Last Updated: February 2, 2023
New entrepreneurs have a hard time deciding whether they should opt for a sole proprietorship or an LLC. Both options might sound great for beginners, but each has an entirely different business structure. This article addresses what sole proprietorships are and how they differ from LLCs and weighs the pros and cons of a sole proprietorship vs LLC and such features as management, liability protection, and taxes.
What Is a Sole Proprietorship?
A sole proprietorship is a business with only one owner who pays personal income tax on profits earned from the company. Sole proprietorships don’t have many governmental regulations, which is why they’re quite easy to form and dismantle. They are excellent options for individuals looking to start their first business.
How is a sole proprietorship formed? One of the most significant advantages of a sole proprietorship is that it’s a simple structure. A sole proprietorship does not require state registration, as opposed to partnerships, LLCs, and corporations, which must file a registration form.
With a sole proprietorship, you first create your business name and include an address for your business, file for a business license (obtain permission if your business will work from home), and set up a business checking account. You’ll find that there aren’t many disadvantages of a sole proprietorship regarding setting it up; the whole process is straightforward.
|NOTE: Sole proprietorships have become the most popular type of business in the US, with over 23 million operating since 2018.|
What Is an LLC?
A limited liability company (LLC) is a type of business with the same limited liability a corporation provides but can be formed easier than a corporation and is more cost-effective to run. LLCs operate with multiple owners, as opposed to a sole proprietorship, which works with only one. In many states, there’s no restriction of ownership, which means that all individuals, corporations, and foreign entities can be members of the LLC.
Forming an LLC requires a few more steps than a sole proprietorship—which identifies the difference between LLC and sole proprietorship businesses).
- Choose a name that complies with your state’s rules.
- Fill out and file articles of organization (certificate of formation) with the Secretary of State.
- Finding a registered agent is essential.
- Decide on the type of management (member vs manager management).
- Create an LLC operating agreement (optional).
Most states in the US require you to file an annual report for your LLC and do an out-of-state LLC registration if your LLC is planning on doing business in a state outside the state of formation.
|NOTE: One person can own multiple LLCs, but this requires more paperwork, and taxes must be paid for each LLC. Fortunately, there are specific LLC services that aim to make this process easier for all new entrepreneurs.|
Sole Proprietorship vs LLC: Key Differences
Most of the key differences between sole proprietorships and LLCs boil down to the distinctions in management structure, the type of liability provided to the owner(s) regarding all legal obligations and debt, as well as taxation arrangements.
Sole proprietorships have one business owner who is the person that manages all aspects of the business—from finances to recruiting employees. This, of course, doesn’t require the owner to execute all job positions, but they have the final word in all aspects of business management, which is one of the best advantages of a sole proprietorship.
If your business efficiently operates from home and can be managed by just one person, then this is the perfect type of business for you. There’s no need to take into account expenses and paperwork related to employing others. But if your business requires more hands on deck, you’re responsible for all of the additional paperwork, which is another big difference between sole proprietorship vs LLC businesses.
The difference between LLC vs sole proprietorship is that LLCs have a completely different business structure. LLCs are primarily managed by members, who are those that own some interest in the company. LLCs can be managed by members or managers—who can be one or more from outside the LLC with the task of tackling issues, such as strategy plans, decisions about loans, etc.
But an LLC can also be a single-member LLC, which means that the company is its own legal entity apart from its one owner. But keep in mind that individual/sole proprietor or single-member LLC is not the same thing.
LLCs managed by members include all members actively playing their part in making critical decisions about the business. In addition, member-managed LLCs allow members to take actions to bind the company legally.
Manager-managed LLCs, however, do not permit members to have the right to bind the company. In addition, members cannot interfere in managing the LLC, as all crucial issues and business decisions fall on the managers of the LLC. But members do have the right to change the manager or management structure to a member-managed LLC.
Another critical difference between an LLC vs sole proprietorship is that sole proprietors are personally liable for business debts or legal obligations. This marks you as the sole contact for creditors and can, therefore, be personally sued if your business falls into debt, as well as having your personal assets taken in return for those unpaid business debts.
Creditors also have access to your personal accounts and properties if your business falls into outstanding debt. As a sole proprietor, you’re also liable for all kinds of torts surrounding your business, which is another big downfall of opting for a sole proprietorship. But you can purchase liability insurance for the latter liability to cancel it out.
The primary difference between a sole proprietorship and LLC when it comes to liability is that the LLC is the entity held liable for any business debts or failed legal obligations, leaving the owners and managers out of the equation. Even though this sounds ideal, the amount of liability you actually get depends on the state you’ve formed your LLC in.
If you have business debts, you will not be held personally liable by the creditors. They will only go after the LLC’s assets instead of your personal assets (bank accounts, property, car, etc.). But if your LLC doesn’t have enough of these assets to cover the debt, the creditors will need to proceed to accounts related to your LLC to cover the overall amount.
Other LLC advantages and disadvantages appear when there are wrongdoings by other members and even by you. For example, if one member does something to cause damage to the business, the rest of the members are not liable. Whether it’s a debt or legal prosecution, the LLC members’ personal accounts will not be touched.
