is an LLC?
An LLC (limited liability company) is a legally separate business entity that’s created under state law. It combines elements of a sole proprietorship, partnership, and corporation, and offers a lot of flexibility for owners. This structure is popular with many business owners due to the ease of setting it up, its cost-effectiveness, it’s also easier to maintain than other business structures such as S corps or C corps, and it can provide asset protection. One person can form a single-member LLC, or multiple people can form a multi-member LLC.
Here are some key takeaways to consider when forming an LLC:
- More market credibility
- Liability protection in the case of certain lawsuits and commercial debts
- More financing options
- Some paperwork
- Annual state filings
- Tax advantages and disadvantages
Advantages and Disadvantages of a Sole Proprietorship
- No required state paperwork, unless there’s specific licensing such as an occupational license and/or business license.
- No required annual state filings to complete, unless there are specific industry filings required by your industry.
- All profits/losses are passed through to the owner’s personal tax return. These are typically reported on a Schedule C tax form that is filed with the owner’s personal tax return.
- May enjoy the tax benefits of being self-employed, from deducting certain business expenses to utilizing self-employed retirement plans.
- There’s no liability protection against commercial debts, lawsuits, and other obligations. This means you can be sued personally for commercial activities, putting your personal assets at risk.
- Many investors choose not to invest in a Sole Proprietorship, making it difficult to secure financing.
- Many financial institutions will refuse to establish business credit and will categorize loan requests as a “personal loan” rather than a “business loan.”
- You will have a lower amount of market credibility by not operating under a trade name. You can create a “Doing Business As” name (DBA) with your state’s department of revenue or the secretary of state, but this will require fees for the establishment and ongoing fees to continue to use the DBA name.
Advantages and Disadvantages of an LLC
- When you form an LLC, you are creating a business entity separate from yourself; you are not your LLC and your LLC is not you.
- You will have a higher level of market credibility.
- Liability protection against commercial debts, lawsuits, and other obligations as long as you set up and maintain your LLC properly, do not commingle personal and commercial assets, and avoid personal guarantees.
- It’s much easier to obtain equity and debt financing if you have a separate business entity as well as an established business credit score.
- You can combine the “best” of the incorporation worlds, by electing your single-member LLC to be taxed as a Sole Proprietor (which is the standard election), an S-Corporation, or a C-Corporation. Electing tax treatment as a sole proprietor just means all profits/losses flow to the owner’s personal tax return. Electing to be taxed as an S-Corporation means the profits/losses flow to the owner’s individual return, but you have the chance to reduce FICA taxes by establishing a “reasonable salary” and receiving the remaining profit amounts as dividends, with only the “reasonable salary” being subject to FICA (Social Security and Medicare) withholding.
- You can enjoy the tax benefits of being self-employed.
- State-related paperwork will be required, including any specific industry licensing.
- Annual state filings (and the associated fees) will be required as well, including any specific industry licensing fees that are required.
- Besides paying personal federal, state, local, and the self-employed version of FICA taxes, you might also be required to pay State Business Taxes and Unemployment Taxes.
- Costs for completing the tax return of an LLC may be higher than that of a sole proprietorship.
LLC vs. Sole Proprietorship: Which Should You Choose?
Many business owners, particularly freelancers or consultants, start as sole proprietors because it’s easy and it’s attractive for new entrepreneurs, particularly those testing a business idea.
The best business structure for you will depend on many factors, and it’s best to consult a business lawyer and tax advisors before making this important decision. Make sure you take the right steps to establish your business.