Choosing between sole proprietorship vs LLC is a vital step that can make a difference in how the venture operates. To make an informed choice, you need to learn about the difference between sole proprietorship and LLC. Although a sole proprietorship does not attract regulatory requirements and registration fees, it still has considerable downsides. Hence, the need to assess your plans carefully.Table of Contents:
- What to Consider When Choosing Between a Sole Proprietor and an LLC
- What is a Sole Proprietorship
- What is an LLC?
- Key Differences: LLC vs Sole Proprietorship
Some key factors to consider include startup costs, paperwork, liability protection, tax implications, and regulatory requirements.
A limited liability company offers several advantages over a sole proprietorship. However, it comes with high startup costs, such as state LLC registration fees. Additionally, the formation process is considerably more involved. While the sole proprietorship eliminates the need to register, you assume unlimited liability. Depending on your needs and plans, you should weigh factors like the startup costs versus an LLC’s benefits.
Unlike LLCs, sole proprietorships are not subject to any regulatory requirements save for state and local licenses and permits. This advantage ensures that you focus on growing the business and not worry about filings, legal documentation, and other administrative or compliance tasks. With LLCs, you have to deal with annual filings and other matters. On the upside, the law does not make it mandatory for LLCs to hold share meetings and adhere to strict ownership restrictions like corporations.
In the business world, legal protection makes a significant difference. LLCs protect in the event of lawsuits resulting from day-to-day business activities. This aspect is undoubtedly the greatest advantage of LLCs over a sole proprietorship. The latter exposes personal assets, including money in the bank, home, and cars, to risk if a court of law orders seizure. With an LLC, there is a distinction between personal assets and the business.
When it comes to the tax benefits of an llc vs a sole proprietorship, LLCs provide more benefits and options beyond the default tax status, unlike a sole proprietorships. While both LLCs and sole proprietorships are pass-through taxation entities by default, LLCs can elect for alternative tax statuses with the IRS. Beyond their default tax status, LLCs can file a tax status election to be treated as a C Corporation or S Corporation for tax purposes. This can be very beneficial and provides additional tax flexibility that sole proprietorships lack.
Sole proprietorships are the simplest unincorporated business you can start, which does not entail government regulation. For this reason, sole proprietorships are commonly started as home-based businesses. Independent contractors and other self-employed professionals typically operate as sole proprietors. Despite the unlimited liability, this structure eliminates several startup and operational hurdles associated with limited liability companies.
The benefits of forming a sole proprietorship include:
- No Required Paperwork Outside of Business Licenses: If you are looking at minimizing paperwork during the startup stage and operations, you should consider forming a sole proprietorship. This business structure benefits from the lack of regulation, eliminating the need to file registration paperwork and other documents. Depending on your business’ activities, you may be required to obtain permits and licenses or not.
- No Annual Filings: The Internal Revenue Service does not tax sole proprietorships directly. Instead, the owner file a personal return, which reflects the business earnings. This approach helps reduce the administrative work involved in annual filings for the business.
- Pass-Through Taxation: Pass-through taxation exempts the business from filing returns, diverting the responsibility to the sole proprietor. Other business structures with non-taxable entity status include LLCs and partnerships. Conversely, the IRS levies corporate taxes to C-corporations directly. The law empowers the IRS to collect taxes based on the owners’ income as it flows to personal bank accounts.
Notable downsides associated with a sole proprietorship include:
- No Liability Protection: Without liability protection, sole proprietors face exposure to lawsuits initiated by third parties against the business. In such cases, the law allows creditors and any other parties to seek compensation for losses directly from the business owner. Since the business has no legal status, a sole proprietor compensates third parties using personal funds and assets. In extreme cases, lawsuits may translate to bankruptcy for the sole proprietor.
- Harder to Get Financing and Business: Most financial institutions and investors are unwilling to provide loans or operating capital to sole proprietorships. This scenario is due to various factors, including the structure and legal status of the business. Unlike an LLC, this type of business cannot issue stock or invite partners to join the venture without converting it to other business structures.
- Less Credible Without DBA: By default, sole proprietorships use the owner’s name to handle day-to-day business activities. However, the owner’s name does not induce confidence in the business. To boost credibility, sole proprietors can register a DBA (doing business as) name, which allows the venture to use a unique fictitious name. Once the authorities approve the name, customers and other interested parties can identify the sole proprietorship with the trading name.
