Sole Proprietorship vs. LLC

Are you considering starting a business as a solo owner, or will you co-own the business with your spouse? Then, you may be wondering if operating as a sole proprietorship or a limited liability company (LLC) will be the better choice. Keep in mind that there are legal, financial, and tax-related implications when choosing a business structure. Therefore, I encourage you to get guidance from an attorney and a tax or accounting professional as you decide.

When an individual (or married couple) starts a business, it is, by default, considered a sole proprietorship. Operating as a sole proprietorship requires no business formation paperwork with the state. In a sole proprietorship, the owner and the business are considered the same legal and tax-paying entity.

The limited liability company (LLC) is a business entity type formed under state laws. It is a state construct requiring formal registration. The single-member LLC is the entity most comparable to a sole proprietorship. It has one owner, which is known as a “member”. LLCs with more than one owner are multi-member LLCs. Multi-member LLCs may choose to be managed by their members or by a manager (or managers) designated by the LLC’s members. An LLC is considered a separate legal entity from its owner. By default, an LLC and its owners are considered the same tax-paying entity.

Highlights of the Two Business Structures

Here’s an at-a-glance run-down of some highlights to compare a sole proprietorship vs. LLC business structure:

• Sole proprietorships are generally less expensive to establish and easier to maintain administratively.
• In a sole proprietorship, owners are taxed at the applicable individual income tax rates on profits that the business makes.
• LLCs shield their owners legally, providing a level of personal liability protection against the debts of the business.
• LLCs must complete formation documents, register with the state, and pay a filing fee.
• LLCs must follow their state’s laws that govern the LLC entity type. They may need to pay annual fees, file annual reports, and hold annual meetings.
• LLCs must keep their company records and funds separated from those of their owners.
• LLCs have tax flexibility—they may choose to be taxed as a sole proprietorship (or partnership if multiple owners), C Corporation, or S Corporation.

As you can see, there are potential pros and cons to each business structure. Which will be the best option for you will depend on your specific circumstances and objectives.

A Side-by-Side Comparison

Below, I’ve created a table that goes into more detail about what I highlighted above. It explains some of the differences between sole proprietorships and LLCs. With this side-by-side comparison, I hope you’ll be better able to ask your legal and accounting resources the right questions to draw out the insight you need. The more you know, the better you will be able to make an informed decision.

Starting the Business

Sole Proprietorship – No business registration paperwork is necessary to establish a sole proprietorship. No matter in which state a single-owner business operates, it will be considered a sole proprietorship unless the owner files paperwork to register the company as some other business entity type (e.g., LLC or corporation). Note that other requirements may apply to legally operate the business depending on where the business is located and what type of business activities it will conduct.

Limited Liability Company – To form an LLC, states require filing documentation called “Articles of Organization” (sometimes called “Certificate of Organization” or “Certificate of Formation”). The paperwork typically isn’t extensive or expensive. Requirements and costs vary by state. Information required to file for Articles of Organization might include the name of the business, statement of purpose, whether the LLC will be perpetual or end at a specific time, principal place of business, registered agent, and management structure of the LLC. Although most states do not require one, it’s helpful for an LLC to create an LLC Operating Agreement and keep it at the LLC’s principal place of business. An Operating Agreement details LLC members’ and managers’ roles, responsibilities, and authority to make decisions on behalf of the LLC.

Registering the Business Name

Sole Proprietorship – In a sole proprietorship, the business owner IS the business. If the business will operate under a name other than the owner’s legal name, the owner must file a “Doing Business As” (DBA, also known as “fictitious name registration”). For example, if John Wilcox operates his business as “John Wilcox Plumbing and Heating,” he will not need to do a fictitious name (DBA) filing. If, however, he wants to call his business, “West End Plumbing and Heating,” he will need to submit the fictitious name to the state for approval. Some states also require advertisements or notices be run in a local or legal newspaper to disclose to the public who is operating the business under the DBA.

Limited Liability Company – When registering an LLC, the business name is automatically registered when formation documents are filed. In some states, it’s possible to reserve a name in advance of formally registering the business. Business name reservations expire after a certain amount of time if not renewed or if business registration isn’t completed. Most states require an LLC to include the designation of “LLC,” “Limited Liability Co.,” “Limited Liability Co.” or some other identifier after its name.

Personal Liability

Sole Proprietorship – A sole proprietorship and its owner are considered the same entity. No legal separation exists between them. The business owner assumes personal responsibility for all debts and legal concerns of the business. Therefore, if someone sues the business or the business cannot pay its bills or loans, the owner will be held liable. That means the owner’s personal assets and property will be at risk of being used as restitution or payment.

Limited Liability Company – An LLC is considered a separate legal entity from its owner. A member’s personal liability for debts of the business is limited to the amount of their investment in the LLC. This means, in most cases, LLC members are protected from the creditors of the LLC and also from any lawsuits which may arise against the LLC. This is considered one of the main advantages of the LLC entity type over operating as a sole proprietorship.

Default Income Tax Treatment

Sole Proprietorship – The business is not recognized as its own tax-paying entity; its income and losses get passed through to the owner’s personal tax return via IRS Schedule C (Profit or Loss from Business form). Tax rates for individuals are applied to a sole proprietor’s taxable business income. Business income is also subject to self-employment taxes (Social Security and Medicare). Because sole proprietors’ income tax, Social Security, and Medicare aren’t deducted from a paycheck from an employer, business owners usually must make quarterly estimated tax payments to the U.S. Treasury, the state, and sometimes the local tax authority.

