LLC vs. Sole Proprietor: What’s the difference?

Choosing the correct form of business organization for your new company is one of the most important decisions you will make.

Your choice affects how your company looks to the public, and it has a substantial effect on the amount of paperwork and expense you will face as a business owner.

It can also affect how much control you have over your business assets and personal liability if something goes wrong.

LLC vs. Sole Proprietorship: How to Choose?

When you’re ready to choose a business structure, make sure you consider these options:

  • Sole Proprietorship
  • Partnership
  • Limited Liability Company (LLC)
  • Corporation

We will review the difference between two of them; LLC and Sole Proprietorship are.

What is a sole proprietorship?

A sole proprietorship is a business owned and run by one person, who usually reports the company’s income on their personal tax return. The Internal Revenue Service (IRS) does not recognize a distinction between the owner and the business when taxing sole proprietorships.

Advantages of a Sole Proprietorship

  • The owner of a sole proprietorship is taxed only once when they take the profits out of business.
  • The owner may pay themself lower wages than they might otherwise draw if they formed another type of business entity. This keeps the size of the owner’s income tax bill down. A sole proprietor can also reduce Social Security and Medicare taxes by drawing a minimal salary, no salary, or taking distributions instead.

Disadvantages of Sole Proprietorship

  • The sole proprietor has unlimited liability for any debts or judgments against his business. He is personally responsible for all business debts and violations of law committed to his company, regardless of whether he was directly involved in them. If a business can’t pay its bills, creditors might go after its personal assets, such as the owner’s house or car.
  • Your business is exposed to lawsuits. Small business owners are usually only protected from personal liability for accidents and injuries related to their company if they have insurance that specifically covers their business operations. If you don’t have this type of coverage, you could end up paying damages out of your own pocket.
  • The sole proprietor has no way to limit their exposure if they die or become disabled financially. For example, if a sole proprietor borrows money on the business’ credit card and then develops Alzheimer’s disease, his heirs would be responsible for repaying all of those debts before selling the business.

What is an LLC?

An LLC is a business that has been formally recognized by state law. With an LLC, the company’s owners are called members instead of stockholders or partners. Only US states recognize LLCs; they do not have a federal charter. LLC also has its own advantages and disadvantages.

Advantages of an LLC

  • An LLC offers protection from personal liability for business debts and legal judgments against the company.
  • The owners of an LLC aren’t responsible for its liabilities if they don’t invest in its operations.
  • You can choose how you want your LLC to be taxed: as a corporation, partnership, or sole proprietorship.

Disadvantages of an LLC

  • In some states, forming an LLC takes more work than forming a limited or liability partnership. Be sure to check with your state’s secretary of state or another government office and an attorney if you want help setting up an LLC.
  • An LLC may have to pay taxes on money it makes and the profits passed along to its members.
  • It is more costly than a sole proprietorship because some filing fees and ongoing reports must be filed with the state.

Sole proprietorship vs. LLC: Formation

You can form an LLC by filing articles of organization with the Secretary of State, usually through a lawyer. This establishes the business’ legal existence.

To form a sole proprietorship, you don’t need to file any official paperwork; it’s created automatically when someone starts doing business under their own name.

However, if this is your first time starting a company and you want personal liability protection for its debts and judgments against the business, you will need to form it as a corporation or limited liability company (LLC).

LLC vs. sole proprietorship: Operations and management

A sole proprietorship is not a separate legal entity; it has only one owner, and the owner is responsible for all business decisions.

A limited liability company (LLC) or limited partnership (LP) must file an annual report with the state. Still, your accountant usually handles this as part of doing taxes for you as a business owner.

Annual fee

To register a sole proprietorship, you don’t have to pay any fees. The only cost is purchasing the products or materials your business needs to operate.

To create an LLC, certain filing fees and ongoing reports must be filed with the state.

Regular APR

A sole proprietor reports the income and expenses on Schedule C attached to the 1040 tax return. This way, paying both federal income taxes and self-employment tax. All net profit from the business becomes part of her personal income.

