You must decide if an LLC or sole proprietorship is the best legal structure for you and your needs when launching a new small business, whether an online store or a side employment as a freelancer.
Choosing the right business structure is a very important step. Mainly because it determines how successfully you will be able to develop your activities in accordance with your business goals and objectives.
This will determine how much tax you will have to pay, the time you will spend on preparing all the necessary documents, and what reports you will have to consider. However, for someone who is not a lawyer or an experienced entrepreneur, such a choice may seem confusing and complicated.
First-time business owners often don’t fully understand the main difference between sole proprietorship and LLC. Thus, let’s take a look at the differences between the two, how taxes are formed in each case, what the legal protections are, and more.
What Is a Sole Proprietorship?
A sole proprietorship is the most simplest form of business in terms of start-up and taxation. In this case, only one owner operates the business.
To open this business type of entity, you basically don’t need to do anything. You just engage in your business activities and pay taxes on the profits as an individual, i.e., an individual entrepreneur in terms of the law.
You can work in many different areas, like retail, for example. Many people also run online businesses as sole proprietors, providing various services or working as freelancers. Basically, most often, this form of ownership is chosen by self-employed entrepreneurs as their primary or supplemental income.
In a sole proprietorship, the name of the business owner is the name of the business. However, if desired, the entrepreneur can also operate under an assumed business name, i.e., a “doing business as” (DBA) name. The Secretary of State must be informed of such a fictitious name, together with the required filing fee. All your clients will see the name you like, and you will remain a sole proprietor.
The basic characteristic of a sole proprietorship is that the owner and the company are not legally separated. Because of this, the business owner is fully responsible for the debts incurred by the business.
What is an LLC?
A limited liability company (LLC) is a legally separate business structure that is allowed by state statute. An LLC incorporates a number of elements of a sole proprietorship, partnership, and corporation, protecting its owner(s) from personal responsibility for its business debts or liabilities.
Such a business structure provides sufficient flexibility to LLC owners, who can determine their management structure as well as various operating processes and choose how they want to be treated in the tax environment.
You can open an LLC with one member, also known as single-member LLCs (it will be much like opening a business as a sole proprietorship), but you will have to ensure greater accountability. On the other hand, this way, you will protect your business and personal assets.
You can also create an LLC with multiple members, which would be a lot like a partnership but also with protected assets of the members. On the other hand, it will also include certain elements of a corporation, with simpler reporting and more flexible taxation.
- A business owner may determine that the business will be conducted as an LLC. To operate as a legal entity within the chosen state, it’s mandatory to complete and file your Articles of Organization with the Secretary of State. Also, your chosen business name contain the words “limited liability company” or one of its abbreviations.
- When registering an LLC, you can specify your preferred taxation method. Generally, it will be the traditional “pass-through” taxation, and in some cases, you can select to be taxed as a C or S company.
- In an LLC with multiple members, you can develop and legally protect your company by preparing an operating agreement that will contain all the necessary terms, outlined financial and functional decisions, as well as rules and regulations to be followed by all members of the LLC.
- Another very important feature, which should be highlighted separately, is to ensure that LLC members are able to protect their personal assets in the event of bankruptcy or debt incurred by the LLC. This means that all financial obligations of the business are paid by the LLC, and your personal savings remain untouched. This is basically the main reason why many small businesses choose to form an LLC.
LLC vs. Sole Proprietorship: Formation Process
Sole Proprietor Formation
Becoming a sole proprietor is very easy. You may be surprised that you are already a sole proprietor – you just didn’t realize it. Any person who sells goods or offers services on their own is already a sole proprietor. No special registration is required.
Let’s say you have taken up trading, studied the training materials available on the net, implemented a crypto bot to keep up with market fluctuations, and given some paid advice to your old acquaintances for a nominal fee. Feel free to call yourself a sole proprietor as soon as you get the money for your consultation.
To conduct business as a sole proprietor, you might require a business license or permit. Such features depend on your chosen state and the field of business. It may also be that you need a shorter (assumed) name for your company—that’s when you should register a DBA.
Note that registering a DBA does not change the form of ownership—it’s nothing more than an alias or a fictitious business name for your company that you use for marketing purposes. Don’t confuse it with a trademark of an official business name.