Limited Liability Company – The business, unless the owner makes a special tax election, is considered a disregarded entity. It is not recognized as its own tax-paying entity. Business tax obligations flow through to the LLC owner.

Alternative Options for Income Tax Treatment

Sole Proprietorship – None

Limited Liability Company – If it meets all eligibility requirements, an LLC can opt for corporate tax treatment as either a C Corporation or S Corporation. This might help LLC owners reduce their self-employment tax burden, as Social Security and Medicare only get applied to the only the owner’s wages or salary rather than all taxable business income. With C Corp tax treatment, the business files its own income tax returns, and business profits are taxed at the corporate tax rate. For some LLCs, this may prove a disadvantage because some profits get taxed twice–once at the corporate level and again at the individual level–when distributions are paid to the LLC owner. With S Corp tax treatment, income tax obligations pass through to the owner’s personal tax returns (accompanied by IRS Form 1120-S).

Registered Agent Requirements

Sole Proprietorship – None

Limited Liability Company – An LLC must designate a registered agent in the state(s) where it is registered to operate. A registered agent is a person or company with the authority to accept service of process (legal documents and government notices) on behalf of a business. In order to have the authority to perform registered agent services, the party offering those services must have a physical address in the state where the LLC is formed. It can be beneficial for an LLC to seek out a registered agent that is authorized in all 50 states. That way, if the LLC decides to expand into other areas of the U.S., it can use the same registered agent no matter which state it’s registering in.

Separation of Business and Personal Finances

Sole Proprietorship – There is no legal requirement to keep a sole proprietor’s personal and business funds separated. However, doing so will make it easier to keep accurate business accounting records.

Limited Liability Company – LLC members’ personal funds and transactions must be kept separate from those of the company. Violating this rule, for example, by paying personal expenses with LLC funds or vice versa, can result in LLC members losing their personal limited liability protection. That’s why it’s so important for LLCs to have dedicated business bank and credit accounts.

Business Growth Potential

Sole Proprietorship – Sole proprietorships may not sell stock to raise capital for fueling business expansion. Also, outside investors typically will not fund businesses that haven’t formally registered as a statutory business entity (e.g., LLC or corporation).

Limited Liability Company – LLCs may not sell stock to raise capital, however, they can add additional members that can invest their funds in the company to support its initiatives.

Ongoing Business Compliance Requirements

Sole Proprietorship – Because the state doesn’t recognize a sole proprietorship as a legal entity in and of itself, no corporate compliance requirements exist. However, other ongoing requirements, such as renewing business licenses, permits, and DBAs, may apply to legally operate the business.

Limited Liability Company – LLC compliance requirements vary by state. They may include: filing an initial report (sometimes called a “Statement of Information”) with the state; filing an annual report with the state (sometimes these are every other year or on some other interval), keeping business funds and transactions completely separate from the owner’s, filing Articles of Amendment if there are any major changes to the LLC that must be updated in the LLC’s Articles of Organization.

Business Requirements That Apply to Both Entity Types

Some obligations are universally required for both sole proprietorships and LLCs.

Several examples include:

• Pay income taxes (federal, state, local income tax; sales tax (if applicable); payroll taxes — if the business hires employees).
• Obtain an EIN from the IRS (Usually required for opening a business bank account and always necessary if hiring employees, this federal tax ID number is used when filing taxes and submitting other business documentation to the federal government). Fortunately, EINs are free of charge.
• Comply with the local area’s zoning requirements.
• Request W-9s from independent contractors and send them 1099 forms at tax time. I recommend reading up on the importance of classifying workers as independent contractors or employees correctly.
• Obtain and renew applicable business licenses and permits.

These come with the territory of owning a business and should never be ignored. As I mentioned earlier, entrepreneurs must get professional legal and accounting insight to make sure they cover all the bases.

Additional Resources for Small Business Owners

I have said it before in this article, but I would be remiss not to emphasize it one last time: When you’re deciding on which legal structure to choose and figure out what steps you must take to successfully (and legally) launch your business, consider seeking the guidance of an attorney and an accountant (or tax advisor). Look for professionals with business expertise and experience working with business owners so that you have a  team of trusted consultants. They can help you weigh the pros and cons specific to your situation and entrepreneurial preferences.

Other resources that I believe you’ll find helpful as you explore your options include:

• Starting a Business Checklist
• Types of LLCs
• Free LLC Guide
• Free DBA Guide
• CorpNet’s Compliance Portal
• CorpNet Business Structure Wizard

Prepare to Launch

Remember that as you’re ready to move forward, CorpNet is here to handle all of your business formation and compliance filings—in all 50 states! If you’ve decided to move forward with operating as a sole proprietorship and need to file a DBA and apply for the business licenses and permits, we can help. Or, if you want to register your company as an LLC and need to obtain your EIN and designate a registered agent, we can assist you with those tasks and more.

Our filing experts will take the pressure off of you and save you time and money. They will make sure all of your documentation is submitted accurately, on-time, and cost-effectively.