Every day, aspiring entrepreneurs drop their traditional 9-5 desk jobs and set out to start a small business of their own.
Dozens of decisions must be made, though: a business name, how to advertise, securing financing, and more.
One question that demands consideration is which type of business entity to form. Most one-person businesses either choose to operate as sole proprietorships or form single-member limited liability companies (LLCs). Knowing which one is right for your business can be tricky.
To make your decision easier, we’ve compared some of the most important distinctions between an LLC and a sole proprietorship. By the time you’re done reading, we hope you’ll have a better grasp on which one is the right choice for you.
Forming Your Business
Starting a sole proprietorship is very simple, because all you have to do is start selling your goods or services. There is actually no formation process whatsoever for a sole proprietorship, and you’ve technically formed one the moment you make your first sale.
Some sole proprietorships do not have to file any paperwork with a government office, but many are required to get licenses and permits that apply to specific industries. For example, let’s say you bake and decorate the best sugar cookies in town. Even though you operate as a sole proprietorship, you’ll likely need to obtain your state or county’s license for businesses that produce consumable goods.
Technically, the business name of a sole proprietorship is the owner’s legal name. However, many sole proprietors choose to get a DBA, or a “doing business as” registration. Many states offer this registration, allowing you to use a more traditional business name.
The process of forming an LLC is a little more complicated. With an LLC, you must form your business with your Secretary of State prior to commencing business. This process requires both time and money, although fees and processing times vary depending on your state.
Still, the process is relatively straightforward in most states, especially compared to the process for incorporating a corporation. Ordinarily, a business officially becomes an LLC when the state accepts its filing of a document called the articles of organization. As part of this process, you’ll need to appoint a registered agent, who accepts legal process and other government forms on behalf of your business. You can serve as your own agent, but many businesses elect to have a professional service handle this role instead.
Afterwards, the LLC’s members create an operating agreement, which establishes how the business will be run. LLCs also need to obtain any necessary licenses, and if you have employees, you’ll need to obtain a federal tax ID number (EIN) from the IRS, as well as register for taxes.
Maintaining Your Business
Maintaining a compliant sole proprietorship is incredibly easy. There are no ongoing maintenance requirements like filing annual reports, and you don’t even need to keep particularly detailed financial records.
All you need to do for tax purposes is file a Schedule C with Form 1040 which indicates your business profits and/or losses, along with a Schedule SE to calculate your self-employment tax responsibilities. Because the sole proprietorship is not a separate legal entity from its owner, there’s no need to keep your personal and business finances separate, as there is for formal business entities.
The only other significant requirement is renewing your business licenses as needed. You are responsible for keeping track of your own licenses since they’re usually regulated by a variety of departments.
The requirements to maintain an LLC are much more complex than a sole proprietorship. Just like sole proprietorships, you’ll need to keep your licenses up-to-date, but as an LLC, the business financial records are completely separate from your personal records.
LLCs in the vast majority of states are required to file an annual report, which essentially informs the state of your business activities for the year. For example, the LLC annual report usually includes information about your registered agent, ownership group, and business location. This report usually requires a fee, although how much you’ll pay depends on your state — some states have fees as low as $10, while others charge several hundred dollars.
It’s not uncommon for LLCs to grow and change over the years. If your membership changes, you’ll need to make an amendment to your articles of organization. Similarly, if you change some of your business policies, you should amend your operating agreement to reflect that change.
As a sole proprietorship, your requirements to operate a compliant business are fairly minimal. Usually, if you pay your taxes and maintain the appropriate licenses, your business is compliant.
Each state has its own statutes and laws that can give you a picture of the legal requirements for LLCs, which are far more extensive than the requirements for sole proprietorships. As we alluded to earlier, you’ll need to keep records of your income, expenses, assets, purchases, and deductions. LLCs also need to file annual reports, obtain licenses and keep them up to date, and more.
LLCs with employees are legally required to obtain certain types of insurance. This usually entails making unemployment insurance payments (usually in the form of a tax) and workers’ compensation. For a full listing of the laws that will affect your business, we recommend you contact your state’s Secretary of State office.
Fundraising as a sole proprietorship can be difficult. For one thing, most external investors are hesitant to send funds to an individual person. Your business cannot issue stocks or bonds, either, which limits your fundraising options.
Your best option for getting funds from an external source is probably to obtain a personal bank loan. However, you should keep in mind that your business and personal finances are linked; if you have a poor credit score, a bank may decline your application.
Since LLCs are formal business entities, they have more options for fundraising. Of course, an LLC cannot sell stock, but it can offer other securities, like bonds or membership units. Still, private investors typically do not like investing in pass-through entities like LLCs, as corporations are strongly preferred for a number of reasons.
