When choosing a business structure, you may wonder whether you should form a limited liability company (LLC) or a sole proprietorship. Each has its benefits and drawbacks, with the key differences being how they are set up and how your personal assets are implicated.
Your specific business needs will determine which works best for you. Learn the details here.
Key Points
• An LLC provides personal liability protection, shielding personal assets from business debts, while a sole proprietorship offers no separation between personal and business liabilities.
• Sole proprietorships and single-member LLCs are taxed similarly as pass-through entities, but LLCs can also elect to be taxed as an S-corp or C-corp, offering tax flexibility.
• Sole proprietorships are simple and cost-effective to establish, with minimal paperwork, while LLCs require state registration, fees, and annual maintenance.
• LLCs may have better access to funding, as they’re often seen as more formal business entities, appealing to banks and investors.
• An LLC can continue if the owner changes or sells the business, while sole proprietorships dissolve upon the owner’s exit, affecting long-term planning.
Key Differences Between a Sole Proprietorship and LLC
The most significant differences between a sole proprietorship and an LLC structure come down to the requirements for setting up the kind of business and how your personal assets are treated in each structure.
Basically, you don’t have to do anything to set your business up as a sole proprietorship. However, if you want to form an LLC, you must file paperwork, pay a fee, and wait for your state’s Secretary of State to approve your business as an LLC.
As for your personal assets, with a sole proprietorship, they may be claimed to pay business debt. But if you have an LLC, you and the business are considered separate entities so your personal assets are separate.
What Is a Sole Proprietorship?
When you start a business, you can elect a specific business structure, meaning that you formally register it with your state’s Secretary of State and pay a fee. If you don’t do that, your business is automatically considered a sole proprietorship (or a partnership if you have partners).
In a sole proprietorship, you and the business are considered one entity. You file only your personal taxes, and you claim both business income and expenses on them.
Definition and Basic Characteristics of Sole Proprietorships
A sole proprietorship is a business owned and operated by a single individual. It’s the simplest business structure, with no legal separation between the owner and business.
Basic characteristics of a sole proprietorship include:
• Single ownership: Owned and operated by one individual, with no separate business entity.
• Unlimited liability: The owner is personally responsible for all debts and liabilities of the business.
• Direct taxation: Business income and expenses are reported on the owner’s personal tax return (Schedule C).
• Simple setup: Minimal paperwork and low startup costs, with few legal requirements.
• Full control: The owner has complete decision-making authority over the business operations.
• No business continuity: The business dissolves if the owner exits, retires, or passes away.
Advantages of a Sole Proprietorship
When it comes to the benefits of a sole proprietorship vs an LLC, the biggest advantage is the ease of creation. Your business is a sole proprietorship simply by default.
Taxes are also simple, since you file only your personal income taxes and don’t have to file taxes separately for the business.
There are no fees required to be a sole proprietor, either.
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Disadvantages of a Sole Proprietorship
There are, however, some drawbacks to sole proprietorship to consider.
First, because there is no delineation between you and your business, your personal assets could potentially be seized should the business have debts or legal fees that it can’t cover. That could jeopardize not only your business, but also your personal life if, for example, your home or vehicle is taken to cover business debts.
You may have difficulty if you try to get a small business loan through a bank or attract an investor when you are a sole proprietor. You could also struggle to sell your business if you haven’t elected a business structure like an LLC or corporation. Because the LLC is separate from its owner, it may be more appealing to lenders, investors, and potential buyers due to the limited risk.
If you have a sole proprietorship but don’t want to do business under your own name, you’ll usually have to file your DBA (Doing Business As) name. Let’s say your name is Jane Doe but you want your company to be called Dr. Knowhow’s Resume Writing Service. That’s fine, but it will generally require extra paperwork to file that DBA name. The filing fee can cost between $5 and $150, depending on your state.
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What Is an LLC?
LLC stands for limited liability company. To use this business structure, you must elect and apply for it. If a company is an LLC, it’s separate from the business owner (or owners, if there are multiple owners), meaning that the owner or owners aren’t held personally responsible for the business’ liabilities.
Here, a look at the pros and cons of LLCs.
Advantages of an LLC
When it comes to an LLC, your personal assets can’t be taken to cover business debts. You have, as the name indicates, limited liability.
In contrast to another business structure, the corporation, the LLC requires less paperwork to set up and maintain, since a corporation requires annual meetings and annual reports.