But if you are the one forming the LLC and do something to damage it and its members, you will be held liable. For example, if you injure someone, fail to deposit taxes taken from the employee’s salaries, or conduct illegal activities, the creditor will take your personal assets (in addition to your LLCs assets).
LLC vs Sole Proprietorship Taxes
The owner of a sole proprietorship must file a personal income tax return and report all business income and losses. As the sole owner, with no employer, you have no one withholding income taxes from your own paycheck, which means that you’re in charge of setting aside money to pay the estimated amount of personal income tax at the end of each year. Sole proprietors must also pay self-employment taxes, which encompasses Social Security and Medicare, with tax rates of 12.4% and 2.9%, respectively.
One of the biggest advantages of sole proprietorship businesses includes their simple tax business structure. But the self-employment tax and potentially higher income tax do come as a downfall.
LLCs have a much more complicated taxation arrangement but come with greater tax flexibilities compared to sole proprietorships. Multi-member LLCs can be taxed as partnerships, a C corporation or S corporation, with each requiring different IRS filing, as well as offering slightly different benefits.
One of the most significant LLC tax benefits is that LLCs have the option to be considered a pass-through entity eligible for pass-through taxation or to be taxed as a corporation. If treated as a pass-through entity, an LLC does not have to pay federal income tax. In this case, the members are the ones that pay taxes on their share of the profits the LLC makes. If treated as a corporation, income is taxed at a lower rate specific to corporations, as set by the IRS.
A not-so-big difference between LLC vs sole proprietorship businesses is that LLCs have the following taxes applied in a slightly different manner:
An IRS Employer Identification Number (EIN) is an obligatory step for all multi-member LLCs. EIN’s are easy to obtain, as they only require an online application by filing Form SS-4 on the IRS website. Additionally, an EIN protects the Social Security Number information of its members.
Sales and employer taxes
Another difference between LLC vs sole proprietor businesses is that if you have employees or sell products and services, you need to register for this type of additional taxing. Sales taxes are collected from customers that buy your goods, which are remitted back to the state. Employer taxes (payroll taxes) are unemployment taxes, social security taxes, and Medicare taxes for your employees. These taxes are best explained in the LLC Tax and Filings Requirements: 50 State Guide.
Even though the members are not necessarily employees—according to the Self Employment Contributions Act (SECA)—you still need to pay Social Security and Medicare taxes to the IRS, which is another distinction between LLC vs sole proprietor business structures. The total self-employment tax amount is 15.3%.
|A sole proprietorship is a type of business where the person forming it is the company’s sole owner.|
|A Limited Liability Company (LLC) is a business with multiple owners—members with the same limited liability protection a corporation provides. An LLC can be formed a lot easier than a corporation.|
|The key difference between LLC and sole proprietorship businesses boils down to their management/business structure, the type of liability protection they provide to the owners, and the taxation arrangement.|
|Sole proprietorships hold the owner personally liable against potential business debts and legal obligations, while LLCs are the liable entity instead of their members.|
|Sole proprietorships have a simple tax structure but have a higher income tax, whereas LLCs have a more complicated taxation process but provide more tax benefits.|
Sole Proprietorship Advantages and Disadvantages
Sole proprietorships come with their own set of advantages and disadvantages, which can be weighed when deciding if a sole proprietorship is worth the time and investment.
Advantages of a sole proprietorship
- Easy to set up and disassemble.
- Less expensive to register.
- Simple taxation process.
- Complete control over the business.
Disadvantages of sole proprietorship
- The owner is fully responsible for all liability.
- Paying self-employment taxes on any revenue from the business.
- The business operates as long as the owner is alive.
|NOTE: A sole proprietorship has its own credit rating, which, consequently, allows potential lenders, vendors, suppliers, and insurance companies to give you a thumbs-up if you have a good business credit score. Check out how to build business credit so you can start your new business venture on the right foot.|
LLC Pros and Cons
Although LLCs might sound like an excellent idea for businesses that want to raise capital fast and dive deep into the big leagues, keep in mind the LLC pros and cons of opting for this type of business.
- No ownership limitations.
- More LLC tax benefits.
- Liability protection for all members.
- Flexible management/business structure.
- Complex and expensive business setup.
- Elaborate taxation process.
- Possibility of poor management due to too many disinterested members.
|NOTE: One of the best tax benefits of LLC businesses is that a multi-member LLC can decide how to split the taxes. As a result, all members have an equal say in how they think the tax burden should be distributed among members and determine the tax structure.|
Both sole proprietorships and LLCs provide a wide range of benefits, as well as some downfalls. If you’re after the advantages of a sole proprietorship—such as having a self-run business form that offers a specific taxation policy with not too many benefits—then opt for a sole proprietorship. But if you want your business to exponentially grow with the help of stocks, gain tax benefits, and have liability protection—but first, have to go through some laborious steps to get there—then opt for an LLC.
In most US states, the law requires sole proprietors to obtain a business license before operating. If not, you might be faced with costly fines.
The key difference between a sole proprietor vs LLC is that a sole proprietor cannot be an LLC. But you can do business as an LLC. You have the option of registering a business you own yourself as an LLC—more specifically, as a single-member LLC.
Comparing sole proprietorship vs LLC taxes, both types of businesses offer their own set of advantages and disadvantages. But LLCs do tend to have more leeway when it comes to overall tax breaks.