LLC vs. Sole Proprietorship: How to Choose
Setting your business up as a sole proprietorship is typically easy and inexpensive. But forming an LLC can offer legal protections and tax flexibility.
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Nerdy takeaways
- Sole proprietors hold personal liability risk for their business. LLC owners are personally protected.
- LLCs may have additional tax options that allow them to save on self-employment taxes.
- Sole proprietorships are faster and easier to form than LLCs.
- LLCs involve more paperwork and compliance steps than sole proprietorships.
Choosing a business entity structure for your company is one of the most important decisions you’ll make as a business owner. Deciding between a limited liability company (LLC) or a sole proprietorship comes with tax and legal implications. We'll dive into those and other key differences between the two entities below.
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What is an LLC?
A limited liability company is a legally separate business entity that’s created under state law. An LLC combines elements of a few business types and offers a lot of flexibility for owners. The owners of an LLC can decide their management structure, operational processes and tax treatment. One person can form a single-member LLC or or several people can form a multi-member LLC.
An LLC offers members liability protection from the debts and obligations of the business. That means a business creditor or someone who sues the business can’t typically come after the personal assets of the owners.
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What is a sole proprietorship?
A sole proprietorship is an unincorporated business with one owner. It’s the simplest and least expensive type of business to form. An individual who operates a business on their own is by default a sole proprietor. Meaning, if you sell goods or services, you’re a sole proprietor unless you’ve formed another business structure.
The defining characteristic of a sole proprietorship is the personal liability risk it carries. There’s no legal separation between the business and business owner, so the owner is personally responsible for the business’s debts.
Key features of an LLC vs. sole proprietorship
| LLC | Sole Proprietorship | |
|---|---|---|
| Formation |
|
|
| Operations and management | Owners can share decision-making or appoint a manager to make decisions for the LLC. | One owner who has final say on all decisions. |
| Taxes | Pass-through taxation is the default, but LLCs can elect corporate tax status. | Pass-through taxation. |
| Legal protection | Owners aren’t personally liable for business debts. | Owner is personally responsible for business debts. |
| Paperwork and compliance |
LLCs are advised to have an operating agreement, hold member meetings and record membership units. |
|
LLC vs. sole proprietorship
Because you don't need paperwork to form a sole proprietorship, it can be the easiest and least expensive type of business to start. You may still need to apply for business licenses and permits to legally operate, though. And if you want a business name different from your own name, you'll need to file a DBA or "doing business as" name.
In contrast, you form an LLC by filing articles of organization with your state. The cost to file these varies by state, but generally ranges between $35 to $500. Like a sole proprietorship, an LLC may also need to file for a business license, permits and a DBA (if operating under a trade name).
Operations and management
Sole proprietorships have a simple operational and management structure . A sole proprietor, as the single owner in charge, can make business decisions as they see fit. Some, though, choose to hire legal experts, accountants and other professionals. These individuals can help with day-to-day business management.
An LLC’s operational and management structure is more complex. It's often outlined in an LLC operating agreement. This states each member’s ownership stake in the business, voting rights and profit share. Only a handful of states require an operating agreement: California, Delaware, Maine, Missouri and New York. But many LLCs choose to have one, especially if they have multiple members. An LLC can be collectively managed by the members or by an appointed manager.
Usually LLC members decide on company matters in proportion to their ownership stake in the business. For example, a 33% owner would have a one-third vote on company matters, and a 25% owner would have a one-quarter vote. Members generally divide profits in line with ownership percentages as well. So a 33% owner would receive one-third of the business profits, and a 25% owner would get one-quarter of the business profits.
Taxes
A single-member LLC and a sole proprietorship resemble each other in tax treatment. Both are pass-through entities, which means that the business itself doesn’t pay income taxes. Instead business income is passed down to the owner. The owner reports business income on a Schedule C that’s filed with their personal tax return. The income then gets taxed at the owner’s personal income tax rate.
Multi-member LLCs are also pass-through entities. Each owner reports and pays taxes on their share of the business’s income. The only difference is that a multi-member LLC must file a business tax return with the IRS, Form 1065, U.S. Return of Partnership Income and include Schedule K-1. Each member must receive a copy of the Schedule K-1. The form shows the member's share of income, credits and deductions to be used when filing their personal tax return.
