The Ins and Outs of LLCs vs. Sole Proprietorships

Table of Contents

• Sole Proprietorship
• Advantages and Disadvantages of a Sole Proprietorship
  • Benefits
  • Drawbacks
• Limited Liability Company (LLC)
• Advantages and Disadvantages of Forming an LLC
  • Pros
  • Cons
• Deciding between LLCs and Sole Proprietorships
• FAQs

Selecting a business entity structure for your company is one of the most important decisions you can make as a small business owner. However, unless you are a lawyer or tax professional, the specific disparities between each business entity can be difficult to grasp.

Because new business owners are frequently puzzled about the difference between these business structures, let’s take a closer look at each one:

Sole Proprietorship

A sole proprietorship—an unincorporated business with one owner—is the simplest and least expensive legal entity. Individuals who operate a business on their own are considered to be sole proprietors. For example, if you are a professional freelance writer, you are automatically a sole proprietor—unless you have adopted another business structure.

You can identify a business as a sole proprietorship because the owner’s name is the business name—although sole proprietorships can also operate under a brand or trade name, also known as a DBA (Doing Business As). The main differentiator of a sole proprietorship is that there is no legal separation between the business and the business owner. A sole proprietorship is not recognized as a legal entity. The owner is also liable for all of the business’s debts. 

Here are some things to think about when considering a sole proprietorship:

• No required paperwork (except for industry-specific licenses)
• No annual state filings
• Simplified tax filing with the IRS
• No liability protection
• Difficult to obtain financing for the business name
• Can be difficult to build business credit

Advantages and Disadvantages of a Sole Proprietorship

Benefits

• No state paperwork, unless specific licensing is required, like an occupational license and/or business license.
• No annual state filings to complete unless your industry requires specific industry filings.
• Business income and losses are passed through to the owner’s personal tax return.

Drawbacks

• No liability protection against commercial debts, lawsuits, and other obligations, so owners can be sued personally, putting all personal assets at risk.
• It can be difficult to secure equity financing since many investors are less likely to invest in sole proprietorships.
• Establishing business credit to obtain debt financing can be tricky because most financial institutions see the request as a personal loan instead of a business loan.

Limited Liability Company (LLC)

An LLC is a legally separate entity formed under state law. There can be a single-member LLC or a multi-member LLC with multiple people. LLCs combine elements of a sole proprietorship, partnership, and corporation—and offer a great deal of flexibility for owners. The LLC owners determine their management framework, operational processes, and tax structure.

LLCs end with the phrase, limited liability company, or “LLC.” As the name suggests, an LLC provides members with liability protection from the debts and obligations of the business. In other words, a business creditor or someone who sues the business cannot go after the owner’s personal assets like a home, car, or bank account.

There are several important aspects to consider when forming an LLC, including:

• Separate legal entity
• More market credibility and financing options
• Liability protection in the case of certain lawsuits and commercial debts
• Annual state filings
• Tax advantages and disadvantages

Advantages and Disadvantages of an LLC

Pros 

• When you form your LLC, you create a business entity separate from yourself.
• An LLC equates to a higher level of market credibility.
• Liability protection against commercial debts, lawsuits, and other obligations.
• Easier to obtain equity and debt financing.
• Instead of personal loans, you are eligible for small business loans.
• You can take advantage of the tax benefits of being self-employed.

Cons

• State-related paperwork is required, as well as specific industry licensing.
• Annual state filing fees are required
• In addition to federal, state, local, FICA, and self-employment taxes (Medicare and Social Security), you may need to pay state business and unemployment taxes.

Deciding between LLCs and Sole Proprietorships

Many business owners, such as freelancers or consultants, begin with a sole proprietorship because it’s simple. Not only is minimal paperwork required, but the formation cost is quite low, which appeals to new business owners. In addition, sole proprietors do not need to file a separate business tax return, making taxes simple.

However, always bear in mind that sole proprietorships do not provide business owners with legal protection for personal assets. Consequently, business owners could end up bankrupt if they do not succeed or experience unexpected difficulties.

On the other hand, LLC owners are not personally liable for business debts, so they are protected in bankruptcy or a lawsuit. In addition, LLCs provide tax flexibility, as some business owners choose to elect corporate tax status for their LLCs to save money.

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FAQs

Can a sole proprietorship be an LLC?

No. An LLC can’t be a sole proprietor. People would often ask this question, assuming that more than one person has to operate an LLC. However, an individual can do business as an LLC. If you are a sole proprietor, you own and operate your own business, but it is not a corporation. An LLC is a business structure that is not a corporation or sole proprietorship.

Can a single-member LLC be taxed as a sole proprietorship?

Yes. By default, a single-member LLC is considered a “disregarded entity” for tax purposes, meaning the IRS treats it as a sole proprietorship. The business income and expenses are reported on the owner’s personal tax return using Schedule C. However, if desired, the owner can tax the LLC as an S corporation or a C corporation.  

What are the main differences between an LLC and a sole proprietorship?  

The biggest difference is liability protection. A sole proprietorship owner is responsible for business debts and legal issues. LLCs create a separate legal entity, offer limited liability protection, and have more taxation and ownership structure flexibility.  

Do I need to file separate paperwork to switch from a sole proprietorship to an LLC?  

Yes. To transition from a sole proprietorship to an LLC, you must file Articles of Organization (or a similar document) with your state’s business registration office. You may also need to obtain a new EIN (Employer Identification Number) from the IRS, update business licenses, and revise any contracts or bank accounts to reflect the new business structure.  

Does an LLC need a separate bank account?  

Yes, it is highly recommended. Even if you are a single-member LLC, keeping a separate bank account for your business helps maintain liability protection by demonstrating that the LLC is a distinct legal entity. It also simplifies accounting and tax reporting.