What’s the difference between an LLC and a Sole Proprietorship? The main differences relate to company formation, liability protection, routine reporting, access to finance, and credibility. Below we compare the two and weigh up the pros and cons of an LLC vs Sole Proprietorship.
WHAT’S BETTER AN LLC OR A SOLE PROPRIETORSHIP?
What’s a better option for your business – an LLC or a Sole Proprietorship? There are some very clear differences between the two business structures.
An LLC takes a little more time and effort to form but offers some key advantages in liability protection, taxation flexibility, access to finance, and credibility.
On the other hand, a sole proprietorship is much easier to form. You can form a sole proprietorship without taking any formal action. And, they are very simple to manage and require less paperwork and report submission.
Below we take a close look at the key business features of an LLC vs sole proprietorship. If you are in two minds between them, we will help you choose the model that will work best for your business.
WHAT IS AN LLC?
An LLC is a type of business structure used to run a business. LLC stands for ‘limited liability company’. It is a very popular business structure because it is easy to set up, inexpensive to maintain, and comes with several important advantages.
An LLC combines some of the features of a sole proprietorship with those of a corporation. The key attractions of an LLC are its limited liability protection, pass-through taxation structure, and flexible management structure.
WHAT IS A SOLE PROPRIETORSHIP?
A sole proprietorship is the simplest type of business structure. It consists of an unincorporated business owned and run by a single person. A sole proprietorship is the cheapest and easiest type of business to own and run.
You are a sole proprietor by default if you own and operate a business. Sole proprietorships offer no legal separation between the individual’s assets and the business’s assets. This means the owner can be held responsible for debts incurred by the business.
JUMP TO CONTENT
- LLC PROS & CONS
- SOLE PROPRIETORSHIP PROS & CONS
- LLC vs SOLE PROPRIETORSHIP COMPARISON
- LIABILITY PROTECTION
- TAX STRUCTURE
- MANAGEMENT STRUCTURE
- MIXING BUSINESS & PERSONAL FINANCE
- COMPANY NAME REQUIREMENTS
- COMPANY FORMATION
- FREQUENTLY ASKED QUESTIONS
LLC ADVANTAGES & DISADVANTAGES
What are the key pros and cons of an LLC business structure? Let’s take a look at the advantages and disadvantages of forming an LLC.
ADVANTAGES OF AN LLC
LIMITED LIABILITY PROTECTION
One of the key advantages of an LLC is limited liability protection. An LLC is recognized as a distinct legal entity. And, in the eyes of the law, the assets of the business and those of the owner are separate.
This means that the owner’s personal assets are protected from the LLC’s debts or if someone sues the company. However, some scenarios can see an owner’s assets being pursued to cover the debts of the company. This can happen if the owner gives a personal guarantee to secure a business loan.
An LLC company benefits from pass-through taxation. This means all company earnings pass through to the owner without being subjected to business tax. The earnings are then taxed as part of the owner’s personal income tax return.
OPTION TO SELECT TAX REGIME
When you form an LLC you may be able to select a tax regime depending on the nature and structure of your business. In fact, you may be able to choose to be taxed in the same way as a sole proprietor or as a corporation.
Many LLCs choose to be taxed as an S corporation. This allows company earnings to pass to the individual and be taxed in your personal tax return. And, you can reduce your FICA taxes by claiming a reasonable salary from the company and receiving the remaining profits as dividends.
Forming an LLC creates credibility for your company. An LLC company is recognized as a real business in the eyes of the public and carries more weight than a sole proprietor. Most states require that an LLC includes an identifier such as Ltd or LLC in the company name.s
ACCESS TO FINANCING
LLC companies will be able to access financing more easily compared to a sole proprietorship. An LLC is a separate business entity and will find it much easier to obtain equity and debt financing. You will be able to apply for small business loans if you form an LLC.
