Sole proprietorship vs single-member LLC. These are the two most popular business structures for small business owners and deciding which one to go for can be a hard task. This is because you are not just looking at the business side of things but also the legal side.
What’s the legal requirement for forming each business entity? What are the compliance requirements you need to adhere to to ensure you don’t break any law when running your business? What are the tax requirements for each of these business structures?
These are some of the questions you need to answer and in this post, we will try to answer them in as much detail as we can.
However, this is not a topic we can exhaust in a single post. Our intention is merely to provide you with a basic understanding and help you draw a clear distinction between a sole proprietorship and a single-member LLC.
Yes, we will talk about the benefits of choosing one business entity over the other but, ultimately, you will need to talk to a lawyer and accountant. These people will provide unique insights on the topic and help you make a more informed decision for your specific situation.
Note: If you are a sole proprietorship who needs help with invoicing, contracts, proposals and taxes, try Bonsai. Our self-employed software can take the headache away from handling all of these tasks. We have ready to use templates and an expense tracker to help you organize all of your tax deductions. Claim your 7-day free trial today.
A sole proprietorship is a type of business that is controlled by one person and has no legal distinction between the owner and the business. The business and the business owner are one entity.
So, for instance, if the business is in debt then the owner is personally liable. The creditors can go after your personal property like cars and houses to upset the debt.
There are a ton of benefits to sole proprietorships. Let's quickly review some.
Read our detailed resource on the pros and cons of sole proprietorship.
A single-member LLC is a limited liability company that has only one owner. Limited liability means the business is separate from its owner. If the company gets sued, becomes bankrupt, or accumulates debt, the creditors cannot go after the owner’s personal assets to upset the loan.
This is the main distinction between a sole proprietorship and a limited liability company.
Still, there are some circumstances that the creditors can go after the personal assets of members. Like if it is determined that the member did not draw a clear line between the business account and personal account. Or if the owner engaged in fraudulent activities that compromised the business.
Here are some drawbacks of an LLC.
One key difference between a sole proprietorship and a single-member LLC is how they are formed.
For sole-proprietorships it only involves acquiring the necessary licenses to operate.
An example, if you want to run a restaurant as a sole proprietorship then you just need to set up the premises, apply for the necessary licenses such as a food service license, building health license, food handler’s permit and you are good to go.
The other extra step you may have to take is if you are using an invented name for your business. In this case, you will need to file for a DBA which stands for "Doing Business As."
Filing for a DBA allows you to conduct business with a name other than your own. If you choose to use your name as the name of your business, this step is not necessary.
For LLCs, the formation process is not as straightforward. You will still need to apply for the necessary licenses but to make your LLC status official you need to fill out a document called articles of organization.
You then need to submit the document to the relevant state office which in most cases is the secretary of state’s office.
And while this is not an official requirement, part of forming an LLC involves drafting an operating agreement which is a statement of how the business will be run.
In case you are wondering, when you register your business as an LLC you don't have to file for a DBA.
The name you choose when filling the articles of organization becomes the official name of your business.
The only time you would need to file for a DBA is if for some reason you need to use a different name from that stated in the articles of organization.
Like for marketing purposes. Maybe you feel the name you chose won't resonate well with the audience you are targeting and you don't want to go through the process of changing it.
Check out the list of LLC requirements.
As with the formation process, there are not many requirements when it comes to running and operating a sole proprietorship.
In a single-member LLC, however, there are compliance requirements that you need to abide by. One such requirement is filing an annual report to provide the state with important details such as all business activities conducted in the state during that year.
Some states have different reporting intervals and may require that you file the report every two years instead of annually.
Another operational requirement when running an LLC is that you maintain a separate business account for your business transactions.
As we mentioned earlier, mixing business transactions with personal transactions may lead to a situation where the court decides to forego your limited liability status and go after your personal assets.
This is called "piercing of the corporate veil."
Lastly, a sole proprietorship is simpler to run than a single-member LLC in that the owner can make major changes in the business and proceed with business as usual. In an LLC, you have to document any major change by filing an article of amendment with the state.
Both LLCs and sole proprietorships are regarded as pass-through entities by the IRS.
This means LLC owners don’t need to file separate taxes for the business. Instead, they report all business income from the business in their personal returns.
However, a key difference between the two entities is that a single-member LLC can choose not to be taxed as a sole proprietorship and instead elect to be taxed as a corporation.
In such cases, they can either elect to be taxed as an S Corporation or as a C corporation depending on which benefits them more.
