Sole Proprietorship and LLC - Similarities and Differences
Sole proprietorships and LLCs are both ways to operate your business. Here’s a breakdown of the similarities and differences.
Sole Proprietorship vs LLC: Formation and Dissolution
When getting started with either business structure, here’s what to do:
- LLC: You’ll need to file articles of organization to create a new business entity with your state. After filing the paperwork with your state, you’ll need to apply for an EIN from the IRS for tax purposes. To dissolve the LLC, you’ll file a form with the state.
- Sole proprietorship: A sole proprietorship doesn't require any formal paperwork to get started. However, you may need to obtain permits and licenses based on the nature of your business. If you decide to get an EIN from the IRS, dissolving the business is as simple as sending a letter with your intentions to the IRS.
- Similarities: In either case, you’ll get your business up and running. Both structures are required to register their DBA if using one.
- Differences: You’ll encounter more steps and some annual maintenance to form an LLC.
Sole Proprietorship vs LLC: Operations, Employment, and Management
Once the business is open, here’s what to expect with a sole proprietorship:
- Operations: As a sole proprietor, all of the decisions are up to you. The size and speed of the operation are at your discretion.
- Employment: You can hire employees based on your needs if you have an EIN.
- Management: You can manage everything yourself or hire the appropriate employees to handle the day-to-day.
If you are opening an LLC, things will look a little bit different:
- Operations: The operations of your business may be defined in an operating agreement. Typically, an operating agreement covers each owner’s stake, profit sharing, and voting rights. If multiple members are involved, you’ll have to work together to build the business.
- Employment: As with a sole proprietorship, you can hire employees based on your needs.
- Management: The owners can appoint a manager to run the business operations. As an owner, you can choose to be in charge of the day-to-day or hire the right employees.
Ultimately, sole proprietors enjoy more control over their business operations. But an LLC might benefit from the input of multiple members.
Sole Proprietorship vs LLC: Taxes and Business Expenses
When earning income through a business, taxes come into play.
Here’s the tax situation for a sole proprietorship:
- The business itself doesn’t pay taxes. Instead, the owner will report business income on a Schedule C attached to their personal tax return. See self-employed tax reliefs for more details.
- So, you’ll be responsible for paying taxes on the business income. But you’ll be able to deduct business expenses on your tax return as well.
- This is considered a pass-through entity.
Here’s the tax situation for an LLC:
- The business itself has the option to choose an S-corp or C-corp tax status.
- With the C-corp status, the LLC will pay income taxes for itself. This corporation status can mean access to more tax deductions and credits. But some states levy additional taxes on C-corps.
- With an S-corp status, the business owners will treat it as a pass-through entity and pay taxes on business earnings on their personal business tax return.
An LLC has more opportunities to control its tax returns compared to a sole proprietorship, which has less tax flexibility. But in the end, Uncle Sam will take a cut. Both business structures demand that business owners cover self-employment taxes.
Sole Proprietorship vs LLC: Legal Protection
Once the business is open, here’s what legal protections you’ll have.
- Sole proprietorship: A business owner is not legally separate from a sole proprietorship. With that, the owner is personally liable for all business debts and lawsuits.
- LLC: An LLC is a legal entity that’s separate from the business owner. With that, the owner isn’t generally personally responsible for business debts. And in most cases, your personal assets are protected in the event of a lawsuit.
Sole Proprietorship vs LLC: Paperwork and Compliance
The paperwork and compliance responsibilities of these business types vary.
- Sole proprietorship: A sole proprietor will need to keep track of their tax obligations and maintain business permits.
- LLC: An LLC owner will have to keep track of taxes, maintain business permits, file articles of organization, file annual reports, and potentially hold meetings with the other owners.
The difference between sole proprietor and LLC in terms of paperwork is that you’ll find more required paperwork with an LLC.
Pros and Cons of Sole Proprietorship vs LLC
Each business structure comes with its own set of considerations.
Pros and Cons of Sole Proprietorship
Let’s explore the advantages and disadvantages of a sole proprietorship.
Starting with the advantages:
- Minimal paperwork requirements: You won’t need to file any paperwork to form a sole proprietorship. Plus, there is no annual filing requirement.
- Low cost: You won’t need to pay any fees to start a sole proprietorship.
- Streamlined tax filing: You won’t need to file taxes separately for your business.
Now for the disadvantages:
- Personal liabilities: You are personally responsible for the debts and lawsuits against a sole proprietorship.
- Difficult to raise funds: Without a separate legal entity, it can be difficult to find investors.
Pros and Cons of LLC
Let’s explore the advantages and disadvantages of an LLC.
Starting with the advantages:
- Liability protection: Your personal assets are protected from business debts and lawsuits.
- Easier to raise funds: The separate legal entity makes it easier to work with investors.
Now for the disadvantages:
- More paperwork requirements: Beyond the initial filing, you’ll need to file annual reports. Plus, you’ll have to file a separate tax return for your business.
- Additional taxes: As an LLC, the business income might be subject to state business and unemployment taxes.
If you are interested in transferring from a sole proprietorship to an LLC see how to change from sole proprietorship to LLC for more details.
Sole Proprietorship or LLC: Which is Better?
Neither a sole proprietorship nor LLC is inherently better than the other. Instead, the right choice depends on your needs. If you find yourself saying yes to the questions below, then seriously consider forming an LLC.
Do You Need Personal Liability Protection?
One of the major benefits of an LLC vs a sole proprietorship is the liabilities involves. An LLC offers personal liability protection than a sole proprietorship cannot. If your business involves risks or you have significant personal assets, then consider an LLC. Essentially all doctors and lawyers form LLCs.
Do You Plan to Grow Your Business?
If you plan to significantly grow your business, that usually involves more risks and the need for capital. As you grow, consider forming an LLC to mitigate the risks to your personal assets and to have greater access to funding.
Will You Be Employing Staff?
Both businesses can hire employees. But as you bring on more employees, your liabilities increase. For example, if someone gets hurt on the job, the LLC or sole proprietor would be responsible. So, if you are planning to hire employees, then consider an LLC.
Do You Want Additional Tax Benefits?
A sole proprietorship doesn’t have many tax optimization solutions. But with an LLC, you can customize the structure to enjoy tax benefits.
Are You Interested in Branding Your Business?
In general, an LLC lends more credibility to a business. If you want to build a brand for your business, then consider registering as an LLC.