If you are trying to launch a venture, you have to make a crucial decision – LLC or sole proprietorship?
When you consider sole proprietorship vs. LLC, both business structures have various pros and cons. So, you must decide based on the nature of your business and personal circumstances.
In this blog, we will tell you all about sole proprietorship vs. LLC – the pros and cons, when to open what, differences between a sole proprietorship and LLC, and so much more.
Ready to explore?
Let’s get started then!
What is a Sole Proprietorship?
A sole proprietorship is the simplest business structure. When a business runs as a sole proprietorship, it is not considered a separate legal entity.
Here are a few key features of a sole proprietorship business:
- Owned by a single individual
- No separation between the company and the owner (no separate business entity)
- Unlimited liability
- Individual control and decision-making
What is an LLC?
An LLC or a Limited Liability Company is a popular legal business structure with a separate entity concept. Easy to set up and cost-effective, LLC ensures the protection of the owner’s assets.
A few key features of an LLC are:
- Owned by one or more individuals
- Liability protection
- Separate business entity
- Easy taxation
LLC vs. Sole Proprietorship – A Comprehensive Comparison
An LLC versus sole proprietorship comparison is a must to make an informed decision regarding your business structure.
So, here are the differences between sole proprietorship and LLC.
1. Set up and formation
If you start selling a product or service from tomorrow, you will become a sole proprietor by default. You might need to apply for licenses and permits to run the business based on your location legally. Also, you might need a trading name or DBA (Doing Business As) certificate.
To set up an LLC, you will need to register the business first. You must draft the articles of organization and pay the filing fee. The articles of organization document establish the existence of your LLC. Hence, you must file it with the state. The cost of filing the document generally ranges between $50 to $200, depending on the state.
Overall, the formation aspect is a benefit of sole proprietorship over LLC. This is because a sole proprietorship business is a lot easier to set up. It is inexpensive as well compared to that of an LLC.
2. Legal protection
The difference of legal protection in an LLC and sole proprietorship is one of the main aspects of sole proprietor vs. LLC.
The business is the same as the owner in a sole proprietorship business. There is no legal separation between the two. Hence, the owner is personally liable for all the business’s debts. If the business goes bankrupt, the bank and other creditors will easily access the owner’s assets like vehicles, property, etc. Also, if a third party sues the business, they can name the owner personally in the lawsuit and seize their assets if need be.
When it comes to protecting your assets, forming an LLC is better than a sole proprietorship. In an LLC, a business is a separate legal entity. Hence, the owner is not personally liable for the business debts. If the LLC fails, then the owner can file for business bankruptcy. They need not pay from their savings for the business debts. Also, a third-party suing the LLC cannot sue its owner. However, the owner can be sued for negligence, fraudulent activity, or personally guaranteed debts.
So, there is better legal protection in an LLC than in a sole proprietorship. LLCs have limited liability. In contrast, sole proprietorships characterize unlimited liability.
3. Taxation
LLC vs. sole proprietorship taxes is somewhat similar.
In a single-owner LLC, the taxation is the same as in a sole proprietorship. Both are pass-through entities, which means the business is not taxed separately. The owner reports the business income on a Schedule C attached to their tax returns. The business income gets taxed at the same rate as the owner’s income tax.
Coming to multi-member LLCs, these are pass-through entities too. In these LLCs, each owner reports and pays taxes on their share of the business income. The only difference in an LLC with more than one member is filing the business tax with the IRS, Form 1065, U.S. Return of Partnership Income. Additionally, each member must attach Schedule K-1 to their income tax returns showing their shares of the business income.
Whether you have an LLC or sole proprietorship, you might have additional taxes as well. For instance, payroll taxes will apply if you have employees. Plus, sales tax will apply if your product or service is taxable. Also, as a self-employed entrepreneur, paying self-employment taxes to the IRS is a must. These taxes cover Medicare and Social Security taxes.
4. Operations and management
In the case of operations and management, the difference between sole proprietorship and LLC is that operating a sole proprietorship is easier.
In a sole proprietorship business, the owner has the freedom to make decisions as they see fit. They are the sole owners of the business, and hence, they control the business entirely. However, most sole proprietors hire accounting, legalities, and taxes professionals.
