One is less expensive, the other provides more legal protections. Here’s how to decide
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Sole Proprietorship vs. LLC: An Overview
One of the first decisions anyone going into business today needs to make is how to structure their company. The structure they choose can have a variety of important implications, including how they pay their taxes and the extent to which their personal assets can be shielded from legal liability if they’re sued. For many small business owners, the choice will be between a sole proprietorship and a limited liability company (LLC). Here is what you need to know about how each one works so you can decide which might be right for you.
Key Takeaways
- Sole proprietorships and limited liability companies (LLCs) both have their pros and cons.
- LLCs are more expensive to set up and maintain but provide liability protections that sole proprietorships do not.
- Sole proprietorships can only have a single owner, while LLCs can have one owner or multiple owners, known as members.
- LLCs can be established as single-member LLCs, partnerships, S corporations, or C corporations.
- Different types of LLCs are subject to different tax treatment by the IRS.
Sole Proprietorship
A sole proprietorship is the simplest type of business structure. Anyone can establish a sole proprietorship as long as they will be the only owner. If two or more people wish to start a business together, they must choose another structure, such as a limited liability company or a partnership.
Advantages of a Sole Proprietorship
Cost-effectiveness and simplicity of setup: Sole proprietorships are easy and inexpensive to establish. In most states, you don’t need to register the business or take any other official steps if you will be operating it under your own name. If you choose another name you may have to file a doing-business-as (DBA) registration. When it comes time to file your taxes you don’t have to fill out a separate business tax return; you simply report your business’ gains and losses on a Schedule C and attach it to your Form 1040 individual tax return.
Full control and ownership of the business: As the sole owner of the business, you have complete autonomy. You are your own boss and don’t have to answer to partners, a board of directors, or anyone else.
Easy dissolution process: Just as starting a sole proprietorship requires no legal formalities, you can end one whenever you please. The IRS does require that you file a Schedule C for your final year in business, and you may also need to attach a Form 4797 if you sell any property or other assets associated with the business.
The process is a little more complicated if you have used an employer identification number (EIN) rather than your Social Security number (SSN) in filing your taxes, as is required if you have employees. In that case the IRS requires that you send a letter notifying it that you are canceling your EIN.
The U.S. Small Business Administration (SBA) also advises canceling any registrations, permits, licenses, and DBA names you no longer need in order to “protect your finances and reputation.”
Disadvantages of a Sole Proprietorship
Personal liability for business debts and obligations: As a sole proprietor of your business, you are solely responsible for its debts and other obligations. Most other business structures provide greater protections, insulating an owner’s personal wealth from that of the business to at least some extent. However, if you’re a sole proprietor you can mitigate some of the financial risk if you purchase liability insurance.
Difficulty in raising capital: Unless your sole proprietorship has been successfully up and running for some time, you may find it difficult to borrow money if you need to do so. Many sole proprietorships are funded in the early years out of their owner’s personal bank accounts and with help from generous friends and relatives. Unlike C corporations, sole proprietorships can’t issue stock to raise capital.
Limited growth potential: Because of their lack of access to capital and generally limited resources, sole proprietorships tend to stay small. That may be just fine for some owners, who prefer it that way. For owners with grander ambitions, there may come a time to switch to a different and more flexible structure, allowing for faster growth.
Limited Liability Company (LLC)
A limited liability company (LLC) is a step up from a sole proprietorship in terms of complexity. An LLC can have a single owner or multiple owners, and it affords them legal protections that a sole proprietorship does not (hence “limited liability”). LLCs with just one owner are sometimes referred to as single-member LLCs.
Advantages of an LLC
Limited personal liability for business debts: An LLC shields its owners’ personal property, such as a home, car, or personal savings, in the event of a lawsuit or bankruptcy.
Flexibility in management and ownership: Like a sole proprietorship, an LLC’s owners have relative autonomy in deciding how the business is run. There is no limit to how many owners an LLC can have, and in addition to individuals, owners can be trusts, corporations, or partnerships.
