When it comes to founding a business, you might have to compare sole proprietorship vs. LLC. Which type of business structure works best for you? Should you go for sole proprietorships, or are LLCs the better solution?
Each business entity has its own advantages and disadvantages - and for the most part, the choice depends on the small business owners. Some might benefit more from a sole proprietorship, whereas others might get more profit from the LLC.
You need to put both types of businesses in comparison and see the pros and cons for each. Determine what kind of business owner you are, and then make the decision about which one fits your needs. Read our article, and you'll be able to find that information.
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What Is a Sole Proprietorship?
When you open a sole proprietorship, it means that you are opening a business that is not a separate entity from your own person. This is a very common business structure in the United States for those who are only starting out. It can also be among the riskiest options.
A sole proprietorship can be an online business (i.e., freelance marketing), but it can also be a physical one (i.e., construction). The main idea is that sole proprietorships have just one owner. If you get a business partner, that means you are no longer in a sole proprietorship - you are in a business partnership.
Advantages of a Sole Proprietorship
When comparing sole proprietorships vs LLCs, sole proprietorships do come with a few advantages. Here is what you need to keep in mind:
No Need for State Paperwork
One of the main reasons why people go for a sole proprietorship is because they do not need to file any state paperwork. You will only need your industry-specific license that will specify you are doing business as a professional.
No Annual Tax Filings
Taxes and state filings in the United States can sometimes be fairly complicated, which is why a lot of people are afraid to start their own business. However, if you open an LLC, you won't have to open any annual state filings, unless the industry that you are working in requests it.
With big business structures such as a corporation, taxes are filed through the business, which is not always advantageous. However, with a sole proprietorship, you get pass-through taxation. This means that all the profits are passed through the personal tax return of the owner. You will have to report them on a Schedule C form with the IRS, along with your personal tax return.
As the owner of a sole proprietorship or self-employed person, you enjoy a ton of tax benefits. You can deduct business expenses, opt for retirement plans of the self-employed, write off travel costs, and more. The tax filing is also less complicated, proving beneficial to those who are just starting.
Read more about how to file taxes for sole proprietorships here.
Disadvantages of a Sole Proprietorship
As a sole proprietor, you have certain advantages, but there are also some downsides that you should keep in mind. Here is where owning a sole proprietorship might seem tricky:
You Get No Liability Protection
As a sole proprietor, your own persona is directly tied to your business. This means that if you were to go into debt, face a lawsuit, or go bankrupt, you would get little to no liability protection. The creditors would simply seize your personal assets in order to pay your debt.
Securing Equity Financing Is Difficult
Sole proprietors very often find it difficult to secure equity financing, as not many investors want to put their funds in a sole proprietorship. They would rather put their money in a larger, more profitable business. Unless they are friends and family, it's next to impossible to find sponsors.
Getting a Business Credit is Difficult
Business credit is as difficult to get as equity financing. While you may get some money, you will get it in the form of a "personal loan," and not a "business loan." This may put a limit on the amount of money that you can get.
While a sole proprietorship does have a certain amount of credibility, it does not compare with that of a limited liability company. Small business owners that are operating sole proprietorships are basically doing business without a trade name. While this can be fixed with a "Doing Business as" (DBA), very few sole proprietors do this, as it involves extra ongoing fees.
What Is an LLC?
A Limited Liability Company (or, simply put, an LLC) is a legal formal business structure that is fairly popular among small businesses. Limited liability companies offer similar tax benefits as a sole proprietorship, but also offer personal liability protection.
This means that, unlike sole proprietorships, you are not held personally liable for every financial hit that your company takes. You'll have a separate business bank account, as opposed to sole proprietorships, and your assets are not likely to be seized in the event of liability. Read our resource for the best business bank accounts for LLC.
The best time to start an LLC could be right away.
LLCs offer flexibility, as they are somewhere in the middle of sole proprietorships and corporations. If you are a single-member LLC owner, then you may automatically be taxed as a sole proprietor. However, if you have employees, you can choose if you want to be taxed as a corporation (whether it's C-corporation or S-corporation, it does not matter). Read our resource comparing incorporating vs LLC.
Advantages of an LLC
LLCs are pretty advantageous for business owners who want to take it a step up. Here are some of the reasons why sole proprietors switch to an LLC.
You Get Personal Liability Protection
As the owner of an LLC, you get personal liability protection against lawsuits, business debt, bankruptcy, and other financial guarantees. This means that as long as you don't inter-mingle the personal assets with the business kind and avoid any personal guarantees, the creditors won't be going after your personal assets.
Small businesses running under the LLC label have a higher credibility level on the market. Since you are registered with the state, you are also automatically seen as "more professional." Not only will this give you more credibility with the clients, but also with potential investors, employees, and business partners.
It's Easier to Obtain Financing
Whether you are looking for equity or a business loan, it's much easier to obtain it if you have an LLC. Since you have more credibility, investors are more likely to take a chance with your company. Creditors are also more likely to give you a loan, and it will be labeled as a business loan, not a personal loan. This will include factoring, leases, trade credit and many other financial advantages.
Even if you are technically a legal business, it will be exactly like you are paying self-employment taxes, without adding a company into the mix. LLCs take the best out of sole proprietorships and corporations, allowing you to be taxed in the way that fits your business the most. This also means that all of your profits and losses go straight into your personal tax return, and not the corporation's.
Read more about the requirements for an LLC if you want to set one up and reap these benefits.