In an LLC, the management is much more complex. The operations of an LLC are typically outlined in an LLC operating agreement. Though all states do not require this agreement, most LLCs (especially multi-member LLCs) have one for ease of management. This operating agreement includes information like;
- Ownership of each member in the business;
- Voting rights; and
- Profit share
Generally, based on the proportion of ownership stake, members in an LLC make company decisions. For instance, a 33% owner would have one-third vote on company affairs or decision-making. At the same time, a 25% owner would have a one-quarter vote. Similarly, the profits are also divided in proportion with the ownership percentages.
5. Documentation and compliance
In the case of sole proprietorship vs LLC, there is also a difference in paperwork and compliance.
In a sole proprietorship, the amount of documentation is the least. There is no paperwork as such before its launch. After launching the venture, the owner needs to keep up with the local, state, and federal taxes. Additionally, the sole proprietor must renew the business licenses and permits on time.
In an LLC, the compliance is more than in sole proprietorships. LLCs might have to file an annual report in many states after filing the articles or organization initially. In LLCs with multiple members, the compliance is even more. They must draft an operating agreement, issue membership units, record ownership transfers, and hold member meetings. Though these responsibilities are not legally required, they are highly recommended for LLCs. Performing these responsibilities helps the LLCs to preserve their liability protection for members.
6. Financing options
Considering sole proprietorship vs LLC, raising capital or financing is one of the main points of difference.
Raising capital in sole proprietorships is not at all easy. The credibility is comparatively low in sole proprietorships. Plus, the business and the owner’s funds are the same (due to no separate entity concept). Hence, investors do not generally come forward to invest in sole proprietorships.
Though the situation for single-member LLCs is the same as sole proprietorships for raising capital, for multi-member LLCs, it is easier. Getting funds for business expansion or business establishment in these LLCs is pretty easy as investors are supportive. Also, the credibility is higher in LLCs, so banks are often ready to provide them with adequate loans.
7. Naming the business
What’s in a name!
Well, in the case of sole proprietorship vs LLC the difference lies in naming the business.
It is mandatory to add ‘Limited Liability Company’ or ‘LLC’ at the end of the business name in an LLC. But in a sole proprietorship, there is no compulsion. Additionally, LLC and sole proprietorship are that an LLC cannot use the same name as other companies. The name must be unique to the business.
8. Lifespan
One of the LLC and sole proprietorship differences is the business’s lifespan. In a sole proprietorship, the business’s lifespan completely depends on the life of the owner. However, if the owner sells the business or merges, the business will continue to exist.
But the lifespan of an LLC business is infinite. The business is a separate entity in an LLC and does not belong to a specific person or corporation. Hence, the business exists lifelong. In an LLC initiation, there might be contracts related to the continuation of business even after the death or retirement of an owner.
When to Open a Sole Proprietorship?
An LLC might be appropriate when your business grows. But considering sole proprietorship vs LLC, we must mention that sole proprietorship offers benefits too in certain situations.
For example, when starting as an entrepreneur, the sole proprietorship business structure is good. You can set up a small-scale business or even try out some low-risk venture to begin experimenting with entrepreneurship.
Here are a few characteristics of small businesses that make sole proprietorships the best fit.
- A smaller customer base often consists of close family, friends, neighbors, and relatives.
- Start-ups that involve hobbies like blogging, making videos, photography, etc.
- Small businesses with low risk and low profit (Such start-ups ensure low chances of liability and lower financial loss).
The Pros and Cons of Sole Proprietorship
Now that we have seen the sole proprietorship vs LLC comparison let’s explore a few pros and cons of a sole proprietorship.
Pros
- Sole proprietorships require the least paperwork. However, they might need to get licenses and approvals depending on the nature of the business.
- Sole proprietorships do not require annual state filings unless there are specific industry filing requirements.
- These businesses are easy to set up, operate, and manage.
- In sole proprietorships, the owner files the business profits/losses through personal tax returns.