An LLC is a separate legal business structure that must be registered with the state. Setting up an LLC requires business expenses, e.g., the state fee to file your LLC Articles of Organization with the Secretary of State and the registered agent service fee, as well as the time and effort to fill out and submit the necessary paperwork.
Any LLC must file the Articles of Organization (sometimes also called a “Certificate of Formation”) to be listed in the state directory of legal entities on the state’s website and regularly file annual (or biennial) reports. The processing time can take from 1-2 days (if you choose expedited service) to several weeks.
The fee to file LLC Articles of Organization depends on the state but ranges from $50 to $200, on average. On the other hand, you can build business credit with an LLC in a way that is impossible with a sole proprietorship.
LLC vs. Sole Proprietorship: Operations and Management
A sole proprietorship has simplified management and operational structures based on a person owning the business. A sole proprietor has the ability to make certain business decisions at his/her own discretion, without the involvement of any third party.
It’s not uncommon for sole proprietors to hire employees, including accountants, lawyers, and other assistants, to ensure proper company management on a day-to-day basis. Also, sole proprietors often opt for outsourcing business processes. However, in any case, it’s still the entrepreneur who controls the business and is fully responsible for it.
If you want to start a sole proprietorship, keep in mind the following:
- The business must be legal. If any business licenses, certificates, or permits are required, they must be timely obtained. You are personally responsible for having them as a sole proprietor, and your assistants have no such responsibility.
- The profits generated must be sufficient to cover the costs incurred. In the course of the actual business, no debts must be incurred. Otherwise, the entrepreneur will have to pay the debts, including from personal savings and personal assets.
To properly start and run an LLC, follow these next steps:
- Choose a suitable business name for your LLC that will be available and comply with all state requirements.
- Choose a commercial or non-commercial registered agent. You can be your own RA, or this can be a person you trust (must be 18 years old and a resident of the state). However, a professional RA service will always be a better choice.
- File your LLC Articles of Organization with the Secretary of State and pay the state filing fee. For example, an LLC in Texas will cost $300 for mail filing and $308 for online filing. It varies in the case of other states.
- If your LLC business has more than one member, you will likely need to prepare an operating agreement to avoid any possible disputes between the LLC members.
- Send timely reports and pay your taxes to avoid any penalties and interest. Some states will only charge when you submit your annual reports, whereas others have income tax and additional taxes (e.g., franchise tax or use tax).
An LLC is managed collectively by the members or by a hired manager, who is appointed for the purpose.
As a rule, the members of the LLC decide on the activities of the firm in proportion to their shareholdings. For example, a business owner with a 33% share receives a third of the votes in deciding various issues concerning the company’s activities. And if it’s a 25% share, consequently, the owner will only have a quarter of the votes.
The profit received is also divided among all the company members according to the share of ownership. Thus, if the owner has 33% ownership, he/she gets a third of the profits, and so on.
LLC vs. Sole Proprietorship: Taxes
A single-member LLC and a sole proprietorship are very similar from a tax perspective because the former is considered a “pass-through” entity, and therefore, the IRS does not separately require LLC owners to pay income tax on corporate profits.
In both cases, once you make a profit, you report it on your tax return and get taxed accordingly. The income from the LLC is reported on Schedule C. Taxation is based on the currently established income tax rate.
LLCs with multiple members differ primarily in that each participant pays taxes on his or her share of the business income. The difference here is that LLC members must attach a Schedule K-1 to their tax return, which notes their share of the firm’s income. In addition, an LLC with multiple members must file a tax return with the IRS (Form 1065, U.S. Partnership Income Tax Return).
In addition to personal income tax, both sole proprietorships and LLCs may have a number of additional tax obligations. Regardless of which business structure is chosen, the following taxes are mandatory:
- Taxes on the wages received by employees if they are employed by the LLC.
- Local and state sales taxes (if the company sells taxable goods).
As a non-employee, the business owner is fully responsible for paying the taxes due to the IRS. These taxes cover existing tax liabilities, including Social Security.
Sometimes, additional taxes may also be levied on an LLC. They can vary from state to state. Business owners must also pay payroll taxes in addition to state, federal, and local income taxes.