A limited liability company or LLC is a legal entity with flexible tax benefits, legal protections, and improved access to operating capital. This business structure also brings a flexible management structure. In essence, an LLC is a combination of the favorable characteristics of sole proprietorships, partnerships and corporations. LLCs are a formal business structure that is recognized as a legally separate entity from its owners.
Key advantages of starting and operating a limited liability company include:
- More credibility: When choosing between individual sole proprietor or single member LLC, you should consider each business structure’s credibility. With a limited liability company, your business enjoys more market credibility than a sole proprietorship. Hence, an LLC finds it easier to attract customers, investors, and highly skilled employees.
- Personal Liability Protection: Legal protection is an essential aspect of establishing and operating an LLC. Many entrepreneurs find the risk associated with unlimited liability unacceptable. For this reason, business people opt for a limited liability company to protect personal assets from seizure following a lawsuit linked to business activities.
- Easier to Get Financing and Business Credit: The ability to access financing easier is a notable difference between sole proprietorship and LLC. The latter opens more doors to raise much-needed operating capital than the sole proprietorship. On the other hand, an LLC is a legal entity capable of applying for loans under the company name. In turn, an LLC can build a business credit history.
- Pass-Through Taxation: As an owner of a limited liability company, you can elect to use the default taxation, eliminating the need to pay tax at a corporate level. In doing so, you file personal returns for the IRS to account for the business profits.
- Tax Status Flexibility (C Corp or S Corp Taxation): Tax flexibility is another differentiating factor between sole proprietorship vs LLC. You can elect to use the default personal returns filing, file as S corp, or submit returns as a C corp. Opting for corporate tax filing reduces the amount you pay.
The downsides of an LLC include:
- Requires Upfront Paperwork Filing and Fee to Start: State governments require business people to submit a considerable amount of paperwork during formation and on an ongoing basis. Some state filings require fees, which vary, depending on location. The sole proprietorship eliminates most of the paperwork, except licenses and permits.
- Annual Filing Fees: LLC must pay an annual renewal fee and may need to file an annual report as well (depending on the state). This fee can be referred to by a variety of names such as annual report, annual fee or franchise tax to name a few. If an LLC does not pay this renewal fee they risk loosing good status with the state and incurring additional penalties, fees or even the administrative dissolution of the LLC.
- Tax Return Filings Cost More: The filing of tax returns for an LLC generally will cost more money to prepare and file. For a single member LLC you would need to include a schedule C with your Form 1040 that is submitted to the IRS to record the LLCs income and deductions.
If you’re interested in forming your business as an LLC check out our step-by-step guide on how to start an LLC.
Assessing the difference between sole proprietorship and LLC is a surefire way to gain an in-depth understanding of the pros and cons associated with both business structures. There are 6 main areas of difference when evaluating an LLC vs a sole proprietorship.6 Key Areas of Difference between an LLC and Sole Proprietorship:
- Business Formation Process
- Access to Funding
- Tax Status Flexibility
- Registered Agent
- Personal Liability Protection
- Selling the Business
Whether you are keen to operate as an individual sole proprietor or single member LLC, you should understand how the formation process works for both options. A sole proprietorship does not involve any formal filing to get started. If you start conducting business activities as an individual owner you are a sole proprietor by default. Sole proprietors are separate entities from their owners, so if you wan to use a business name that does not include your name you’ll need to file for a DBA name. In addition to this you’ll also need to ensure that you obtain all relevant business licenses and permits so that you are compliant with the laws and regulations your business will be subject to.
The process of forming an LLC has some more moving parts to get started. If you decide to form an LLC, you’ll need to file legal paperwork, known as Articles of Organization, with your state’s secretary of state office. Prior to completing this filing you’ll want to determine the legal name of your LLC. It’s important to note that LLCs have a legal naming requirements so you’ll want to ensure that your name fits with what you state’s rules are. In addition you’ll need to complete a name availability search to ensure that your desired name isn’t already in use in your state. Once you have this determine you’re ready to submit your Articles of Organization to the secretary of state office. Along with this filing each state charges a filing fee that will need to be paid at the same time as the submission of the Articles of Organization.
Once you register the business via the secretary of state office, you are ready to draft an operating agreement (optional but recommended) and obtain an employer identification number from the IRS. You complete the formation process by opening a bank account, obtain permits, and establish a bookkeeping system. Depending on your needs and plans, you should weigh factors like the startup costs versus an LLC’s benefits.