Disadvantages of LLCs
When comparing sole proprietorship vs. LLC, we see numerous benefits, but there are also a few disadvantages of an LLC:
You May Need to File More Paperwork
Compared to a sole proprietorship, you have to handle more state-related paperwork. For instance, you need to get an operating agreement if you are a multi-member LLC. You may also need other potential licenses and permits required by your industry.
Annual State Filings
You are now a legal entity, so you will have to go through annual state filing. For this, you have to pay the associated filing fees. If you have any specific licensing fees related to your industry, you will have to pay those as well.
Depending on the state that you are in, you may have to pay extra taxes aside from your personal state, federal and local taxes. This means that you may be asked to pay unemployment taxes, along with state business taxes.
Tax Return Costs
For the most part, this depends on the nature of your business, but based on your business expenses, you may have to face higher costs for completing your tax return.
Do LLCs Pay More Taxes Than Sole Proprietorship?
When it comes to tax treatment, sole proprietors and LLC owners pay taxes in a similar manner. Both use pass-through taxation, which means that the owner is the one who pays the taxes, not the business.
The difference is that an LLC owner also has to file business tax returns with the Internal Revenue Service (IRS). You might have to file some extra taxes on LLCs, but this mostly depends on the state that you open your LLC in.
In other words, the tax load for both business entities might be the same in some of the states, but in other states, the tax rate might be slightly higher. Sometimes, if you are a multi-member LLC, you might have to pay business income taxes for every shareholder.
The taxes you pay will also depend on your tax status. LLCs are the only business entities that can choose their tax status. You may choose to be taxed as a sole proprietor, or you can pay like an S-corporation. It all depends on which tax option is better for the state that you are in.
Depending on the areal tax law, you might also pay fewer taxes as an LLC than you would as a sole proprietor. As the owner of a limited liability company, you may get several federal, state, or local tax advantages. During tax season, you might get more deductions for your businesses, which can actually prove more advantageous in the long run.
This is why you need to familiarize yourself with the tax law of your state. If you don't want to fall into a disadvantage, you need to choose the tax status that works best for your needs.
Is a Single-Member LLC the Same as a Sole Proprietorship?
One might think that a single-member LLC and a sole proprietorship are the same thing, simply because there is only one person in the entire business, managing things.
Physically speaking, they are right - there is just one person holding the reins and doing the work. They can also hire employees if they want, they get pass-through taxation, and they can withhold payroll taxes if they have employees or contractors working for them.
The difference between the two lies within the lines of liability protection. With a sole proprietorship, your name and your company are the same - which means that if you have business debts, your personal assets will be on the line. Creditors can seize those assets in order to pay the debt.
On the other hand, a limited liability company is separate from your personal assets. It is a disregarded entity that works like a corporation but has the advantages of a sole proprietorship. You have the tax advantages of a self-employed person, but you get limited liability protection (i.e., your personal assets are not at risk).
Do I Need an LLC If I Am a Sole Proprietor?
Technically speaking, you do not need an LLC if you are a sole proprietor. Sole proprietorships represent a basic type of business structure, and allow you to conduct your business without necessarily registering a license as a business owner.
However, while you may not necessarily need it, it is still worth considering this option. Sole proprietorships are good for business owners who want to keep their business small, and want to do the work as a "side gig". In that case, you do not necessarily need an LLC.
However, if you plan on growing your business, turning it into the main gig and increasing trust with your clients, then you might need an LLC .
LLCs are higher than sole proprietorships, so people will be more likely to collaborate with you if they see you raising the LLC flag.
You also need a sole proprietorship if you are afraid that your personal assets are going to be seized. Sole proprietors are not usually protected from debt collectors, and if your business goes bad, then your home, car, or personal bank account may be seized. With that in mind, LLCs do not carry that risk, and your assets usually get personal liability protection.
Is It Easier to Form a Sole Proprietorship than an LLC?
Forming a sole proprietorship is rather easy, as there isn't much paperwork involved. Depending on the work that you are doing, you may need to get some permits, licenses, zoning clearance, and some other extra documents - but this is not the case for every business. If you are only running an online business (i.e., content marketing), then you won't need as much paperwork done.
You may choose to have some extra documents done if you wish to make matters easier for you. For instance, to help you during tax season, you may get an Employer Identification Number (EIN). You may also get an operating agreement if you have other people working for you.
LLCs take a bit more as compared to a sole proprietorship, but the process is still quite simple. You'll have to come up with a legal name for it, something that you would not have had to do with informal business structures.
You will also need to appoint a registered agent. If it's a single-member limited liability company, then this can be you. However, if there are multiple members, you may choose someone from your company to fill the role. The need for getting an operating agreement becomes stronger with an LLC.
As an LLC, you also have to file Articles of Incorporation. The name and specifics can differ from state to state, but if you can find someone offering business advice delivered straight, the process can be much streamlined. Read our resource on how much does it cost to open an LLC.
Which Is Better: LLC or Sole Proprietorship?
Each business structure has its own benefits, so you cannot say that one is better than the other. An LLC is good for those looking for low-risk businesses, as it offers personal liability protection. Aside from the legal protection, you also get more credibility.
However, a sole proprietorship involves less paperwork hassle. You won't have to file for as many licenses, nor do you need to pay as many annual fees. However, you do get less credibility, as it's the most basic type of business structure.
Sole Proprietorship vs. LLC - The Rundown
Both LLCs and sole proprietorships have their advantages and drawbacks. One will provide personal liability protection, whereas the other involves less hassle. One is more appropriate for bigger, growing businesses, whereas the other is more recommended for smaller side hustles. It's up to you to decide which type of business you want to run.