LLC vs. Sole Proprietorship: Which Should You Choose?
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One of the first decisions every business owner must make is which type of legal entity they’ll use to conduct their business. Limited liability companies (LLC) and sole proprietorships are two of the most popular options for small business owners.
Here’s what you should know about LLCs and sole proprietorships to determine which is best for your situation, including how they work, their advantages and disadvantages, and their most significant differences.
What Is an LLC?
An LLC is a legal entity structure hybrid between a corporation and a sole proprietorship or partnership, depending on the number of business owners.
Like corporations, LLCs are legally separate from their owners, known as members. As a result, they limit each member’s liability for business debts, protecting their personal assets from creditors.
Personal liability protection is one of the primary reasons business owners form LLCs. The regulations vary between states, but there’s often less paperwork and fewer fees involved in creating an LLC than a corporation, making them an easier route to safety.
However, while LLCs are closer to corporations from a legal perspective, their default tax treatment is that of a sole proprietorship or partnership. In other words, they’re pass-through entities, paying no taxes at the entity level.
Instead, members only pay taxes on their business’s profits at the personal level, unless they file additional paperwork with the Internal Revenue Service (IRS) to elect S corporation or C corporation treatment.
Advantages of an LLC
In many ways, LLCs are attractive due to their well-roundedness. They can offer you the best of both worlds regarding corporations and sole proprietorships or partnerships. More specifically, their most significant advantages include:
- Liability protection: If someone sues your sole proprietorship or you default on a business loan, creditors can pursue your personal assets to cover your debts. An LLC protects those assets as a corporation would.
- Low compliance requirements: Establishing and maintaining a corporation takes a lot of paperwork and costs a lot in filing fees and tax prep expenses. An LLC offers many of the same benefits but costs less time, effort, and money.
- Flexible tax treatment: Business owners can request that their LLCs be taxable as sole proprietorships or partnerships, S corporations, or C corporations.
Ultimately, limited liability companies are an excellent legal entity for many small business owners due to their liability protection and general flexibility.
Disadvantages of an LLC
LLCs offer some significant advantages, but they’re not ideal for every small business owner. While it’s uncommon for LLCs to be a poor choice per se, there are situations where they won’t be optimal.
That’s because the fundamental disadvantage of an LLC is the same as its primary benefit. LLCs do most things well, but they don’t do some things quite as well as their more specialized alternatives.
For example, LLCs have lower compliance requirements than corporations but still require a notable amount of paperwork and funds to generate and maintain. Meanwhile, you can start doing business as a sole proprietor without either.
Conversely, LLCs exist separately from their owners like corporations, but they’re not as independent. For example, an LLC member‘s death could dissolve the entity without a carefully worded operating agreement.
Meanwhile, a corporation always allows for the transfer of an owner’s shares to their heir if they pass away.
What Is a Sole Proprietorship?
A sole proprietorship is the default business structure in the United States. If you do business for yourself without any partners, you’re automatically considered a sole proprietor. There’s no need to complete any paperwork or pay any registration fees.
In fact, sole proprietorships are essentially the same entity as their owners. They often share the same name, and there’s no need to file an additional tax return for the business. Unfortunately, that means they don’t limit your liability for business debts.
Because of their simplicity, sole proprietorships are popular among freelancers and small business owners. Self-employed individuals frequently begin doing business as sole proprietors and then shift to a more sophisticated entity structure once they grow.
Sole proprietorships are often spoken of in the same breath as partnerships. The only difference between them is that sole proprietorships have a single owner, while partnerships have at least two, who must split the business income or loss each year.
That said, opting for a sole proprietorship doesn’t mean you must work alone. Contrary to what you might expect, sole proprietors can still hire employees, though they must obtain an employer identification number (EIN) from the IRS first.
Advantages of a Sole Proprietorship
The primary advantage of a sole proprietorship is that it costs neither time nor money to create or maintain one. They let you start doing business immediately without worrying about forming a separate legal business entity.
That saves you time and money upfront and gives you the flexibility to try out business ideas without making a significant commitment. If you decide to go in a different direction later, you can pivot quickly and easily with few sunk costs.
Because these entities aren’t separate from the business owner, they also simplify your tax situation. You never need to file an additional return for the company like you would with a corporation or LLC. Instead, you pick up its income on your personal tax return.
Disadvantages of a Sole Proprietorship
Sole proprietorships are great for self-employed individuals looking to get a small business off the ground quickly. However, they have limitations that significantly restrict their utility.
The most notable downside is that they come with unlimited liability. If you operate as a sole proprietor, your personal assets are vulnerable to creditors trying to collect on business debts due to the entity structure’s lack of legal protection.
Another issue with sole proprietorships is that they don’t allow for the same sophisticated tax strategies as other legal structures. That can cause them to pay more taxes than some business entity types.
For example, the owner of an S corporation can pay themselves a salary from their business, which is the only portion of their earnings subject to self-employment taxes. Meanwhile, sole proprietorships pay self-employment taxes on their entire net income.
Finally, it’s often harder to qualify for business credit accounts as a sole proprietor. Not only does that limit your access to financing, but it can hamper your ability to build business credit.
Differences Between the Two
Limited liability companies and sole proprietorships are two of the most popular legal entity structures among small business owners. If you’re trying to decide between the two, these are the most significant differences between them to consider.
Formation Requirements
One of the primary reasons small business owners choose to do business as sole proprietors is the lack of formation requirements. You don’t need to file paperwork or pay registration fees to get started.