- Considering the tax benefits of LLC vs sole proprietorship, sole proprietors might enjoy the tax benefits of being self-employed. Like getting deductions for certain expenses, using self-employed retirement plans, writing off business expenses like marketing, travel costs, etc.
Cons
- No protection of personal assets. Creditors might seize the owner’s personal property or sue the owner personally for business debts.
- It is difficult to raise capital for sole proprietorships as the business’s credibility is low for customers, vendors, and investors.
- Debt financing is difficult as many financial institutions consider the owner’s loan request as a personal loan rather than a business loan.
- Growth Potential is limited.
When to Open an LLC?
The difference between sole proprietorship and LLC is that an LLC offers better opportunities, increased credibility, and, most importantly, legal protection of assets.
LLCs are the best fit for businesses with the following characteristics:
- Increased liability risk or risk of loss
- A comparatively larger customer base
- Potential to earn immediate and sustainable profits
- Possibility of benefiting from unique tax options
The Pros and Cons of LLC
Listed below are a few pros and cons of LLC that might help you choose between sole proprietorship vs LLC.
Pros
- LLC offers personal liability protection. This means that if the owner is not personally liable to pay for the business debts. Plus, if any third party sues the business, they cannot name the owner personally in the lawsuit. Hence, the owner’s property, car, personal bank account, etc. remain legally protected in case of business lawsuits and losses.
- LLCs have the flexibility to customize tax structures. Hence, they can choose the best tax strategy for themselves.
- LLCs overs sole proprietorship have better growth potential. Though the risk involved is higher, the growth opportunity in LLCs is also higher.
- It is easier to raise funds for LLCs due to their better credibility in the market.
Cons
- Involves more paperwork like filing articles of organization and other state-related documentation, including industry-specific licensing.
- Start-up costs are higher in LLCs than in sole proprietorship.
- Apart from paying federal, state, local, and self-employed FICA taxes, LLC owners might also need to pay State Business Taxes and Unemployment Taxes.
Is a Single-Member LLC the Same as a Sole Proprietorship?
We hope that the pros and cons of LLC vs sole proprietorship are clear. Now, let’s find out the similarities and differences between sole proprietorships and single-member LLCs.
Here are the differences between a sole proprietorship and a single-member LLC.
- Sole proprietorships do not provide personal liability protection. But LLCs do. The business is identified as a separate legal entity in both single and multi-member LLCs. Hence, the personal assets of the owner(s) stay protected.
- Another difference between a sole proprietorship and single-member LLC is that an LLC is formal and legal. On the other hand, a sole proprietorship is an informal business entity.
There are a few similarities that sole proprietorships and single-member LLCs share. These include:
- Pass-through taxation in both sole proprietorships and single-member LLCs
- Withholding of payroll taxes if the business has employees
- The EIN (Employer Identification Number) requirements for opening a bank account and recruiting employees are the same.
When Should a Sole Proprietor Become an LLC?
At times, sole proprietors get caught up between – small business LLC or sole proprietorship?
Making the crucial decision of switching from a sole proprietorship to an LLC might be confusing. So, when do you know that it’s time to become an LLC?
Well, here are two benefits of an LLC over a sole proprietorship that might convince you to make the shift.
- Legal Protection – When you think about the longevity and well-being of your venture, legal protection is a priority. Converting your sole proprietorship to an LLC can help you protect your assets from business liabilities.
- Financing – An LLC appears to be more stable than a sole proprietorship business. Hence, your vendors, creditors, customers, and business partners might consider higher business credibility. In that sense, trust will be more, so will be investments.
Running sole proprietorship ventures is easy. You simply need to track your business income and expenses and keep them separate from personal ones.
So, the ultimate decision is yours to make – sole proprietorship or LLC?
Remember that while sole proprietorship is easy to start and run, business growth might fuel your risk-taking attitude.
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FAQs
Q. Can a sole proprietor be an LLC?
No. They may function similarly side-by-side when managing your businesses, however, once you convert your sole proprietorship to LLC, your business is legally separated from you, forming a new entity.
Q. Can you convert a sole proprietorship to an LLC?
Yes, you can convert a sole proprietorship to an LLC through the procedures, requirements, and paperwork needed by the state where you plan to register.
