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LLC vs. Sole Proprietorship

Updated: November 15, 2023
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What is the difference between an LLC and Sole Proprietorship?

A Limited Liability Company, or LLC, and a sole proprietorship are both legal entities that can be formed to operate a business. Both structures allow a business owner to legally run their companies, however they each have unique features, advantages, and disadvantages.

The main ways that an LLC differs from a Sole Proprietorship are:

  • Liability protection for the business owner
  • Ownership structure
  • Government regulation
  • Taxes

A sole proprietorship is an unincorporated business that is not legally separated from the business owner. There is only one owner, and that owner reports the business’s profits and losses on their individual tax return. The owner is liable for some risks, depending on the nature of the business and its activities.

An LLC on the other hand provides personal liability protection to a business owner because the business is considered a separate entity from the individual owner. LLC’s can have multiple owners and have the option to choose how they are taxed. They can opt to be taxed as a partnership, corporation, or a disregarded entity.

Which is better, LLC or Sole Proprietorship?

Determining which business structure is better depends on the type of business and business needs. Both an LLC and a Sole Proprietorship offer different advantages and disadvantages.

Sole Proprietorships are extremely simple to set up and are subject to less government regulation than an LLC. For a business owner that is looking to make minimal profit and has low risk, a Sole Proprietorship is a great option.

If a company is looking to have more than one owner, or carries a higher risk, an LLC would be the better option because owners are protected from business related liabilities.

For more information on how to make the right choice between an LLC and a Sole Proprietorship, read this article.

How LLCs Work

When an LLC is formed, it becomes its own legal entity separate from the business owner or owners. An LLC must have a registered agent and must file articles of organization or a certificate of formation with the state in which they are doing business.

There are two ways to structure an LLC:

Ownership Structure- Owners of LLCs are called “members”. There can a be a single-member LLC in which there is only one owner, or a multi-member LLC in which there are two or more owners. Depending on how many people are involved in the business will impact whether you form a single-member or multi-member LLC.

Management Structure- A management structure allows the day-to-day operation of the business to be controlled by managers. In a single member or small multi-member LLC, it is common to have one member act a manager. This is called a member-managed LLC.

Generally, members of the LLC will make all major business decisions while the managers run daily operations. LLCs can also establish voting rights of each member to help govern decision making.

Read this article for more information about LLCs.

How to Form an LLC

The process to form an LLC will depend on the business laws of the state where the company will be operating. Typically, an LLC is required to file articles of organization or a certificate of formation with the Secretary of State. This document will require basic information about the company like:

  • The name of the LLC
  • The effective date of the formation of the LLC
  • The name and address of the registered agent of the LLC
  • The company’s principal office
  • The business purpose or sometimes called “general character” of the LLC
  • Duration of the business
  • The name and address of one member of the LLC
  • The name and address of each organizer of the LLC
  • Some states require a copy of the name registration certificate
  • Signature of the authorized representative

Many LLCs will also choose to have an LLC operating agreement similar to corporate bylaws in which all the details of how the company will be run are described.

LLC’s must also select a registered agent that can accept legal documents on behalf of the entity.

Pros of an LLC

LLC’s provide business owners with a variety of advantages. The advantages will vary depending on the preferences of the owners. Below are a few benefits of forming and LLC:

  • Limiting Personal Liability for Business Debts: An LLC protects an owner from certain liabilities like business debts. In the event of a lawsuit or claim of a creditor, only business assets are at risk to be claimed to satisfy a business debt. An owner’s personal property and assets are protected.
  • Ability to Raise Capital from Investors: The owner of an LLC has the option to bring in investors who can contribute additional capital, property, or even services to the business.
  • Tax Advantages: An LLC owner does not have to file a separate tax return for the business. LLCs are “ pass through entities ” because profits and losses from the business pass through the business to the owner’s personal tax return.
  • Credibility: Forming an LLC makes your business its own legal business entity. This makes your business look and feel more professional and credible to consumers.