For instance, the experts will tell you that if the business is making a lot of profit such that it can afford to pay its members a good salary and regular yearly distributions of about $10,000 or more, that would be a good reason to choose to be taxed as an S corp.
This is because the IRS does not require that you pay self-employment taxes on distributions which saves you about 16% on taxes.
Another good reason to elect to be taxed as an S Corp is if you are not reinvesting your business profits back into the business. In this case, you will only be taxed 15% for all profits that carry over to the next tax year.
This is more economical than having to pay income tax and self-employment tax on the profits that carry over to the next year as is the case when you are taxed as a sole proprietorship.
The situation is a little bit tricky with C corporations because you have to pay taxes at the business level and also pay income tax on payments you receive from the business otherwise known as double taxation.
However, a C corp can be a good option to attract investors since they only get taxed on dividends they have received. Other entities require that you pay taxes on dividends even if you never received them in your account.
As you are already aware, there is no legal difference between a sole proprietorship and its owner. If the business gets sued, has unpaid debts or loans, the law can and will go after the owner’s personal assets including personal bank account, house, car, and other properties.
If you want legal protection from your business then an LLC will provide you with that. You should consider forming an LLC for this reason alone.
Again, we cannot over-emphasize this point. Poor business practices by the LLC owner may lead to the piercing of the corporate veil where the court removes the legal protection of your personal property from the business.
Luckily there are steps you can take to avoid such incidences. One of them is accurately tracking all your business transactions so that they never mix with personal transactions.
Unfortunately, this is easier said than done. Tracking your business transactions means keeping a record of every money you receive and spend in your business. And, having proof in the form of invoices and receipts.
This is hard to do manually which is why most business owners prefer to use professional bookkeeping software.
A common misconception among many business owners is that an LLC will help them pay less tax. This could not be further from the truth.
A limited liability company is not a tax loophole. It’s a business structure that exists to protect the owner against personal liability if there are issues with the business.
That said, there are instances when being taxed as an LLC will be more beneficial than being taxed as a single-member LLC.
A good example is when it comes to tax deductions. It’s harder to separate business expenses from personal expenses if you are running a sole proprietorship than when running an LLC.
This means there are deductions like your home office expenses that you will be able to easily write off if running an LLC compared to if you are running a sole proprietorship.
Talking of which, a lot of small-business owners end up overpaying their taxes because they are not aware of all the eligible expenses that can be written off.
Luckily, there are now multiple tools you can use to track your expenses and Bonsai tax comes highly recommended.
Our software integrates with your business bank account and credit cards and tracks all your business transactions to help you simplify the tax filing process. The tool is created with the main aim of tracking deductible expenses from your business income and helping you estimate your quarterly taxes.
Among some of its useful features is the receipt scanner. The scanner comes equipped with optical character recognition technology to read the content on the scanned receipt and input the data on your expense report.
This way, you are assured to always have the proof needed to justify deductible expenses when filing your taxes. Unlike physical receipts, digital receipts cannot be lost or damaged.
Bonsai also comes with other extra features such as an invoicing system that supports automatic payment requests, payment reminders, and the option to add penalties for late payments.
See for yourself why we are the best tax app for professionals.
Note: if you need help tracking your receipts for taxes, try Bonsai Tax. Our app will scan your bank/credit card receipts for taxes, organize your deductions, and send you filing reminders. Users typically save $5,600 from their tax bill. Claim your 7-day free trial today.
Absolutely. A lot of small businesses start as sole proprietorships because of how simple this business structure is. To convert your sole proprietorship to a single-member LLC, you just need to follow the right steps which include filing articles of organization in your state.
Read our resource on how to change to an LLC from a sole proprietorship.
If you are just starting out and not too sure about your business it would make more sense to start as a sole proprietorship. This is because the formation process is cheap, straightforward, and there are no compliance requirements necessary to run the business.
Also, you can always upgrade to an LLC anytime you are ready. However, if you are all about the future and you are looking at the bigger picture, an LLC makes more sense.
An LLCs biggest benefit is that it's a separate legal entity from the owner and that should mean everything to you as an entrepreneur. The last thing you want is to go bankrupt because your business did not go as planned.
Then there is the tax aspect of it. LLCs offer more flexibility because they are taxed as sole-proprietorships by default but also give you the option to be taxed as corporations.
Still, we recommend you talk to an attorney and accountant for the best advice on which route to take for your business.
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