Sole Proprietorship Vs. LLC: How To Make The Right Choice?

Choosing the right business structure is an important decision when starting a new business. Many small business owners prefer the two famous business structures, the limited liability company (LLC) and the sole proprietorship, because of their flexibility and simplicity. Unless you are a lawyer or tax professional, it can be difficult to understand the difference between each type of entity in practice.

However, the type of business entity has real-world implications. For example, how much tax you pay, how much time you spend on paperwork, what if someone complains about your company.

This guide takes a closer look at LLCs vs sole proprietorships, explaining exactly how they differ in terms of incorporation, taxation, legal protections, and more.

Sole Proprietorships vs. LLC: Key Differences

Key points from both structures:

Below is a summary of the highlights for comparing the business structure of sole proprietorships and LLCs.

  • Sole proprietorships are generally cheaper to set up and easier to manage.
  • For sole proprietorships, the owner is taxed at the applicable personal income tax rate on the profits from the business.
  • LLCs provide legal protection for owners and personal liability protection for business obligations.
  • The LLC must complete corporate registration papers, register with the state, and pay an application fee.
  • LLCs must comply with state laws governing types of LLC entities. You may be required to pay an annual fee, submit annual reports and hold an annual general meeting.
  • LLCs must keep company records and funds separate from their owners.
  • LLCs have tax flexibility. You can choose to be a sole proprietorship (or partnership if you have multiple owners), a C corporation, or an S corporation.

As you can see, every business structure has potential strengths and weaknesses. The best option depends on your specific situation and goals.

Forming a Sole Proprietorship vs. LLC

Sole Proprietorship

Forming a sole proprietorship is as easy as finding a job. There is no need to register a business name to create a sole proprietorship. Regardless of the state in which a sole proprietorship operates, it is considered a sole proprietorship unless the owner files documents to register the business as another type of business entity (such as an LLC or corporation).

Please note that the requirements for the legal operation of your business may vary depending on the location of your business and the type of business you operate. You may need to obtain a license, permit, zoning or other approval from your local government. If you want, you can form a legal entity, register a temporary company name, and get an EIN (Employer Identification Number) to make tax season more bearable.

Limited Liability Company

To form an LLC, the state requires documents called “Articles of Organization” (sometimes called “Certificate of Organization” or “Certificate of Formation”). Paperwork is usually neither extensive nor expensive. Requirements and fees vary by state.

Information required to register an organization’s articles of organization includes the business name, description of purpose, perpetuity or expiration of the LLC on a specific date, principal place of business, registered agent, and administrative structure of the LLC.

See also :  What is a Direct Quote?

Before submitting your filing, you should choose a legal name for your LLC and review the proposed name. Choose a name that is unique to your business and consult with an attorney before using a name that has been trademarked by someone else. You must also select a registered agent. This is yourself in the case of a single-member LLC or one of your business partners in the case of a multi-member LLC.

Although not required in most states, it is beneficial for an LLC to have an LLC operating agreement and keep it on file at the LLC’s principal place of business. The operating agreement describes the roles, responsibilities, and authority of the LLC’s members and managers to make decisions on behalf of the LLC. Some states require you to get an EIN for tax reasons.

What About Personal Liability Protection?

Sole Proprietorship: A sole proprietorship and its owner are considered a single entity. There is no legal separation between them. Entrepreneurs are personally responsible for all debts and legal concerns of the company. So, if someone sues the business or if the business defaults on its bills or loans, the owner is liable. This means that the owner’s property and personal assets are at risk of being used for repayment or payment.

Limited Liability Company: An LLC is considered a legal entity separate from its owner. A member’s personal liability for business debts is limited to the amount invested in the LLC. This means that LLC members are protected from the LLC’s creditors in most cases, as well as from lawsuits that may be filed against the LLC. This is considered one of the main advantages of the LLC type of company.

Financing a Sole Proprietorship vs LLC

Regardless of the type of legal entity you choose, fundraising is a hot topic and can be a challenge. A veteran small business owner may suggest that you hold down a full-time job while you start your business. This personal income can be a steady flow of capital in starting and running a business. Either way, you should get a business bank account and credit card if possible.

Getting a startup loan for a new business can be difficult, but there are other financing options. Consider crowdfunding. You can reward donors for their contributions, make them shareholders, or simply rely on their goodwill. There are also many commercial lenders.

Can You Mix Business Funds and Personal Finances?

Sole proprietorship: There is no legal requirement to keep sole proprietorship personal and business assets separate. However, it makes it easier to keep accurate accounting records.