LLCs can choose how they’re taxed. They can take advantage of what’s referred to as pass-through taxation, in which the business doesn’t file and pay its own taxes. Instead, its income and expenses are passed through to the owners’ personal tax returns. This equates to the LLC being taxed like a sole proprietor, and may mean it can be referred to as a “disregarded entity.”
Alternately, an LLC can also be taxed like a corporation at a lower corporate rate for the first $75,000.
Another benefit is that an LLC has no limit on the number of members (or shareholders) it can have. An S corporation, by way of comparison, is limited to no more than 100 shareholders.
And finally, you may find it easier to qualify for financing or to sell your business if it’s an LLC.
Disadvantages of an LLC
So what are the drawbacks of an LLC? First off, to start a limited liability company, you have to apply with your state’s Secretary of State department, which may require a fee and take time for the paperwork to be processed. You may also have to pay an annual or biannual fee to keep your LLC in good standing. As of 2024, those fees (in states that require them) range from $9 in New York to $800 in California.
Additionally, you may have to pay unemployment insurance for yourself and any partners, although you wouldn’t have to do so for a sole proprietorship. Costs for unemployment insurance vary by state.
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How to File an LLC
To file an LLC, start by reviewing the requirements set out by your state’s Secretary of State. Each state has a slightly different process. Some let you apply online, while others may require you to mail in your application.
You will likely be required to file articles of organization, which is a document outlining information about your business and its members. You may also be required to file other forms as well as pay a filing fee, which may range from $35 to $500. Some states may require you to have certain business licenses or permits to qualify as an LLC, too.
Working With a Registered Agent
If you think the process of setting up an LLC yourself sounds overwhelming, you have another option. You can employ the services of a registered agent. This is an individual or company who can set up your business structure on your behalf, as well as ensure that you keep up with annual fees and paperwork deadlines. Registered agents charge a fee for their services.
Key Comparison Factors
When comparing sole proprietorships and LLCs, key factors include:
• Liability protection: LLCs offer limited liability, safeguarding personal assets, whereas sole proprietors are fully liable for business debts.
• Tax implications: Tax implications differ as both allow pass-through taxation, but LLCs can opt for S-corp or C-corp taxation, adding flexibility.
• Setup and maintenance costs: These are higher for LLCs due to state fees and annual reports, unlike the minimal costs for sole proprietorships.
• Operational flexibility: Operational flexibility is greater for sole proprietors, who have full control, while LLCs require more formal structures.
• Credibility: LLCs often appear more professional, appealing to clients and investors.
How to Choose a Business Structure for Your Company
When it comes to choosing a business structure for your company, consider how much effort you’re willing to put into setting up your business structure and the fees you’re willing to pay. An LLC does require some effort to prepare, and it may require an annual fee and/or paperwork to be filed.
You may also want to factor in how likely it is that your business might ever be sued. If you run a writing business out of your home, that risk might be minimal. But if you have a fitness training business, you might incur more risk of being sued, if, for example, a customer is injured during training.
Finally, think about how likely you are to want to get investors or a type of business loan. An LLC will likely be more appealing to potential investors or lenders than a sole proprietorship. And it may also be easier to sell an LLC.
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The Takeaway
When you’re looking at a sole proprietorship vs an LLC, the most important thing is to carefully consider which will provide the biggest benefit to your business. How you file and pay taxes, whether you separate your personal assets from the business’s assets, and whether you’re willing to go through the process and paperwork of setting up and maintaining a legal business structure should weigh into your decision.
If you’re seeking financing for your business, SoFi is here to support you. On SoFi’s marketplace, you can shop and compare financing options for your business in minutes.
FAQ
Can an LLC be a sole proprietorship?
No, an LLC cannot be a sole proprietorship. While a single-member LLC allows one person to own the business, it is legally distinct, providing liability protection not offered by a sole proprietorship. A sole proprietorship is an unincorporated business without separate legal status from its owner.
What are the tax filing differences between sole proprietorships and LLCs?
A sole proprietorship reports taxes on the owner’s personal tax return via Schedule C of Form 1040. A single-member LLC does the same, but multi-member LLCs must file Form 1065 as a partnership or elect corporate taxation. LLCs offer flexibility to choose between pass-through or corporate tax structures.
Can I change my business structure later?
Yes, you can change your business structure later. Many businesses start as sole proprietorships or partnerships and later transition to LLCs or corporations as they grow. Changing structures involves registering with the state, updating licenses, and notifying the IRS, often for tax benefits, liability protection, or funding opportunities.
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