Potential tax benefits: For tax purposes, LLCs can be set up as pass-through (or flow-through) entities. That means any profits or losses are simply passed on to the owners, who then report them on their individual tax returns. That is also true for sole proprietorships, partnerships, and S corporations, but not for C corporations, which are subject to an additional layer of corporate taxes, sometimes referred to as double taxation.
Disadvantages of an LLC
Formation and ongoing fees: LLCs must typically be registered in their home state and in any other state where they do business. States vary in their filing requirements, but LLCs will generally need to submit a set of documents including an operating agreement that spells out how the business will be run. States charge filing fees for establishing an LLC and require that the registration be renewed periodically at an additional cost. In addition, an LLC may be subject to other fees, often including annual or biennial report fees, which are required to preserve its legal status. If the owners wish to end the LLC, they will be required to pay a (generally small) dissolution fee.
Additional administrative requirements: As mentioned, LLCs are generally required to file a report, sometimes called a statement of information, annually or every two years with their states. These reports include such details as the LLC’s current owners and their addresses. If the LLC fails to file its report by the state’s deadline, the state can impose late fees or even dissolve the LLC. Importantly, as the accounting firm Wolters Kluwer points out, an LLC without an up-to-date report on file “will not be in good standing with the state. This can jeopardize your business’ ability to secure a loan, close contracts, or expand operations.” LLCs may also be required to obtain a state EIN and state or local sales tax identification number depending on the type of business. If an LLC has payroll, they will need a state EIN or withholding account number. Some states also require employers to have an employer account number with the state Department of Labor for unemployment tax collection.
LLCs can be subject to additional tax filing requirements, as well. The IRS doesn’t consider LLCs a distinct type of entity for tax purposes, but instead subjects them to the rules for sole proprietorships (single-member LLCs), partnerships, or corporations, depending on which of those they have chosen. LLCs with more than one member can be treated as either partnerships or corporations. In the case of a partnership, the LLC must file an informational tax return with the IRS each year, known as Form 1065, as well as prepare Schedule K-1 forms for each of its owners. The partnership is not taxed on its income, but each owner must report the information that’s on their K-1 and pay any required taxes when they file their individual returns. LLCs that are classified as corporations must file different forms, depending on whether they are set up as C corporations or S corporations.
Potential for involuntary dissolution: LLCs can dissolve of their own accord based on a decision by their owners, or they can be involuntarily dissolved by the state (administrative dissolution) or a court (judicial dissolution). When an LLC is dissolved it loses the liability protections previously afforded to its members. Reasons for involuntary dissolution can include the failure to pay taxes or meet other state requirements. LLCs can also be dissolved in the absence of members, such as if the owner or owners have died.
Sole Proprietorship vs. LLC: Similarities and Key Differences
Sole proprietorships and LLCs have much in common, but there are also some differences worth noting.
Similarities Between Sole Proprietorships and LLCs
Tax reporting requirements: Both sole proprietors and LLC owners are required to file certain tax forms and pay taxes on any profits they make. Sole proprietors report their business income and losses on their individual tax returns by attaching federal Schedule C. LLCs are subject to different filing requirements, depending on whether they are classified as a single-member LLC, a partnership, or a corporation.
Business licenses and permits: Both sole proprietorships and LLCs can be required to obtain federal, state, or local business licenses and permits, depending on the nature of the business they are in. For example, a restaurant or construction company may be required to obtain a business license regardless of its ownership structure.
Use of assumed business names/(DBA): Both sole proprietorships and LLCs can choose a name for the business (assuming it hasn’t already been taken by another business). Sole proprietorships have the option of running the business under the owner’s name, while LLCs must choose and register a DBA name.
Differences Between Sole Proprietorships and LLCs
Liability protection: Sole proprietors bear the entire financial responsibility for any lawsuits or legal judgements against their business. LLCs can protect their owners’ personal assets in that situation.
