As a new business owner, you’re probably juggling many tasks to get your company up and running. One of those tasks, likely, is deciding whether to register your company as a sole proprietorship or an LLC.
There’s no straightforward answer to this, as it depends on your specific needs and goals. Understanding the pros and cons and key differences between a sole proprietorship and an LLC can help you decide which option is best for your business.
What is a sole proprietorship?
A sole proprietorship is the simplest type of business structure. In a sole proprietorship, there’s no legal separation between a business owner and their business entity. Essentially, you act as an extension of your company.
This business structure is the least complicated to set up and manage, so it may be best for small businesses that are just starting out. But, like any new endeavor, it’s important that you weigh out the advantages and disadvantages before you make your decision.
Advantages of sole proprietorship
Let’s look at some of the top perks of a sole proprietorship.
It’s simple. There isn’t actually any work required to establish a sole proprietorship. If you’ve received business income for anything you’ve done on your own, whether that’s selling a product or providing a service to a client, you’re automatically considered a sole proprietor.
There’s less legal red tape. Because you’re automatically a sole proprietorship when you do business on your own, you won’t need to file any complicated paperwork or follow any legal guidelines.
Taxes are easier. Since they’re operating as an unincorporated business, sole proprietors will file only a personal tax return. This means you don’t have to worry about filing multiple tax documents, or filing out complex or complicated forms. This may be the same for a single-member LLC, but if there are multiple owners, you’ll need to look into things like a partnership tax return.
Disadvantages of sole proprietorship
And now for the drawbacks.
More risk from personal liability. In an LLC, you’re separate from your business entity. This means that if you find yourself in a lawsuit for business debts or other problems, it’s less likely that someone can come for your personal assets like your money or property. But in a sole proprietorship, you don’t have personal liability protection—meaning you could lose it all in a worst-case scenario.
You’re on your own. Running a business alone can be tough, especially when you don’t have partners or investors. This is one reason that business owners opt for another business structure or setup.
Trouble getting funding. Generally speaking, a sole proprietorship is viewed as less “official,” and therefore less credible, in the eyes of investors, banks, and other partners who can provide business loans or funding.
What is an LLC?
An LLC, or limited liability company, is a business structure category that mixes elements of a sole proprietorship and a corporation. There are many types, each with its own set of rules and considerations.
We’re going to focus on a single-member LLC, which is the closest to a sole proprietorship. In this type of LLC, there’s one person who owns 100% of the company (that’s you).
Advantages of LLCs
Here are some LLC perks:
You have personal liability protection. While you’re not 100% protected in every single scenario, an LLC will give you a base level of liability protection. This means that your business is separate from you, so you’re less likely to lose your personal assets like money or property if your business gets sued.
Flexibility with your taxes. As a single-member LLC, you have a choice in how to pay taxes. You can be taxed as a sole proprietor and file a personal tax return, or you can file as an S corporation or C corporation. Many choose to file as a corporation for “pass-through” tax benefits, meaning that business income “passes through” to the personal tax returns of owners and shareholders.
Less setup than other business types. Single-member LLCs require some paperwork to set up, but it’s simpler than other types of business structures like multi-member LLCs or corporations. After you file your articles of corporation with the state, the paperwork is done.
Disadvantages of LLCs
Here are some LLC drawbacks:
Higher costs. You’ll have to pay some fees as an LLC, which might include a state filing fee, registered agent fee, and state annual report fee. These could total several hundred dollars or more per year.
More bureaucracy. There are more rules and regulations and more paperwork. You’ll need to regularly deal with entities like federal and state governments and possibly more, depending on the nature of your business.
Sole proprietorship vs. LLCs: The key differences
Costs
Starting a sole proprietorship usually costs less than an LLC because there’s no need for formal paperwork. Some sole proprietors might choose to register a doing-business-as (DBA) name, and the cost for this varies by location.
For an LLC, the setup cost depends on the business location, since each state has its own requirements. For example, many states require the LLC owner to register a unique name with the secretary of state. According to the US Small Business Administration, this registration generally costs less than $300, but the exact amount can vary, depending on the location and type of business.
Liability
Liability is one of the main reasons that any business owner opts for a limited liability company over a sole proprietorship. That’s because limited liability companies offer more protection to business owners, as their business is a separate legal entity from them.
With an LLC, the personal assets of a business owner are more protected. Say, for example, you’ve taken out a business loan that you can’t repay. Because your personal assets are separated from your business assets, you’re less likely to lose any of your personal assets if your lender takes legal action against your business.
Whereas with a sole proprietorship, you might be at risk to lose your personal assets because you don’t have that personal liability protection.
Funding
When raising capital, LLCs often have an advantage over sole proprietorships. Investors typically view an LLC as more secure because it’s a distinct business entity. This perspective is consistent among investors, as well as for business loans and lines of credit.
Banks also favor LLCs, providing them with business loans. In contrast, they might offer personal loans only to sole proprietorship owners. Moreover, an LLC can invite more partners to invest, while a sole proprietorship remains a one-person show.