DISADVANTAGES OF AN LLC
To form an LLC there are several formal steps you will need to complete. Although the process is straightforward, you will have to complete some paperwork, file an application with your state authority, and pay a fee. For more, see – How To Start an LLC.
In most states, LLCs have to file an annual report. In others, it is a biennial requirement. These reports keep all the important details of the company up to date.
They inform the state authorities of everything they need to know about the company. For a breakdown of fees for each state see – LLC Formation and Maintenance Costs.
Most states require an LLC to pay some kind of annual business tax. Often referred to as a franchise tax it is a legal requirement in most states. In addition, you will have to pay a fee to file your annual or biennial report. For more on the pros and cons of forming an LLC, see – Advantages & Disadvantages of LLC.
SOLE PROPRIETORSHIP ADVANTAGES & DISADVANTAGES
What are the advantages and disadvantages of operating as a sole proprietor? Let’s take a closer look at the pros and cons of the sole proprietor business structure.
ADVANTAGES OF A SOLE PROPRIETORSHIP
EASY FORMATION – NO PAPERWORK
A sole proprietor is the simplest business structure to form and run. It does not require any paperwork to establish. If you set up a business and do not form a corporation, you will automatically be classed as a sole proprietor. Forming a sole proprietorship requires no formal action.
NO ANNUAL STATE REPORTS
A sole proprietor does not have to file any annual or biennial reports. In fact, you don’t have to file any reports with the secretary of state. This frees you up to focus on running your business. This lack of red tape and official forums is a key benefit of a sole proprietor.
Like an LLC, a sole proprietor benefits from pass-through taxation. This means no corporate tax is paid on company profits. Instead, all the earnings pass through to the company owner. The owner then pays tax on these earnings in their personal tax return.
OTHER TAX BENEFITS
In addition to pass-through taxation, there are several other benefits you can take advantage of as a sole proprietor. These include deducting business expenses such as the use of your car, marketing costs, travel expenses, and entertaining clients.
DISADVANTAGES OF A SOLE PROPRIETORSHIP
NO LIABILITY PROTECTION
The biggest disadvantage of a sole proprietorship compared to an LLC is the lack of liability protection. In the eyes of the law, there is no separation between the assets of the company and those of the owner.
This means that the owner’s personal assets can be pursued to cover any debts run up by the business. And, you can be sued personally for the commercial activities of your company.
DIFFICULT TO SECURE FINANCING
It can be difficult to secure financing for a sole proprietorship. Most investors are wary of investing in sole proprietorship businesses and instead favor incorporated companies. The only means of securing an investment may be from a friend or family member.
DIFFICULT TO SECURE BUSINESS LOANS
It is difficult for a sole proprietorship to secure a business loan. The vast majority will view a loan to a sole proprietor as a personal loan. And, to secure the loan you may have to offer personal assets as collateral – for example, your home.
Sole proprietorship businesses do not carry the same market credibility as an incorporated company. The Ltd or LLC letters next to a limited liability company offer reassurance that the company is a real business. Most sole proprietorships are run in the name of their owner.
LLC vs SOLE PROPRIETORSHIP COMPARISON
When we compare an LLC vs sole proprietorship, the biggest difference is liability protection. An LLC offers its owner limited liability protection and a sole proprietorship does not.
An LLC is recognized as a legal entity. Its assets are separate from its owner’s. And, if the company is sued or incurs a debt – the owner’s assets are out of reach in most scenarios.
A sole proprietorship does not offer this protection. In the eyes of the legal system, there is no difference between the assets of a sole proprietorship and those of its owner.
This means a sole proprietor can be held personally responsible for any debts the company runs up. This places the owner’s bank account and personal assets such as their home in danger.
By default, an LLC and a sole proprietorship are taxed in the same way. Both these company structures benefit from pass-through taxation.
This means all company earnings are passed through to the business owner without having to pay any corporate tax. Tax is then paid in the personal income return of the business owner.
However, an LLC has more flexibility. An LLC can choose to be taxed as a corporation or as a partnership. If you wish to tax your company using the S corporation model, for example, you will have to form an LLC.