Corporate Tax Status
The main difference that exists today between an LLC and a sole proprietorship is tax flexibility. LLC owners, unlike sole proprietors, have the ability to choose exactly how their business will be taxed. This can be a default “pass-through” taxation scheme, or you can choose to be taxed as an S corp or C corp.
If an LLC is taxed as a C corporation, the company pays a prescribed corporate income tax determined at the federal level. Plus, any after-tax profits distributed to shareholders as dividends will be taxed again. They will also have to be reported by the shareholders on their personal tax returns. Depending on local state laws, it may also be necessary to pay local taxes.
LLCs have the opportunity to save money by choosing a corporate tax status. If the firm is taxed as a corporation, dividends received from business activities are generally taxed at a low rate. Undistributed profits earned by corporations are not subject to income taxes.
On the other hand, LLC members cannot treat the income they receive as dividends. They must pay taxes on all of the profits the company receives, regardless of whether they remain in the company at a later date. The corporation is entitled to additional tax deductions and other benefits.
LLC vs Sole Proprietorship: Legal Protection
In a sole proprietorship, there is no formal distinction between the company and its owner. The owner of the business, in this case, is fully responsible for the debts that the company incurs as follows:
- If the business goes bankrupt, the entrepreneur files for bankruptcy on his/her part. In this particular case, the bankruptcy will be personal.
- If the company has any debts, the sole proprietor will pay such debts, including from personal and other funds.
The main reason for this approach is the impossibility of separating personal and business assets for a sole proprietor.
An LLC is one of the best methods to provide liability protection for both your and your employees’ personal assets. Since it’s a separate legal entity, and in the event of debts or bankruptcy, only the company itself is liable. Your personal savings and assets are protected by what is called a “corporate veil.”
Why this is possible:
- An LLC is a legal entity.
- The assets of the company and the owners are completely separate.
If you violate the separation of assets, the “corporate veil” can be “pierced” by the court. This happens, for example, when you accept money from customers into your personal account or, conversely, if you pay personal bills from your company’s corporate account.
In other cases, the owners of a legal entity may be personally liable in the case of fraudulent and misleading actions or in the case of debts that arose as a consequence of the business owner’s personal actions. There are literally no business structures that are capable of providing business owners with full protection from existing business liabilities. However, an LLC is one of the most reliable options.
LLC vs. Sole Proprietorship: Paperwork and Compliance
The bottom line difference between the two types of business structures primarily deals with the paperwork and existing compliance requirements.
The following are some considerations to make when deciding on your company structure:
- A sole proprietor may not register any documents at all if he or she does not need a business name or permits to do business (professional, business licenses, etc.).
- An LLC needs to register as a legal entity, which requires additional paperwork and financial expenses.
Also, an LLC has more responsibilities regarding compliance with statutory requirements.
After filing all the necessary registration documents, LLCs must also submit an annual report.
A limited liability company with multiple members takes on an even greater variety of responsibilities. In particular, there’s a necessity to prepare an operating agreement and get proper insurance policies.
In addition, an LLC with multiple members needs to hold membership meetings and register the transfer of ownership. This is necessary for the LLC to ensure the liability of the members. Because an LLC is a registered business entity, its dissolution will also require additional documentation.
Bottom Line: What to Choose?
Beginning small business owners, primarily freelancers, consultants, freelancers, or real estate agents, start out as sole proprietors. Simply because it’s so easy, and many don’t even think about the fact that their part-time job is already the start of a new business.
Also, working as a sole proprietor is very convenient if you need to test a business idea without any additional investment at the start. It’s very simple since you don’t need to register a company or file separate reports or tax returns.
However, if you are planning a serious business from the very beginning or can even clearly predict your business growth, it’s time to consider your asset protection. In this case, an LLC will be your optimal solution.
On the one hand, you get a relatively simple company registration, a profitable and clear taxation system, and minimal reporting. On the other, your personal assets will be legally protected in the event of litigation or bankruptcy of the company.
An LLC also provides tax flexibility. Meaning that in many cases, you can choose the most favorable taxation model, either similar to a sole proprietorship or as a C or S corp, which allows you to optimize your taxes.
The best business structure depends on a number of factors. In this article, we considered the main ones so that you can choose the best for your business.