Employee considerations
If your business involves hiring employees or independent contractors, an LLC is generally a better choice. Employees can create additional liability risks, which an LLC can help mitigate. With a sole proprietorship, you are personally liable for any issues arising from employee actions, which can increase your risk.
Taxes
When you run a sole proprietorship, your personal assets can be in danger if your business owes money, especially if you’ve made big investments.
In contrast, an LLC owner bears responsibility for the amount they’ve invested in the business. If the business experiences financial issues, the owner’s personal assets remain protected. Still, it’s vital to keep business and personal transactions separate. Always talk to a tax adviser for guidance.
Comparing the two, an LLC provides stronger protection for personal assets than a sole proprietorship. This protection is a prime reason many choose the LLC route.
Management and control
In a sole proprietorship, one person shoulders all business operations and management tasks. This means the owner enjoys full control. However, this also might curb the business’s growth potential, placing a substantial weight on a single individual.
On the other hand, LLCs offer greater management flexibility. A single-member LLC can function much like a sole proprietorship, but there’s also the choice to add more members or hire employees. While the owner retains primary control, they must consider the preferences and requirements of other participants.
Record-keeping and compliance
While both business structures require some level of record-keeping, an LLC typically requires more formal compliance, such as annual reports and operating agreements. This increased level of formality can provide clearer guidelines for operations and decision-making, which can benefit the business in the long run. However, it also means more administrative work compared to a sole proprietorship.
Who should become a sole proprietor?
A sole proprietorship offers simplicity and ease of setup that can fit various business needs. Below are some examples of who can benefit from forming a sole proprietorship:
Local freelancers. Freelancers situated in a specific area will find that incorporating as a sole proprietorship allows them to manage their business independently. It works well for graphic designers, writers, and consultants working from home.
Solo entrepreneurs. Solo entrepreneurs running businesses such as lawn care services can benefit from the straightforward and uncomplicated nature of a sole proprietorship. They can handle everything on their own without much hassle.
Part-time side hustlers. Individuals with seasonal or part-time businesses, like bakers selling at farmers’ markets, will find a sole proprietorship perfect for their needs. The simplicity of this structure helps avoid the complexities of forming an LLC.
Self-funded business owners. Small business owners starting with their own savings, such as consultants or coaches, can operate effectively as sole proprietorships. This setup is suitable for those who do not plan to hire employees or seek investors.
Who should form an LLC?
In the LLC vs. sole proprietorship debate, an LLC offers benefits like liability protection and a formal business structure. Below are a few examples of businesses that might benefit from forming an LLC:
High-risk business owner. If you’re a retailer or manufacturer dealing with valuable assets or physical activities, an LLC can protect your personal assets. It provides liability protection, giving you peace of mind.
Aspiring entrepreneur seeking investors. For those looking to attract investors, an LLC is usually the preferred choice. Investors like the formal structure and the liability protection it offers.
Multi-state operator. Planning to operate in several states? An LLC makes this easier. It provides consistency and structure, helping you navigate different state regulations without hassle.
Business partners. Teams running a business together can benefit from an LLC. With a clear operating agreement, it helps ensure smooth cooperation and reduces potential conflicts.
Image-conscious professional. Want your business to look stable and formal? An LLC can enhance your reputation. Many see LLCs as more reliable and established, which can help attract more clients.
Time to start your business
Registering your business is a strategic move: you’ll be able to take advantage of certain things like tax considerations and have the ability to control your image. Ultimately, the decision is yours to make: What do you envision for your brand, and will an LLC or sole proprietorship be the best fit for that vision? If you’re still on the fence, consider consulting a lawyer or tax professional for their sage advice and tips.
Sole proprietorship vs. LLC FAQ
Why is a company better than sole proprietorship?
In a sole proprietorship, one person makes all the decisions and faces all the risks. A company, on the other hand, can have investors. These investors provide funds and aren’t liable for the company’s debts. This benefit often makes companies a preferred choice for many.
What is the biggest difference between a sole proprietorship and an LLC?
- Liability. LLCs offer enhanced protection against personal risks.
- Funding. An LLC typically finds it easier to obtain external finance than a sole proprietorship.
- Taxes. The tax structure of a one-member LLC can change based on specific circumstances.
- Costs. Setting up a sole proprietorship is free, whereas LLCs have registration and ongoing expenses.
- Management and control. Sole proprietorships grant more control than LLCs.
When should a sole proprietor become an LLC?
A sole proprietor should think about becoming an LLC for two main reasons. First, if they plan to bring in more owners. Second, to protect their personal assets from legal and financial issues. Given these points, moving to an LLC can be a wise step for many entrepreneurs.
How do self-employment taxes affect a sole proprietorship?
In a sole proprietorship, the owner pays self-employment taxes on their business income. These taxes cover Social Security and Medicare contributions. It’s important to set aside funds for these payments to avoid surprises at tax time.
What does it mean to run an unincorporated business owned by an individual?
Running an unincorporated business owned by an individual (like a sole proprietorship) means the business isn’t a separate legal entity. The owner is personally responsible for all debts and obligations. This setup can be simpler to manage, but carries more personal risk.