Limited Liability Company: LLC members’ personal funds and transactions must be kept separate from company funds. If this rule is violated, for example, by paying personal expenses with LLC funds, or vice versa, LLC members may lose personal liability protection. This is why it is so important for LLCs to have dedicated business and credit bank accounts.

See also :  What are Debt Covenants?

Business Growth Potential

Sole proprietorship: Sole proprietors cannot sell their shares to raise capital to facilitate business expansion. Additionally, foreign investors typically do not invest in companies that are not formally incorporated as legal entities (such as LLCs or corporations).

Limited Liability Company: An LLC is not allowed to sell shares to raise capital, but may add members who can invest funds in the company to support its plans.

Ongoing Business Compliance Requirements

Sole proprietorship: The government does not recognize sole proprietorships as separate legal entities, so there are no compliance requirements for companies. However, other current requirements may apply to the lawful operation of our business. For example, business licenses, license renewals, and DBAs may apply to legally run a business.

Limited Liability Company: LLC compliance requirements vary by state. These may include: submit an annual report to the state (this may be every two years or at various intervals), keep funds and business transactions fully owned by the owner, and if there are major changes in LLC existed Update with LLC. If necessary, filing amendments when there are major changes to the LLC that need to be updated in the LLC’s Articles of Organization.

LLC vs. Sole proprietorship: Taxes

Single member LLCs and sole proprietorships have similar tax treatment. Both are managed companies. In other words, the company itself is not subject to income tax. Owners report business income on Appendix C of their personal tax return, and the income is taxed at the owner’s personal income tax rate.

A multi-member LLC is also a pass-through entity where each owner reports and pays taxes on a share of the business’s income. The only difference is that a multi-member LLC must file a business tax return, Form 1065, Return of United States Partnership Income, with the IRS. In addition, each member must include a Schedule K-1 on their personal tax return to show their business share of the income.

In addition to income taxes, both LLCs and sole proprietorships may have additional tax obligations. Regardless of your business structure, if you have employees, you must pay payroll taxes. If you sell taxable goods or services, you must also collect state and local sales tax. Ultimately, as a self-employed individual, you are responsible for paying self-employment taxes to the IRS. These taxes cover Social Security and Medicare tax obligations.

Some state and local jurisdictions impose additional taxes on LLCs. Depending on the state, this may be called a franchise tax, an LLC tax, or a business tax. You also have to pay state and local income taxes.

Only LLCs can choose a corporate tax status

The main difference between an LLC and a sole proprietorship is tax flexibility. Only LLC owners can choose how their business is taxed. You can choose to adhere to the standard pass-through tax or tax your LLC as an S or C corporation.

See also :  What is an Earnings Announcement?

An S Corporation is a pass-through entity. When taxed as a C-Corporation, LLCs pay a 21% federal corporate tax (most states and some municipalities also impose corporate taxes).

LLCs may save money by choosing corporate tax status. If a company is taxed as a corporation, business dividends are usually taxed at a lower rate than ordinary business income. In addition, the retained earnings of the company are not subject to income tax.

In contrast, LLC members cannot treat their income as dividends and must pay taxes on all company profits, whether the company keeps them or not. Eligible for tax credits and deductions

If you have a sole proprietorship, when should you form an LLC?

The decision is ultimately yours. However, keep in mind that legal protection for your new business can be important to your well-being and the longevity of your business. Forming an LLC early on can help protect you personally from business liability. It can also make your business appear more stable to lenders and vendors, as well as customers and business partners. With that in mind, it can be an investment in your success.

Running a sole prop is as easy as getting to work and tracking your income and the breakup. You are the owner and the company, so all decisions are yours. This makes it easy for you to get started, but as your business grows, you take more risks.

LLC vs. sole proprietorship: Which should you choose?

Many business owners, especially freelancers and consultants, start out as a sole proprietorship because it’s easier. It is attractive to startups, especially those trying out business ideas, because it requires minimal initial documentation and costs nothing. Taxes are easy for us.

As your business grows, the rubber hits the streets. A sole proprietorship structure does not provide legal protection for your personal assets, so if your business does not perform as planned or you run into unforeseen problems, you may become personally bankrupt. On the other hand, LLC owners are not personally liable for their business debts, so they are more protected in the event of business bankruptcy or business litigation.

Additionally, LLCs offer tax flexibility. Most LLC owners adhere to the pass-through tax so that they are taxed as a sole proprietorship. However, if you can save more money, you can choose the LLC tax status. All 50 states allow LLC structures to encourage small business growth.

Which company structure is best depends on many factors. We recommend that you consult with a business attorney before making this important decision. However, the combination of liability protection and tax flexibility make LLCs often the best choice for small business owners.