Conversely, forming a limited liability company is a relatively involved process. The steps vary somewhat between states, but here are the necessary steps in California to give you an idea of the requirements:
- Choose a unique name for your business
- Appoint a registered agent
- File articles of organization and pay a filing fee
- Create an operating agreement
- File a statement of information and pay a filing fee
- Acquire an EIN (if you have employees or multiple members)
Generally, it’s better to do business as a sole proprietorship than a limited liability company if you want to prioritize forming your entity quickly and with minimal expenses.
Management Structure
As you’d expect, sole proprietorships are extremely limited in their management structures. They’re only a viable legal entity option if you’re content with owning and operating the business by yourself.
That can be an advantage or a disadvantage, depending on your preferences. A sole proprietorship is perfect if you want the final say on all business decisions. However, they’ll be problematic if you’d prefer to share the burden of leadership.
Meanwhile, LLCs are highly versatile in this regard. Not only can they support as many business owners as you want, but an LLC owner can usually be any of a wide variety of entities, such as individuals, corporations, or other LLCs.
That flexibility is part of what necessitates the creation of an operating agreement. When you create a multi-member LLC, you need to define each owner’s voting rights and share of the annual business profit or loss.
Personal Liability
One of the most significant dangers of doing business as a sole proprietorship is that your personal assets are vulnerable to creditors. If the risk of a lawsuit or debt default is high, doing business as a sole proprietorship isn’t a good idea.
You could lose your most valuable property, such as your house or car. You may even have to declare personal bankruptcy if you don’t own assets that can cover your business debts.
Unlike a sole proprietorship, an LLC is a separate legal entity from its owner. As a result, LLCs can significantly limit your personal liability for any business debts, and third parties who sue your business usually have to sue the entity instead of you.
That said, even limited liability companies can’t insulate you completely. There are still circumstances where you’ll be liable for business debts, such as personally guaranteed business credit accounts or lawsuits for negligence.
Tax Implications
By default, LLCs with a single owner and sole proprietorships receive the same tax treatment. They’re both pass-through entities, which means you’ll pay no taxes at the business level.
Instead, you must report their activities on your Schedule C and pay the appropriate personal income tax and self-employment tax on their net earnings at the individual level.
However, owners of LLCs can also choose to treat their businesses as S corporations or C corporations for tax purposes. That opens up additional opportunities to lower your tax burden with intelligent planning.
However, you probably shouldn’t try to execute complicated tax strategies alone. If you’re interested in doing business as an LLC to minimize your tax burden, make sure you consult with a Certified Public Accountant (CPA).
Ongoing Compliance
Sole proprietorships generally require no paperwork and cost nothing to maintain. You don’t need to file anything with federal or state governments, there are no recurring annual fees, and you don’t have to pay anyone to prepare an additional tax return.
Unfortunately, you can’t say the same for limited liability companies. It might not take as much work to maintain an LLC as a corporation, but the ongoing compliance requirements for LLCs are still significant.
Again, the requirements vary between states, but LLCs usually increase your business expenses and cause you to file extra reports each year.
For example, California charges an $800 annual franchise tax for all LLCs. If your income exceeds $250,000, they also charge an LLC fee that ranges from $900 to $11,790.
In addition, the state requires that you file a Statement of Information and a separate tax return for your LLC each year. Failing to file the former will cost you $250, and you’ll usually need to pay a tax preparer to complete the latter.
Which One Should You Choose?
There are few universally correct answers to tax strategy questions, as everyone’s financial situation is different. As a result, whether you should choose to operate as an LLC or a sole proprietorship depends on your unique circumstances.
Generally, sole proprietorships are best suited for self-employed individuals who want to start doing business immediately or lack the revenue to justify paying to form and maintain a separate business entity.
Meanwhile, LLCs are generally superior to sole proprietorships if you plan to take on business debt or suspect there’s any risk that someone might sue your business.
Even if neither of those applies to you initially and you start as a sole proprietor, you’ll probably want to transition to an LLC or a corporation once your business grows enough.
Fortunately, you don’t have to make the decision alone. Consult a CPA to get expert tax advice on the best legal entity structure for your business.
FAQs
Which Pays Less in Taxes, Sole Proprietorship or LLC?
By default, sole proprietorships and LLCs are pass-through entities. That means they pay nothing in taxes at the entity level, and you’ll pay the same amount of personal income and self-employment taxes with each, assuming you own a single-member LLC.
However, if you request that your LLC be taxable as an S corp or a C corp, the business will be subject to entirely different rules. Unfortunately, there’s no way to know whether that will effectively lower your tax liability.
The best way to determine whether you’ll pay less in taxes as an LLC or a sole proprietor is to hire a CPA. They can help you calculate and compare your total tax burdens under both scenarios.
Can You Convert a Sole Proprietorship to an LLC?
You can always convert a sole proprietorship into an LLC. In fact, that’s a common practice, as self-employed individuals often start doing business as sole proprietors and then switch to LLCs once they’ve grown enough to justify the effort and the cost.
The process of changing a sole proprietorship to an LLC is no different from forming one from scratch. However, the steps involved vary between states, so you’ll need to check with your local government to find the rules that apply to you.
Do You Need an LLC for an Online Business?
No, you don’t always need an LLC for an online business. Whether your activities take place online or in person doesn’t usually affect which is the best legal entity structure for your business.
Generally, the best reasons to choose an LLC over a sole proprietorship are to access business financing, better business credit scores, limited personal liability, or additional tax treatment options.
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