One major advantage of the LLC in this area is the fact that, as a formal business entity, the LLC can apply for business loans. Considering that the sole proprietorship is only eligible for personal loans, this is a significant edge for LLCs.
As a sole proprietor, you will not pay any business income taxes. Instead, your business income tax will be reported on your personal tax return. As a result, you’ll pay the personal income tax rates, which depending on your income level may be lower than the corporate income tax rate of 21%.
That said, you are responsible to pay self-employment tax, which is a 15.3% tax that includes the employer and employee portions of Medicare and Social Security. You can find more information on these taxes here. With traditional employment, your employer deducts these taxes from your paycheck, but since you are your own employer, you’ll need to pay them yourself.
Taxation as an LLC is flexible. You can elect to be taxed like a sole proprietorship (single-member LLCs), a general partnership (multi-member LLCs), or as a corporation. If you choose to be taxed like a sole proprietorship or general partnership, your tax responsibilities will be nearly identical to those of a sole proprietor.
LLCs that are taxed as C corporations are subject to what’s known as double taxation. This is due to the C corp paying taxes at the corporate income tax rate, and then again on the personal level once the company pays its dividends. This form of taxation usually produces a higher tax burden than the default pass-through method, and it’s only recommended if your owners are high-income individuals who can save money by avoiding paying all of the taxes at individual rates.
Finally, the LLC can elect S corporation taxation, which is a form of pass-through tax that is pretty similar to the default method. The big difference is that the LLC’s owners qualify as employees under the S corp model, which means you can usually avoid self-employment taxes.
However, the S corp model has some restrictions that make it less common than you might think, because every owner must be an American resident or citizen, the company cannot have more than 100 owners, and business entities may not have ownership stake in the company.
Liability protection is easily the most important distinction between a sole proprietorship and an LLC. For many businesses, liability protection is the primary motivation to create a formal business entity.
In a sole proprietorship, there is no division between your personal and business finances. As a result, if your business is involved in a lawsuit or defaults on a loan, then you personally have to pay up. This means that your personal assets (like your car, house, personal bank accounts, etc.) would be up for grabs if someone sued your business.
An LLC allows for personal asset protection. An LLC is treated as a legal person, and it will be prosecuted and expected to pay its own debts. The assets of the owner(s) cannot be taken if the entity is sued or fails to pay a loan, unless there’s some sort of fraud involved, or if the LLC was improperly maintained. This division is commonly referred to as the corporate veil.
As a result of this protection, the entity must keep the finances of the business and the personal finances of each owner separate. Failing to do so could destroy your corporate veil and your protection.
Business Name Exclusivity
Another significant difference is the fact that LLCs receive exclusive rights to their business names, which means that no other company in your state would be able to use your name, or one that’s deemed to be too similar.
This is in sharp contrast to the sole proprietorship, which has no legal business name unless it files a DBA, which provides no exclusivity at all. If you want exclusive rights to your business name, the LLC is the better option.
How Important Is Liability Protection for Your Business?
Whether or not you pursue personal liability protection is ultimately your decision, but it’s almost always wise to get it by forming an LLC. Whether or not you need it ultimately depends on the goods or services you sell.
For example: If a customer gets sick or injured while interacting with your business, they could sue you. Let’s go back to our sugar cookie shop example. You’re a sole proprietorship — a customer gets food poisoning from a bad batch of cookies, and they sue. You can’t pay the whole settlement from your business funds, so the court orders your car to be taken in order to pay the rest. An LLC would not have this problem.
Some low-risk businesses might not need this protection, though. Take Etsy craft shops, for instance. Many of these crafters are sole proprietorships, but since there is little risk of injury from these products, the liability protection’s importance drops.
Which Is Right for You?
If you’re not sure which entity type is right for you, don’t worry. This decision is critical, and taking your time to weigh your options is wise. Legal professionals advise that, if you’re in doubt, it’s better to form an LLC because of the protection it provides. Additionally, LLCs offer greater potential for growth, especially if you want to bring another person into business with you.
That said, a sole proprietorship could be right for you, as it’s an acceptable option if you simply want to test your business concept. The filing fees of an LLC could also be too burdensome of an investment for a startup with extremely low capital. Plus, you can always start out as a sole proprietorship and convert to an LLC later — it’s easier to convert into an LLC than vice versa.
You can also get legal advice to help you weigh the exact pros and cons of your business situation. Your business is unique, so what works for one business might not work for yours. A business lawyer can help you pick the entity type that will set your business up for success.
Still, in our opinion, it’s almost always advisable to form an LLC rather than operate a sole proprietorship. The sole proprietor simply takes on too much risk for us to be comfortable operating this business type.
Plus, with business formation services, creating an LLC is quick and easy. They’ll handle the paperwork for you.