Last Updated: January 12, 2023
First-time entrepreneurs often get confused when facing the sole proprietorship vs LLC dilemma.
In a nutshell, a sole proprietorship is an enterprise owned and run by one person. On the other hand, a limited liability company (LLC) exists independently of its owners and shareholders.
Although the main difference is clear, each of these business structures has its own set of advantages and downsides. The only way to make the right choice is to develop an in-depth understanding of the two concepts.
Here’s what you need to know:
What Is a Sole Proprietorship?
The sole proprietor vs LLC question is all about the ownership structure of the company.
As a sole proprietor, you own the enterprise in its entirety, and the liability is all yours. While you don’t have to go through the hassle of separating your private from business books, your personal assets are on the line if anything goes wrong. As a result, you might find yourself in need of legal services. This is where that additional legal insulation provided by the LLC structure may come in handy.
How to set up a sole proprietorship?
Setting up a sole proprietorship takes a simple process of coming up with a unique business name and filing for a business license. The latter has to be done within your city or country of origin. If you want to work from home (many sole proprietorships are single-person startups), you might also need permission from the locality.
Depending on the country that you’re filing in, you might need to handle a bit more paperwork. Some countries require that the proprietor is a permanent resident. The cost of registering also depends on the locality, but it’s usually between $20 and $30.
Can you change a sole proprietorship to an LLC?
While there’s really no such thing as a shift from a sole proprietorship to an LLC, the truth is that you can make this change at any time.
All it takes is for you to register as an LLC and stop using your sole proprietorship. This would, however, require you to sign up for a new business account, as an LLC cannot use your private account (like in the case of sole proprietorship).
Why choose sole proprietorship?
The reasons to choose sole proprietorship are several. First of all, it’s the quickest, simplest, and cheapest way to start your own business. It doesn’t take much paperwork, and you have complete control as an owner of an enterprise. Additionally, the business structure doesn’t limit you in terms of profit or the number of people you can hire. Still, for the vast majority of sole proprietors, this is merely a stepping stone to incorporation at a later date.
What Is an LLC?
An LLC stands for a limited liability company, which is a specific form of legal entity. When discussing the sole proprietorship vs LLC pair, it’s important to stress the significance of the legal protection that comes from the latter.
In a way, LLCs provide the same type of liability as a corporation, but they are easier and cheaper to set up. It’s the US-specific form of a private limited company, although there are alternatives and equivalents across the globe. The biggest confusion comes from the fact that you can register as an LLC, even on your own. So, should you be an individual/sole proprietor or a single-member LLC?
For your operating model, this is pretty much the same. The real difference lies in how you’re seen in the eyes of the Internal Revenue Service (IRS).
With an LLC, your personal assets will be protected in case anything goes wrong. By contrast, with a sole proprietorship, there’s no legal delineation between you and the company.
How to set up an LLC?
Another item on the LLC vs sole proprietorship comparison list is the process of setting up an LLC.
You need to start by picking a state where you want to form an LLC and select a suitable (and available) name for your business. Next, you have to choose a registered agent, put together an operating agreement, and obtain an Employer Identification Number (EIN). If you plan to do business in territories of other states, you also need to register specifically for this purpose.
Some companies specialize in LLC formation services, which can make the entire procedure even simpler.
What is a registered agent?
Another difference between a sole proprietorship and an LLC is that with the latter you need a registered agent.
A registered agent is a person or entity appointed to accept notices, service of process, and official mail on behalf of your LLC. This role isn’t restricted to the company’s owner. It doesn’t even have to be an employee (although it can be).
In fact, many advise against being your own registered agent. Indeed, there are a lot of scenarios where this isn’t optimal. For instance:
- If you don’t have a physical address in the state where you want to register
- When you don’t want to use a personal home address
- You plan to move in the near future
- You can’t keep regular business hours
- When you intend to do business in multiple states
- If you’re not vigilant enough
With that being said, you shouldn’t base your LLC vs sole proprietor decision solely on your ability to take on the registered agent role. Specialized services providers offer a viable solution.
Why choose an LLC?
The most straightforward answer to this question would be – to protect your personal assets.
As a sole proprietor, the company and you are one and the same. The truth is that you have no idea whether your business plan will work. This means that you might be in for some claims against the business or even lawsuits against your company.
The difference between a sole proprietor and an LLC is also in the way they pay taxes. While this does make things a bit more complex (in the case of an LLC), there are some tax benefits for limited liability companies that sole proprietors don’t have access to.
