Sole proprietorship vs. LLC: What you need to know

Insureon Staff.
A sole proprietorship is a business that’s owned and operated by one person, while a limited liability company (LLC) can be formed by an individual or a group of entrepreneurs. Each has their own unique benefits as an effective business structure.
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How you classify your business entity is a decision that could affect your exposure to risk and how you pay taxes. The differences can be subtle, but it’s important to consider the benefits and risks of classifying your business as a sole proprietorship versus a limited liability company (LLC) before you start your business.

What is a sole proprietorship?

A sole proprietorship is a business that’s owned and operated by one person. It’s the easiest type of business to form because it’s unincorporated, meaning you don’t have to file any paperwork with your state government.

You might need a business license from your local government, and of course, you would need any professional licenses that are required by your industry.

As a sole proprietor, you could run your business using your personal bank account, although business experts recommend keeping a separate set of books for your business and personal life.

Either way, your business income and your own personal income would be one in the same under the law on a “pass-through” basis. You wouldn’t have to file a separate tax return for your business, and you would likely report your business income on a Schedule C form with your personal tax return.

You would also have to do business under your own legal name. If you want your business name to be something different than your legal name, you would have to register it as a “doing business as” (DBA) with your state or local government when you apply for a business license.

What are the risks of forming a sole proprietorship?

Because you and your business are the same entity in the eyes of the law, it can be harder to obtain business loans and establish credit for your business.

Sole proprietors have unlimited liability, meaning any debts incurred by your business would be your personal responsibility. You also wouldn’t have the kind of protection from personal liability and business debts that a limited liability company (LLC) provides.

What is an LLC?

A limited liability company is a legal entity formed by an individual or group of entrepreneurs that’s created by filing paperwork with your state government (usually the secretary of state’s office). The business becomes a separate entity under the law, which offers financial and legal protections to the owner.

The LLC can be owned by one or more people who run the business themselves or hire a manager. The LLC’s business structure and membership are spelled out in legal documents called an LLC operating agreement, or articles of organization, that clearly defines each person’s role within the business.

Your LLC must also name a registered agent who can accept tax and legal documents for the business. This could be the LLC owner or a separate business or person, such as a law firm or attorney.

While creating and running an LLC is more complicated than a sole proprietorship, many small business owners form an LLC because it protects their personal assets in the event of a lawsuit. If your business lost an expensive lawsuit, the assets of the LLC would be at risk, but your personal assets would be protected.

What are the risks of forming an LLC?

The biggest downside to forming an LLC is the complexity and the paperwork. You must keep separate records and accounts for your business and personal life, even if you’re the only owner of the LLC.

You must also file a separate tax return for the LLC, and will likely have to file an annual report with your state when you renew your business license.

Depending on how your LLC is structured and the laws in your state, you may have to hold meetings among the LLC’s owners and keep records of them.

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What's the difference between a sole proprietor and an LLC?

The IRS defines a sole proprietor as a person who owns an unincorporated business. Any person who has their own business but isn’t registered as a corporation, partnership, or a limited liability company is considered a sole proprietor, by default.

A sole proprietor is personally liable for any debt accrued by the business, including lawsuits and other business obligations. Sole proprietorships tend to be low-risk businesses and startups whose owners prefer the simplicity of a sole proprietorship, and who don’t need the kind of personal liability protection that an incorporation as an LLC would provide.

So, while sole proprietors would benefit from receiving all of the business profits themselves, they also face all of its liabilities on their own without the legal protections of an LLC.

If a sole proprietor owes money from a debt or lawsuit and the business assets aren’t enough to cover it, creditors could go after the owner’s personal assets. If the business was an LLC, the owner’s assets would be protected from any claims made against the business.

Sole proprietors can make business decisions on their own, whereas decisions made by an LLC must be made by its members, in accordance with its operating agreement. Running an LLC can be especially complicated if the owners have different stakes or ownership amounts.

Key differences between a sole proprietorship and an LLC

The primary differences between a sole proprietorship and LLC can come down to a few distinct factors in business operations:

Filing for your business classification

Filing for an LLC usually has a filing fee, which can vary from $50 to $500, depending on your state. The process only takes a few weeks in most cases, but filing and processing with the state will take some time. There’s no cost to becoming a sole proprietor. You need to manage your own tax withholding and insurance, but there’s no payment or government filing required to start a business.

Credit and loans

If your business has overhead that you need to pay for with a line of credit or a loan, an LLC will be more credible and less risky to a lender than a sole proprietorship. The LLC can sometimes offer an ownership interest in the business as collateral, in exchange for financing. A sole proprietor cannot offer ownership of the business to another person or entity because it would no longer be a sole proprietorship.

Ownership

By definition, a sole proprietorship is owned by one person. If you have LLC status, you’re able to include additional owners that are people, corporations, other LLCs, partnerships, trusts, or estates.

Ongoing business status

A sole proprietorship will typically cease to exist if the owner decides to sell the business, or if they pass away before doing so. An LLC can continue with an operating agreement to protect the assets of the business.

Paying income taxes

For tax purposes, a single-member LLC and a sole proprietorship both pay their taxes as pass-through entities, with the owner reporting their business income on a Schedule C form with their tax return.

The proprietor can deduct allowable business expenses from this form. These tax benefits would be deducted from the owner’s net income, which is taxed at the owner’s personal income tax rate.

An LLC with one owner would be taxed the same as a sole proprietorship. If an LLC has more than one owner, the LLC must file a business tax return with the IRS and will likely have to file one with their state tax authority.

Each owner will have to report their own share of business income from the LLC by attaching a Schedule K-1 form to their personal income tax returns.

LLCs also have the option of paying income taxes on a pass-through basis to the owners, or as an S-corporation or C-Corporation. S corps also pay their federal taxes on a pass-through basis, while C corps pay a federal corporate income tax, and possibly at the state and local level as well.

Regardless of how your business is structured, you’ll have to pay:

  • Payroll taxes for any employees
  • State and local sales taxes
  • Your own self-employment taxes to cover your Social Security and Medicare taxes
  • Any additional state or local taxes, such as a business tax

Hiring employees as a sole proprietor or LLC

Whether you’re a sole proprietor or LLC, your workers’ compensation requirements will likely be the same if you hire an employee. Most states require any business with employees to carry workers’ compensation, and some states have specific requirements for whether coverage is required for the sole owner.

If you decide to hire employees, it’s especially beneficial to file as an LLC for liability purposes. Workers’ compensation coverage would provide protection in the event that an employee suffers a workplace injury. However, it wouldn’t provide protection for any other kind of liability from an employee’s negligence or accidental damage of property.

General liability insurance for your small business

Whether you’re a sole proprietor or the owner of an LLC, general liability insurance is crucial. General liability insurance covers company assets and is often required to sign contracts. If you are a sole proprietor, liability policies can also help shield your personal assets if you are held liable for an injury or property damage.

General liability insurance can cover the legal fees associated with a lawsuit and provide general protection for property damage and injury of non-employees, product liability, and even advertising injury protection in the event of a lawsuit for slander, libel, or accidental copyright infringement.

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