LLCs are taxed as either a corporation or partnership, depending on how many members it has. Members who actively participate in the business must pay reasonable salaries for their work; this is reported on Form W-2 just like any other job.

LLC vs. Sole proprietorship: Taxes

Sole proprietorship tax advantages:

  1. Profits from the business are taxed as personal income. If you make $35,000 a year as a sole proprietor and your business earns another $5,000 in revenue, you will report this income on your tax return as supplemental income. It’s best to have it automatically deposited into your bank account so that you don’t forget about it.
  2. You can claim deductions for all of the expenses that your business incurs. This includes things like gas and mileage if you use your own car to conduct sales calls, cell phone service, office supplies, product samples, and marketing costs

LLC tax advantages:

An LLC is not currently treated as a pass-through entity by the IRS

  1. Members of an LLC are taxed as either a corporation or partnership. If the LLC has no members (one owner), it is called a “single-member” LLC and will be taxed like a sole proprietorship.
  2. An LLC with multiple members can choose to be taxed as either a corporation or partnership. If this choice is made, the LLC provides each member with form K-1 which reports their share of business profit or loss for that year.

Corporate tax status

Only LLCs can choose corporate tax status, but the IRS has not yet granted LLCs pass-through treatment. The other elections that can affect your tax status include:

  • An LLC with multiple members can choose to be taxed as either a corporation or partnership. If this choice is made, the LLC provides each member with form K-1 which reports their share of business profit or loss for that year.
  • LLCs are currently not subject to self-employment taxes, so all net income from the business is distributed to members who report it on their personal income tax returns just like any other source of personal income.

Generally speaking, leasing equipment such as machinery and power tools often includes special features such as warranties and maintenance agreements that would be more expensive if purchased outright. These leases also offer tax-deductible benefits such as reduced overhead and depreciation expenses.

Leasing is also simpler than buying business equipment, which means that you will spend less time learning about new technology and filing tax forms at the end of the month.

LLC vs. sole proprietorship: Legal protection

All sole proprietorships are automatically considered separate legal business structures under state law. This means that you can protect your personal assets in the event of a lawsuit.

Sole proprietorships are not required to incorporate or file any other business forms with the state, saving you both time and money upfront.

On the other hand, LLCs must be filed officially with the Secretary of State’s office where it is formed. This gives them many of the same protections as a corporation.

LLC vs. sole proprietorship: Paperwork and compliance

LLCs must file Articles of Organization with their state’s business office. There are also rules about how LLCs need to manage the paperwork for compliance, which can get complicated if you are not familiar with them.

Sole proprietorships require no official filings or compliance beyond your annual tax return, so there are no complicated rules to learn or forms to file.

LLC vs. sole proprietorship: Relationship with employees

The one drawback is that it is responsible for all debts and obligations that stem from the business. The IRS generally does not consider an LLC separate from its owners, which means that losses or lawsuits can affect your personal assets.

Sole proprietorships are legally the same as their owner, so any lawsuits filed against the LLC can also claim damages from the individual who owns it.

When Should a Sole Proprietor Become an LLC?

If you have a high turnover business, require separate insurance policies, or involve substantial equipment, hire employees, or take out a loan. An LLC will offer you the greatest protection from lawsuits and other unexpected financial issues.

All sole proprietorships are automatically considered separate legal entities under state law. This means that your personal assets can be protected in the event of a lawsuit.

LLCs should probably not become LLCs if:

  • There is only one owner (sole proprietorship)
  • The business will involve little to no debt (sole proprietorship)
  • The profit margin for the business is less than 20% after all costs (payment on credit card debt doesn’t count as cost)
  • There is minimal risk of employee turnover or lawsuits (sole proprietorship)
  • The business is relatively uncomplicated (LLC requires more paperwork and compliance than a sole proprietorship)
  • The business involves little to no equipment or inventory (LLCs are liable for all business debts, so they need assets to back them up).

Business Licenses and Permits

Sole proprietorships do not need to apply for business licenses. Unless specifically structured under another type of entity, LLCs usually need to get a separate tax identification number and file paperwork with the Secretary of State’s office.