The simplest way to figure out which of these two business structures is the right for your business is to make a side-by-side sole proprietorship to LLC comparison:
Sole Proprietorship vs LLC: What’s the Difference?
|Business formation||No filing or complex paperwork necessary. Inexpensive, often about $26 to register.||More complex and expensive than sole proprietorship. Filing fees go from $50 to $250 in some states.|
|Liability||The owner is personally liable for any debts made by the business. The proprietor and the proprietorship are one and the same in the eyes of the Internal Revenue Service.||As long as the owner doesn’t participate in the management, they have limited personal liability. This is also true in the case of sole ownership, where the business is run by someone else.|
|Management and decision-making||As a sole proprietor, you own the entirety of the company, which gives you the right to make all decisions independently and on your own accord.||You still maintain the option of managing the business personally. But as an LLC owner, you’re originally referred to as a member. The decision to also be a manager is available, but it does increase your liability.|
|Annual state fees||No annual fee. There’s just a renewal fee that seldom exceeds $30.||They range from $50 in states like Mississippi and Missouri to $800 in California. For most states, this fee is in the $100-$300 range. In New Mexico and Ohio, there’s no annual state fee.|
|Separating finances||There is no separation of personal and business finances.||As a sole owner of an LLC, the IRS won’t acknowledge your business and personal finances as separate. This is only possible for LLC partnership members.|
|Corporate maintenance||No corporate maintenance is needed (at least in a formal sense).||General partners can raise cash without the involvement of outside investors in general business management. They are, however, personally responsible for any business debt.|
|Taxes||You are reporting taxes on the owner’s personal tax return.||Owners receive profit similar to dividends, which means that they end up paying taxes both as an LLC and through the personal tax return. The exceptions are LLCs set up as S-corporations, which avoid double taxation. Single-member LLC or sole proprietorship, on the other hand always avoid double taxation.|
Starting out as a sole proprietorship is a lot simpler than starting out as an LLC. It doesn’t involve any additional paperwork or taxes. All it takes is for the proprietor to come up with an available name and pay a registration fee.
On the other hand, there are several additional steps in the LLC formation process. It requires an agreement with all the partners, appointing a registered agent, and compliance with other tax and regulatory requirements.
The LLC vs sole proprietor dilemma is primarily a comparison of liabilities. As a sole proprietor, there is no delineation between what you own and what the company owns. This means that there’s no difference between what you owe and what the company owes, either.
The main reason people start an LLC is to get the necessary tax and legal protection for their personal assets (home, private vehicle, heirlooms, etc.) in case things go wrong.
Management and decision-making
In terms of executive power, the difference between the sole proprietorship and LLC structures is simple.
As a sole proprietor, you make all the calls. As an LLC, you need to act within your position in a company (member or a manager) in order to enjoy the limited liability protection.
In other words, the decision-making process depends on the number of owners more than the structure itself, as well as the current managerial situation. In the case of sole ownership of a limited liability company, there’s really not that much difference between an LLC and a sole proprietorship in terms of accountability.
Annual state fees
To run an LLC, you need to pay an annual state fee, which differs based on the state. Not only is this potentially expensive, but it can also become a logistical nightmare.
Different states have different due dates, which shouldn’t be an issue unless you decide to register in multiple states at once. ‘Payable to’ and form name also differ, which can cause quite a bit of confusion.
Yet, some states like Arizona, Missouri, New Mexico, and Ohio have no LLC annual fees.
And when it comes to sole proprietorships, there are only renewal fees and no annual state fees.
In the LLC versus sole proprietorship comparison, the biggest advantage of an LLC is that you’re only liable for the amount you’ve invested in the company. That is, provided that you’re not a manager or a general partner withdrawing cash from the company. As a sole proprietor, any debt that your business makes is yours, as well. On the other hand, you share profit with no one and don’t have to ask for any special status.
The LLC vs sole proprietor dilemma can also be brought down to the ability to raise cash for the business management without being accountable to anyone.
For a sole proprietor, this really isn’t a major issue. Even in an LLC, this logistical complication can be bypassed from the position of a general partner. The problem is that a general partner also tends to be personally liable for any business debts. In other words, with greater authorizations comes greater liability. Therefore, this criterion might not be the go-to answer when on the fence between an LLC and a sole proprietorship.