Cons of an LLC

An LLC will be more expensive and complicated to form than a Sole Proprietorship. LLCs require formation documents to be filed with the state, therefore they are subject to more regulation and legal expenses.

Even though the business formation of an LLC provides the owner with great liability protections, there are limits to this protection. An LLC owner will still be personally liable in the following situations:

  • A lawsuit for their own negligence, even if the claim is related to the business.
  • Losses due to fire, floods, lawsuits, or economic downturn

LLCs and Taxes

A single-member LLC is usually taxed just like a Sole Proprietorship by what is called “pass-through taxation”. Profits and losses of the business pass through the business and are filed with the owner’s personal tax return.

The LLC owner will report their businesses profits, losses, and deductions to the IRS using a Schedule C form filed with their personal tax return. If there is more than one owner, each owner will file profit and losses with their own personal tax return.

LLCs owners also have the option to be taxes like a corporation. An LLC owner can file Form 2553, Election by a Small Business, with the IRS. If approved, an LLC will now be treated like a corporation by the IRS for tax purposes.

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How Sole Proprietorships Work

A Sole Proprietorship, also called a sole trader or just a proprietorship, is an informal business structure with one owner. There is no distinction between the business and the owner, so the owner does not benefit from any liability protection like in an LLC.

Sole proprietorships are common for individual business owners, sub-contractors, and consultants. This business formation is best if the business has the following qualities:

  • A low-risk business with a low chance of liability
  • A low profit business with a low chance of financial loss
  • A company with a small customer base

How to Form a Sole Proprietorship

Sole proprietorships are the easiest type of business to establish because there is very little government regulation.

Owners of a sole proprietorship can either do business under their own name or they can register a “Doing business as” or “DBA” to operate under a business name.

The owner then needs to file for a business license either under their own name or their DBA with the city or county in which they plan to operate. If operating from home, some counties require that the business owner request permission.

The final step is to open a business checking account. It is very important to keep business and personal spending separate for tax purposes.

Pros of a Sole Proprietorship

A Sole Proprietorship can offer many positive features for a small business owner. Some of these advantages include:

  • Little to No Start-Up Costs: Sole proprietorships are easy and inexpensive to establish and often do not require any sort of startup investment. There are no government documents to file and no elaborate business structure.
  • Full Control of Your Business: The owner of a sole proprietorship maintains complete control over all business operations. As the sole owner, they make all decisions and do not require votes or concurrence from other members.
  • Pass-through Taxation: Just like an LLC, a sole proprietor will claim business profits and losses on their personal tax returns. This allows an owner to use business losses to offset personal income from other sources.

Cons of a Sole Proprietorship

The largest disadvantage of establishing a sole proprietorship rather than an LLC is the absence of protection from liability. The owner of the sole proprietorship is fully liable for all business debts and liability.

In the event the business is sued or targeted by a creditor, the business owner’s personal assets like real estate, vehicles, or personal bank accounts are at risk.

Some other potential downsides include:

  • If a sole proprietorship becomes profitable, the owner may see a large increase in taxes because this business structure is required to pay FICA taxes.
  • There is limited growth potential because the more a business grows, the more the risk increases and the need for a different structure that offers protection will increase.
  • There is less credibility with this kind of business because a sole proprietor is usually just operating under their name.

Sole Proprietorship and Taxes

A Sole Proprietorship is a pass-through entity so profits pass through the business and on to the owner while will report profits and losses on their personal income tax return.

Sole Proprietorships are eligible to claim various tax deductions to offset any income. These deductions include:

  • Home office deductions
  • Contributions to retirement plans
  • Contributions to a health savings account
  • Interest on business loans
  • Education expenses
  • Legal and professional services
  • Cell phone and internet service
  • Business meals
  • Business use of a vehicle
  • Licenses

Owners can also use these deductions to offset their income from other sources which is another great benefit of establishing a sole proprietorship.

Click here for an overview of more similarities and differences between LLCs and Sole Proprietorships.

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