An LLC can be owned and managed by one or more people. An LLC owned by one person is called a single-member LLC. And, an LLC owned by more than one person is known as a multi-member LLC.
The owners of an LLC are called members. You can choose to have the members of an LLC run the company or you can appoint managers. The management structures are known as member-managed and manager-managed LLCs.
A sole proprietorship is owned and run by a single individual. It does not have members or partners. This business structure allows for just one person to run the show and make all the decisions.
MIXING BUSINESS & PERSONAL FINANCE
In an LLC you mustn’t mix business and personal finances. You must keep your business bank accounts and finances clearly separate from your own personal account. If you fail to do this you can lose the liability protection offered by an LLC.
A sole proprietor does not have to worry about this. If you are a sole proprietor the law sees your business finances and your personal finances as one and the same. There is no distinction between the two. This means you do not have to legally separate your personal and business accounts.
COMPANY NAME REQUIREMENTS
There are strict laws surrounding the naming of an LLC. For example, in most states, there are many words that cannot be included in your company name – such as bank, agency, or university.
Many states also require that an LLC includes some sort of identifier in its name to make it clear it is an officially incorporated company – such as the letters Ltd.
In addition, you cannot use the name of a pre-existing business, a name that could be easily confused with an existing business, or any name that could be confused as being a government agency.
A sole proprietorship does not have to be worried about these requirements. Most sole proprietorships are operated under the name of their owner. However, if you wish to apply for a company name you will need to fulfill the naming requirements for a DBA, (doing business as), in your state.
Forming an LLC requires you to complete a series of formal steps. The most important of these is completing and filing your ‘Articles of Organization’ with your state authority – usually the secretary of state.
Most states require payment of a fee when you file this document. We recommend you create an operating agreement at this point to formally detail how the company will be run and owned.
Forming a sole proprietorship is much more straightforward. Technically you don’t have to complete any paperwork. If you form a business and choose not to incorporate your business will automatically be classed as a sole proprietorship.
Comparing LLC vs sole proprietorship, the later is much easier to form. If you need some help forming an LLC, check out the Best LLC Formation Companies 2022.
However, most businesses require some form of license or permit to operate in a region. You should check with your local and state authorities to see if you need to apply for a permit for your business. There is usually a fee charged for business permits.
FAQ LLC vs SOLE PROPRIETORSHIP
IS LLC A CORPORATION OR SOLE PROPRIETORSHIP?
An LLC is a business structure that combines many of the features of a corporation with those of a sole proprietorship. LLC benefits from pass-through taxation like a sole proprietorship but also offers liability protection to its owners.
IS AN LLC BETTER FOR TAX?
An LLC can choose to be taxed the same as a sole proprietorship or as a corporation. Like a sole proprietorship, LLCs benefit from pass-through taxation. This means that company earnings are not subjected to any business tax. All earnings pass through to the company owner who then pays tax on them as part of their personal income tax return.
CAN A SOLE PROPRIETORSHIP BECOME AN LLC?
Yes, a sole proprietorship can be converted into an LLC. You should follow the same process as any company applying to form an LLC. Typically, this involves completing an Articles of Organization document and filing it with your local secretary of state.
- WHAT IS AN LLC REGISTERED AGENT?
- PROS & CONS OF USING LLC FILING SERVICE
- PROS & CONS OF REGISTERED AGENT SERVICES
- LLC FOR RENTAL PROPERTIES
ABOUT THE AUTHOR
Editor in Chief
Jason is editor in chief at My LLC Guide. He holds a wealth of business management experience and has been advising companies on business formation issues for many years. Jason specializes in resource planning management, staff utilization, and productivity consulting.
He has worked predominantly in the west coast area where he graduated from the Marshall Business School at the University of South California. When he's not working in his business advisory role, Jason likes to climb on his Indian Scout motorbike and enjoy the open road.