Ability to raise capital: Obtaining a loan or attracting investors can be difficult for sole proprietorships, especially those without a long track record of profitability. LLCs can raise capital in a number of ways. For example, they can take on additional members (as LLC owners are known). If the LLC is structured as a C corporation it can also sell shares of stock or issue bonds to raise capital.
Regulatory requirements and costs: LLCs are more strictly regulated than sole proprietorships—and not just in the state where they are based but in any location where they do business. This means that LLCs face many additional and ongoing costs, making them more expensive to operate.
Factors to Consider in Choosing the Right Business Structure
Business owners have a choice in how they wish to structure their companies. A single-owner operation, for example, can set up as either a sole proprietorship or a single-member LLC. Multiple owners can form a partnership or corporation. Before deciding, here are some things to consider.
The nature of the business and its risks: Because LLCs provide additional protections for their owners’ personal possessions and other assets, they can be more appropriate than sole proprietorships for businesses that run the risk of lawsuits. As the U.S. Small Business Administration puts it, “Sole proprietorships can be a good choice for low-risk businesses and owners who want to test their business idea before forming a more formal business,” while “LLCs can be a good choice for medium- or higher-risk businesses, owners with significant personal assets they want protected, and owners who want to pay a lower tax rate than they would with a corporation.”
Growth potential and funding needs: Sole proprietorships are limited in their growth potential both because they can have no more than one owner and because they are likely to have a harder time obtaining capital for expansion. However, as the SBA notes, a sole proprietorship can be a practical way to start a business. If it catches on, the owner can later restructure it as any of the several types of LLCs.
Personal liability concerns: Sole proprietorships provide no protection for their owner’s personal assets, although that can be mitigated to some extent through liability insurance and, if worse comes to worst, filing for bankruptcy. So anyone with substantial assets to protect should weigh the benefits of forming an LLC. That is especially true if their business faces a serious likelihood of being sued at some point.
Tax implications: Sole proprietorships and certain types of LLCs all enjoy the tax benefits of being pass-through entities, where any profits are taxed only once. The exception is if the LLC is established as a C corporation, in which case its income is taxed on both the corporate and individual levels.
Administrative requirements and costs: LLCs require considerably more paperwork to set up and maintain than sole proprietorships do. They are also subject to additional costs. For prospective business owners, the question comes down to whether the extra work and expense is justified by the LLC’s greater liability protections.
Can You Convert a Sole Proprietorship to an LLC?
Yes, you can convert a sole proprietorship into an LLC by filing essentially the same paperwork with the state as if you were starting an LLC from scratch. A business owner might want to do this if it has become more important for them to protect their personal assets.
Can You Convert an LLC to a Sole Proprietorship?
You can also go in the opposite direction and convert an LLC into a sole proprietorship. You will have to dissolve the LLC with the state and transfer its assets to yourself. A business owner might consider doing this if, for example, they are now the sole owner of a business that once had partners and they want to save on administrative costs. They will, however, lose the liability protections of their old LLC.
How Much Does It Cost to Form an LLC?
The costs of forming an LLC vary from state to state. According to Wolters Kluwer, the fee to establish an LLC varies from $50 in Colorado and Iowa to about $300 in Texas and Tennessee. Most states are in under $200. Bear in mind that if you plan to do business in more than one state, you will have to register in each of them. In addition, there may be other costs, such as business licenses.
How Much Does It Cost to Form Sole Proprietorship?
It might not cost anything to form a sole proprietorship, since you normally aren’t required to register with your state. As with LLCs, however, you may incur costs if you need to obtain business licenses.
The Bottom Line
Sole proprietorships and LLCs both have advantages and disadvantages. Sole proprietorships are simpler and cheaper to set up and run, while LLCs provide liability protections that sole proprietorships do not. For anyone about to launch a business, these tradeoffs are important to think through. However, whichever structure you choose, it is relatively easy to switch to the other one if you later decide that it would be a better fit.
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