Both LLCs and sole proprietorships might also have additional tax responsibilities. No matter which business structure you adopt, you’ll need to pay payroll taxes if you have employees. You’ll also need to collect state and local sales taxes if you sell taxable goods or services. And as a self-employed business owner, you’re responsible for paying self-employment taxes to the IRS. These taxes cover your Social Security and Medicare tax obligations.
A few states and local jurisdictions levy additional taxes on LLCs. Depending on the state, this might be called a franchise tax, LLC tax or business tax. You’ll also have to pay state and local income taxes and payroll taxes.
Only LLCs can choose corporate tax status
A key difference between LLCs vs. sole proprietorships is tax flexibility. LLC owners can choose how they want their business to be taxed. They can either stick with the default, pass-through taxation, or elect for the LLC to be taxed as a corporation.
An S corporation is still a pass-through entity. But the owners are treated as employees and so aren’t responsible for self-employment taxes. If the LLC elects to be taxed as a C corporation, it will pay a corporate income tax at the federal level, which could result in some tax savings for the business entity. Consulting a tax expert is the best way to learn if either structure is a good option for your business structure.
Legal protection
A sole proprietorship offers no legal separation between the business and the owner. The owner is personally responsible for the business’s debts. If the business goes bankrupt, the sole proprietor has to file for personal bankruptcy. Both personal and business debts are included in the bankruptcy proceedings. Also, someone who sues a sole proprietorship can name the owner in the lawsuit and come after their personal assets.
But an LLC structure offers more protection in the event of a business bankruptcy or lawsuit. Since an LLC is a legally separate entity from the owner, the owner isn’t personally liable for the business’s obligations. If the business fails, the owners can file for business bankruptcy, and they don’t have to pay business creditors from their own assets. And with some exceptions, someone who sues an LLC can’t personally sue the owners. Although, it’s still recommended you have LLC insurance.
Of course, owners in an LLC can be held personally liable for fraud, negligence or personally guaranteed debts. There’s no business structure that offers absolute legal protection for owners.
Paperwork and compliance
The final difference between an LLC vs. sole proprietorship has to do with paperwork and compliance requirements. A sole proprietorship requires the least amount of paperwork. A sole proprietor may need to register a trade name. After that, they may only need to maintain necessary business permits and licenses and keep up with taxes.
An LLC has more compliance responsibilities. After filing initial articles of organization, LLCs have to file an annual report in many states. An LLC with multiple members has even more responsibilities. Those can include drafting an operating agreement, issuing membership units, recording transfers of ownership and holding member meetings. None of these steps are legally required. But they are highly recommended for LLCs to preserve liability protection for members. And since an LLC is a registered business entity, dissolving one takes extra paperwork.
Should you choose an LLC or a sole proprietorship?
Many business owners start out as sole proprietors because of the minimal paperwork and cost. Freelancers and consultants often start here. A sole proprietorship may also be attractive for new entrepreneurs.
An LLC structure can be a good fit for many small-business owners. It can be especially appealing to those who want tax flexibility or a legal separation between their business and personal assets. But there’s often a state filing fee to establish your LLC as well as an annual fee to keep it in good standing.
The best business structure for you will depend on many factors. It’s often best to consult a business lawyer before making this important decision.
Frequently Asked Questions
Is it better to start as a sole proprietor or LLC?
Many new businesses start out as sole proprietorships because they're the simplest and least expensive to start. Entrepreneurs testing out a business idea often start as sole proprietors. You may need to get a local business license or permit. But you aren’t required to file paperwork with the state to form a sole proprietorship, as is the case with an LLC.
Does an LLC pay less taxes than a sole proprietor?
Generally, you won’t pay less in taxes as an LLC than a sole proprietor. However, you do have more tax flexibility with an LLC because you can select how you will be taxed. And choosing to be taxed as a C corporation or an S corporation could offer tax benefits in certain situations.
What is one advantage an LLC has over a sole proprietorship?
Because an LLC is a legally separate entity, the owner is protected from personal liability. This means that creditors aren’t able to come after the personal assets of the owner, with some exceptions.
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