Choosing a business structure is one of the first challenging decisions a founder has to make. Limited Liability Companies (LLC) and sole proprietorships are two of the most common forms for small business owners.
The key here is this: there’s no “right” choice for everyone. The best choice for you depends on risk, income, and goals. To help you, we’ll look at LLC vs sole proprietorship, including which offers the benefits you need. That includes how each structure works, key differences, tax impact, and when to use either.
What is a sole proprietorship?
A sole proprietorship is a single-owner business that requires no formal setup. Here’s what that means.
How a sole proprietorship works
A sole proprietorship is the automatic structure your business has once you start selling or offering services. There’s no formal registration required in most states. Some states will still require your business to have a license or DBA, though. There’s no separation between you, the owner, and your business. It’s the same legal entity.
Pros of a sole proprietorship
- Simple and inexpensive to start, with no actual work to do to form your business
- Minimal paperwork and ongoing requirements to follow over time
- Straightforward tax filing that keeps everything in your name
Cons of a sole proprietorship
- No legal separation between personal and business assets
- Personal liability for business debts and lawsuits, meaning your assets can be used to pay your liabilities
- May appear less formal to banks, partners, or clients, and that could be challenging as you grow to secure support
- Harder to scale or bring on partners because it is less formal
What is an LLC (limited liability company)?
An LLC is a legally recognized business separate from the owner’s liability. Here’s what that means.
How an LLC works
An LLC is a legally registered business entity that’s officially formed with the state. Once formed, it creates separation between the owner and the business. That makes the business its own legal entity. LLCs can have one owner, called a single-member LLC, or can have multiple owners.
Pros of an LLC
- Limited liability protection for personal assets, keeping your business and personal assets separate
- More credibility with banks, vendors, and customers because it has a formal, legal entity
- Flexible tax treatment options that allow you to choose the best tax reporting for your situation
- Clear business structure for growth and opportunities.
Cons of an LLC
- Formation and annual state fees are necessary
- Ongoing compliance requirements may be required to keep your business operational
- Slightly more administrative work than a sole proprietorship
Single-member LLC vs sole proprietorship
Consider how a single-member LLC vs sole proprietorship differ in real-world situations.
Both a single-member LLC and a sole proprietorship are owned by a single person. And, both can be taxed similarly as a result. The key differences here are that an LLC creates legal protection by separating your business assets and debts from your personal assets and debts. The difference isn’t in the ownership itself but in the legal design.
Is a sole proprietorship vs LLC the same thing then? No, they are not. A single-member LLC is a separate legal entity from your personal identification. That separation creates liability protection for your personal assets. In situations where a creditor seeks action against you, an LLC faces the brunt of it, but your personal assets remain separate and protected.
LLC vs sole proprietorship taxes
LLC vs sole proprietorship taxes are about the same. Your business income could be reported on your personal tax return. That means it is subject to income tax and self-employment tax. There’s no separate business tax filing necessary with either form.
How LLC taxes work by default
A single-member LLC is typically treated like a sole proprietorship. That means the income your business earns is passed through to the owner’s personal return. You report your LLC’s income on your personal taxes each year. You are still subject to self-employment tax in this process.
Key tax differences to understand
Creating an LLC does not automatically reduce your taxes. It’s still very important for you to work with a tax professional to go over these opportunities.
Any tax savings you see depend on your income level and the elections you take. Having an LLC doesn’t really change the tax process, but it does offer some flexibility that a sole proprietorship does not. That’s the ability to change tax treatment later if you want to do so.
“LLCs pay less tax” is not always true. There are many situations where there is no effect, and some cases where you may pay more. Your accountant will review every method to determine which is best suited for your needs.
Benefits of LLC vs sole proprietorship
Some business owners choose an LLC over a sole proprietorship. Here’s why that could be.
With an LLC, you gain personal liability protection. You can maintain a clear separation of finances, meaning that both your debts and assets for your business are separate from your personal ownership.
LLCs also create a sense of legitimacy because you have taken the time to establish your business’s legal entity. This shows a sense of professionalism. LLCs give you options, too. Over the long term, there’s flexibility to grow your business and adjust tax strategies to optimize your actions.
But don’t overlook the fact that in some cases, an LLC is not required. It may not be necessary to take this step, depending on your individual situation.
The benefits of LLC vs sole proprietorship depend on the amount of business risk your company has, not on the size of your company. Carefully consider making the move as your business grows, takes on more debt, or acquires more assets.
When a sole proprietorship may make sense
There are some situations where a sole proprietorship is a reasonable decision. That means you would not have to take any formal action. Some examples of when this may be beneficial include:
- You have a very low-risk business with few to no debts or assets.
- You are testing an idea or just engaging in a short-term side hustle.
- You’re at a very early stage of operation with fewer assets or liabilities.
- Your revenue is minimal, and your exposure is low.
A sole proprietorship is both common and valid. It certainly makes sense for businesses to start here and, as they grow and thrive, to evolve into an LLC.
When an LLC may make sense
There are some situations where an LLC makes the most sense now, meaning taking the formal step can be helpful to your personal and business assets.
- Your business has any type of legal or financial risk.
- You have regular clients or contracts, or are moving into that process.
- Revenue is growing for your business.
- You want to separate your business and personal assets and liabilities, even if you don’t have to do so.
- You plan to remain in business long term. You’re ready for the formality of an LLC.
An LLC is not always beneficial. However, you should consider this move carefully when your business starts to grow.
What to do before choosing between an LLC and sole proprietorship
Before choosing an LLC vs sole proprietorship, take the time to consider the following factors. Being prepared and ready to make this structural decision is a must.
First, understand basic liability and risk. Consider how it applies to your business and personal assets. Consider all potential types of risk your company faces.
Next, get organized. Gather your business information and separate your personal and business finances. You’ll need to establish a business bank account to create that formal separation.
Consider why formal registration of your business may be appropriate for you now. To get to that point, you’ll also need to establish the following:
- Have a clear business name that’s not used in your state by any other company. Your state will require you to verify that your business name is unique.
- Get a federal employer identification number (EIN) with the IRS. While a simple process to complete, it is a necessary first step in establishing your company.
- Create accurate records and documentation of your business. That should include clear income and expenses, asset ownership, as well as clear ownership of the business and how it is run.
This is where the process can become somewhat overwhelming. Platforms like Tailor Brands help founders form LLCs, manage documents, and stay organized as they grow. It allows you to move through the process quickly and put your LLC in place right away. That includes overcoming state-specific challenges or requirements that may apply.
Conclusion
An LLC vs sole proprietorship is a big business decision and one you should make after carefully considering opportunities and risks. There’s no one-size-fits-all answer here. Simply, you need to consider the benefit of separating your business from your personal assets and liabilities to determine if one is right for you.
Making informed decisions means carefully evaluating your risks, goals, and readiness. With thoughtful planning and consideration for what your business goals are, making the decision between an LLC vs sole proprietorship can become a bit easier.