Sole proprietors pay taxes on the owner’s personal returns. LLCs, on the other hand, have the option of being taxed as partnerships or as corporations.
Individuals owning LLCs or parts of LLCs pay taxes for their business entity and once again when they personally make a profit. In the case of a single-owner LLC, things work in the same way as they would for a sole proprietorship. LLCs registered as S corporations can avoid double taxation by not paying corporate taxes on the income.
Benefits of an LLC Over a Sole Proprietorship
The first and most significant benefit of LLCs is your ability to protect your personal assets from any debts or losses made by the company.
The second advantage lies in a potentially effortless transfer of ownership of the company to another party. There’s also the issue of bringing new partners on board without having to change the structure of the business.
The third advantage is the option to choose how you pay taxes. As an LLC, you can pay taxes as a sole proprietorship (a single-member LLC), S corporation, or C corporation.
Benefits of a Sole Proprietorship over an LLC
The advantage of a sole proprietorship primarily lies in the simplicity of the organization. Starting a sole proprietorship is easy, inexpensive, and quick.
For people who run their own documentation, sole proprietorship provides an opportunity for effortless self-bookkeeping. In other words, you simply manage your books and accounts like an individual and pay taxes in the same manner.
Pros and Cons of LLC vs Sole Proprietorship
Another method of handling an efficient and unbiased LLC and sole proprietorship comparison would be to quickly list their pros and cons.
Sole Proprietorship Pros
- No corporate business taxes
- Low setup cost
- No annual reports
- No formal business structure restrictions
Sole Proprietorship Cons
- Unlimited liability
- Unincorporated entity
- Limited capacity to raise capital
- Complete responsibility for day-to-day decisions
- You can form it anytime
- Flow-through income taxation
- Liability protection
- Flexibility to choose how you’re taxed
- Cannot pay yourself wage as a member
- Potentially high annual state fees
- Ownership spread across members
- Franchise or capital values tax
In other words, the difference between an LLC and a sole proprietor often comes down to the number of LLC members, as well as the local (state/country) legal requirements and taxes.
Bottom Line: Should I Form an LLC or a Sole Proprietorship?
As a sole proprietor or a single-member LLC, the IRS would treat you as an unincorporated entity. But if you’re a partnership member, the benefits of registering as an S corporation type LLC are quite a few.
Namely, you can gain legal liability for any debts made by your company. This also makes sure that your business is incorporated and formalized. So if you ever decide to expand, bring in other people as partners or transfer ownership, you can do it without much hassle. Still, switching from a sole proprietor to an LLC is quite easy, too.
Is a sole proprietorship or an LLC the best structure for your business? This is one of the first choices to make as an entrepreneur. Weigh all the pros and cons before embarking on a decision.
To establish a sole proprietorship, all you need to do is choose a name and pay a registration fee. This fee depends on the state, but the amount seldom surpasses $30. On the other hand, registering as an LLC can cost up to $300, and there are annual state fees involved.
Not exactly. The sole proprietorship is more of an informal business structure, which means that you don’t really have to cancel it or convert anything. All you have to do is register as an LLC and stop using the sole proprietorship structure.
The biggest challenge when going to LLC is the need to have a unique business name. For sole proprietorships, this is not a hard-set requirement. You also need to submit the organization’s files, write an operating agreement and apply for a new bank account. You will no longer be legally allowed to use a personal bank account for business purposes.
The LLC structure is all about legal protection, which means that it’s never too early to register under this structure. You can become an LLC even when you have just one paying client. The problem lies in the fact that a single-member LLC isn’t treated any differently than a sole proprietorship by the IRS. This means that if you’re doing this for the sake of taxes and tax schemes, it might not be as effective.
In the eyes of the IRS, a single-member LLC and sole proprietorship are the one and the same. The biggest difference between the two lies in the potential passing on ownership. An LLC is a separate entity from the owner, while sole proprietorship is not.
DBA is not the same thing as a sole proprietorship. Sole proprietorship is a legal structure, while DBA is merely a trade name. The DBA is an abbreviation of the phrase – doing business as. So, technically, it’s easy to confuse the two without making that much of a mistake.
LLCs have to pay all the same taxes as sole proprietorships, as well as a couple of additional taxes. So, in short, yes, LLCs pay more taxes than sole proprietors. Nonetheless, in the case of registering as an S corporation, LLCs can avoid double taxation. This makes the sole proprietorship vs LLC into an even more complex equation.