Access to operating capital is undoubtedly a high priority for all businesses. Securing funding is more challenging for the sole proprietorship since the owner lacks the financial support of partners or co-owners. On top of this, most major financial institutions like banks view sole proprietorships are less credible and stable businesses and as a result are much less likely to provide access to business loans and lend credit. As a result, many sole proprietors are forced to rely on personal loans and savings when starting out.
LLCs have a much easier time getting access to required funding when starting out. Since an LLC is a separate entity from its owner(s), they are viewed as a more credible and reliable business. In turn, banks are much more likely to issue credit and approve business loan applications from an LLC. LLC can also build a business credit history, which is vital for accessing credit lines under the business name.
LLCs and sole proprietorships are both pass-through taxation entities. In fact, single-member LLCs are treated as a “disregarded entity” by default by the IRS. This is the same way the IRS treats sole proprietorship. Pass-through taxation simply means that the business’ profits or losses are passed directly to the owners personal income and paid by them. While a single-member LLC is treated the same as a sole proprietor by default, LLC have the option to elect for 2 other tax statuses. The LLCs can elect for corporate or s corporation tax status by filing an tax status election form with the IRS.
By filing form 8832 an LLC can elect for corporate tax status. While this will mean that they are subject to “double taxation”, it has the benefit of allowing the LLC to retain a portion or all of their profits as retained earnings. This is very beneficial for a business that is trying to grow or expand as they can retain previous years profits to spend on growth initiatives. For LLCs with a default taxation status, the owner(s) would need to pay taxes on the profit generated by the business, even if they don’t distribute this income. This would limit the total amount of capital the business has available for expansion.
LLCs also have the option to elect s corporation tax status, under subchapter S of the tax code. This can be very beneficial for LLCs that are very successful and generate sizable profits. The s corporation tax status is designed to allow small or family operated businesses to avoid double taxation. S Corps do this by passing their income directly through to the business’ owners. This is very similar to how an LLC works by default however in a default tax status LLC, all of the business income generated is treated as self-employment income and thus is subject to this additional tax. Under an s corporation tax status, the owners of the business pay themselves a reasonable wage via payroll which is subject to employment taxes. However, any additional income from the LLC is paid as a dividend, thus is not subject to self-employment tax. This can result in a fairly sizeable tax savings for an LLC with s corporation tax status.
Sole proprietorships are unable to change their tax status since they are an informal, unincorporated business. As a result sole proprietorships are subject to self-employment tax on all of their income.
A commercial registered agent plays an integral role in helping owners of limited liability companies handle legal documentation. Although many states allow entrepreneurs to represent themselves, hiring a professional agent has many benefits. For LLCs, a registered agent can assist during the formation stages to ensure a glitch-free registration.
Meanwhile, sole proprietorships do not require the services of an agent during the formation process. However, the agent can be useful when converting a sole proprietorship to a limited liability company. Entrepreneurs can count on the agent to forward critical documents in a timely fashion.
Representing yourself can potentially create unwanted risks considering that any errors have a direct impact on the future of your business. The majority of commercial registered agents render quality services at reasonable fees. Hence, reasons for not hiring a reputable agent are negligible. The importance of an agent’s role applies to the limited liability company during registration and sole proprietorship during conversion.
Personal liability protection is a factor that you should not take lightly. Thus, opting for an LLC business structure safeguards your assets and future. With an LLC, there is a distinction between personal assets and the business. Although some business activities have more of a reduced risk of attracting lawsuits than others, the limited liability status creates an additional layer of protection.
As the owner of a sole proprietorship, you face direct exposure to legal ramifications in the event that third parties sue your business. Any debts incurred by the business may lead to personal assets’ attachment following a ruling by a court of law. It becomes possible to face bankruptcy if the outstanding amount exceeds the combined value of your assets.
Depending on your financial situation and commercial activities, the risk level may be negligible. Assess the advantages and disadvantages of the two business structures carefully before forming the venture.
Selling a sole proprietorship is undoubtedly a complicated matter due to various factors. Potential buyers often find it difficult to make an offer for the entire business since it lacks legal status. This scenario results in sole proprietors resorting to selling individual assets to interested parties. For buyers keen to purchase the business, they can use the trade name if the sole proprietor registered a DBA.
On the other hand, owners of an LLC do not grapple with the same challenges. Since an LLC is legally recognized as a separate entity from its owner(s), it makes selling a business formed as an LLC a much easier process.