LLCs are typically required to have separate EINs. Sole Proprietorships are typically not required to get an EIN if you don’t take out any credit cards or loans in your business name. If you do, then you should contact your accountant to see what applies to your situation.

Both LLCs and sole proprietorships must get all necessary permits and licenses depending on their industry.

Choose a registered agent.

Choosing a registered agent is important for an LLC. Sole proprietorships don’t need to designate a registered agent since that role doesn’t exist.

A registered agent is a person who receives legal documents on behalf of the business.

LLCs are required to have what is called a “registered agent” – who will be available during normal business hours (most likely you, if you run your company alone).

Do I Need an Employer Identification Number (EIN)?

Sole proprietorship owners can use their Social Security numbers combined with “doing business as” for a pseudonym if they wish. Single-member LLCs should get an EIN, which allows them to pay taxes and file employment taxes.

An Employer Identification Number (EIN) isn’t required for sole proprietorships. If you plan to hire employees, then you will need an EIN.

How Do I Write a Business Plan?

LLCs do not require business plans, but they are recommended. A sole proprietorship does not have any business plan requirement.

Benefits of a business plan:

  • A business plan is beneficial because it forces you to think through every aspect of your company – from marketing to management.
  • It’s also a great way to communicate your goals with potential investors and creditors.
  • More than likely, if you go the SBA route or apply for a bank loan, they will want some indication that you’ve done this planning work before asking them for money.
  • As such, many bootstrapped entrepreneurs start as sole proprietors until their businesses are more established.
  • A business plan is also required if you want to apply for a loan or other financing, as well as if you’re trying to get into an accelerator.
  • You can even use your business plan as part of your pitch deck when looking for investors.

LLCs need business plans as well as good operating agreements and good corporate governance practices. Sole proprietorships do not need any such documents.

Does Your Business Name Need to Be Registered?

Your business name must be registered with the state to avoid legal issues or complications when you try to do business under a specific name.

Whichever entity you choose, your business will typically need a tax ID number and a separate bank account in its name. If you have employees, you’ll also need workers’ comp insurance.

Sole proprietorship owners can use their own names with “doing business as” for a pseudonym if they wish. LLCs cannot.

How to Activate Each Structure for Your Business?

Sole proprietorship: there is nothing to do to activate this form of entity. You need no additional filings, and you can start operating as soon as you incorporate your business.

LLCs: need articles of organization filed with the state’s business office – typically the same agency that handles corporate filing. The process usually takes around 4-6 weeks.

Is a Single-Member LLC the Same as a Sole Proprietorship?

Yes, it is. A single-member LLC is treated as a sole proprietorship. It is not a separate tax entity, so all business income and expenses must be reported on Schedule C.

Do I Need an Operating Agreement?

An operating agreement creates internal rules for the business and how it will be run. It covers items like distributions of profits, what happens if someone wants to sell their share or if any member dies.

LLCs need operating agreements to establish “governance”–a set of rules that govern how the company does business. Operating agreements are not legally required in every state, but they are recommended.

Sole proprietorships don’t need an operating agreement because there isn’t anyone else involved who could agree to them (so there’s nothing to govern). You can include these provisions in your business plan if you want to cover issues like profit allocation or ownership transfer.

Do I Need to File an Annual Report?

LLCs are required to file annual reports in the state they are registered. What about a sole proprietorship? Sole proprietorships have no such requirement.

An LLC needs to file an annual report in each state it is registered in. They all follow the same format, but some need additional information like stock info or official statements.

A sole proprietorship does not have to file annual reports with any agency.

Filing fees for the LLC tend to be higher than filing fees for a sole proprietorship. If you want to save on this expense at the end of your fiscal year, when you’re doing your taxes for that year, you can close down your LLC and reopen it at the beginning of your next fiscal year.

Conclusion

An LLC is a good choice if you have high turnover, require separate insurance policies or involve substantial equipment, hiring employees, or taking out a loan. Sole proprietorships are better for one-owner businesses with little to no risk of turnover or lawsuits.

If your small business does not meet these criteria, it is probably wise to consult an experienced accountant before deciding on incorporation.

Leave a Reply

Your email address will not be published. Required fields are marked *