LLC vs. Sole Proprietorship: How to Choose

Choosing a business entity structure for your company is one of the most important decisions you’ll make as a small-business owner. And deciding between a limited liability company (LLC) or a sole proprietorship can have consequences, especially when it comes to paying taxes, filing for bankruptcy or responding to business lawsuits.

We’ll look closely at LLCs vs. sole proprietorships, and explain exactly how they differ in terms of formation, operation, management, taxes, legal protection and more.

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What is a sole proprietorship?

A sole proprietorship is an unincorporated business with one owner, and it’s the simplest and least expensive type of business to form. An individual who operates a business on their own is by default a sole proprietor. For example, if you operate as a retailer, freelance, run an online business or otherwise sell goods and services, you’re automatically a sole proprietor unless you’ve adopted another business structure.

The main characteristic of a sole proprietorship is that there’s no legal separation between the business and business owner, so the owner is personally responsible for the business’s debts. A sole proprietorship often uses the owner’s name as the business name, though sole proprietorships can also operate under a brand name or trade name.

What is an LLC?

An LLC is a legally separate business entity that’s created under state law. An LLC combines elements of a sole proprietorship, partnership and corporation, and offers a lot of flexibility for owners. The owners of an LLC can decide their management structure, operational processes and tax treatment. One person can form a single-member LLC, or multiple people can form a multi-member LLC.

The defining feature of an LLC is that it offers members liability protection from the debts and obligations of the business. In the normal course of business, a business creditor or someone who sues the business can’t come after the personal assets of the owners. You can identify a business as an LLC because its legal name will end with the phrase “limited liability company” or the abbreviation “LLC.”

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Key features of an LLC vs. sole proprietorship

LLC vs. sole proprietorship

Formation

Because no specific paperwork is needed to form a sole proprietorship, it can be the easiest and least expensive type of business to start. Many consultants, freelancers and independent contractors default to this business type. However, depending on where your business is located, you may need to apply for business licenses and permits to legally operate your sole proprietorship. And any business, including a sole proprietorship, that wants to operate under a trade name, needs to register their fictitious business name, also known as a DBA or “doing business as” name.

In contrast, an LLC is established through the filing of articles of organization with the state in which the business operates. The cost to file articles of organization varies by state, but generally ranges between $50 to $500. Like a sole proprietorship, an LLC may also need to file for a business license, permits and a DBA (if operating under a trade name).

Operations and management

A sole proprietorship has a simple operational and management structure because one person is in charge. Sole proprietors can make business decisions as they see fit, although they often hire legal experts, accounting experts and other individuals to help with the day-to-day management of the business.

An LLC’s operational and management structure is more complex and is typically outlined in an LLC operating agreement. Though only a few states (New York, California, Missouri, Maine and Delaware) require an operating agreement, most LLCs have one, particularly those with multiple members. The operating agreement outlines each member’s ownership stake in the business, voting rights, and profit share. An LLC can be collectively managed by the members or managed by an appointed manager.

Usually LLC members decide on company matters in proportion to their ownership stake — called membership units — in the business. For example, a 33% owner would have a one-third vote on company matters, and a 25% owner would have a one-quarter vote. Profits generally are divided in line with ownership percentages. In the previous example, the 33% owner would receive one-third of the business profits, and the 25% owner would be entitled to one-quarter of the business profits.

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Taxes

A single-member LLC and a sole proprietorship resemble each other in terms of tax treatment. Both are pass-through entities, which means that the business itself doesn’t pay income taxes. Instead business income is passed down to the owner. The owner reports business income on a Schedule C that’s filed with their personal tax return, and the income gets taxed at the owner’s personal income tax rate.

Multi-member LLCs are also pass-through entities, with each owner reporting and paying taxes on their share of the business’s income. The only difference is that a multi-member LLC must file a business tax return with the IRS, Form 1065, U.S. Return of Partnership Income and include Schedule K-1. In addition, copies of the Schedule K-1 must be provided to each member showing their share of income, credits and deductions to be used when filing their personal tax return.

In addition to income taxes, both LLCs and sole proprietorships might have additional tax responsibilities. No matter which business structure you adopt, you’ll need to pay payroll taxes if you have employees. You’ll also need to collect state and local sales taxes if you sell taxable goods or services. And finally, as a self-employed business owner, you’re responsible for paying self-employment taxes to the IRS. These taxes cover your Social Security and Medicare tax obligations.

A few states and local jurisdictions levy additional taxes on LLCs. Depending on the state, this might be called a franchise tax, LLC tax or business tax. You’ll also have to pay state and local income taxes and payroll taxes.

Only LLCs can choose corporate tax status

A key difference between LLCs vs. sole proprietorships is tax flexibility where owners can choose how they want their businesses to be taxed. They can either stick with the default—pass-through taxation—or elect for the LLC to be taxed as a corporation.

An S-corporation is still a pass-through entity, but the owners are treated as employees and as such aren’t responsible for self-employment taxes. If taxed as a C-corporation, the LLC will pay a corporate income tax at the federal level (most states and some localities also levy corporate taxes) which could result in some tax savings for the business entity. However, consulting a tax expert is the best way to learn if either structure is a good option for your business structure.

Legal protection

A sole proprietorship offers no legal separation between the business and the owner. The owner is personally responsible for the business’s debts. If the business goes bankrupt, the sole proprietor has to file for personal bankruptcy, and both personal and business debts will be included in the bankruptcy proceedings. In addition, someone who sues a sole proprietorship can name the owner personally in the lawsuit and come after their personal assets.

On the other hand, an LLC structure offers more protection in the event of a business bankruptcy or lawsuit. Since an LLC is a legally separate entity from the owner, the owner isn’t personally liable for the business’s obligations. If the business fails, the owners can file for business bankruptcy, and they don’t have to pay business creditors from their own assets. And with some exceptions, someone who sues an LLC can’t personally sue the owners. Although, it’s still recommended you have LLC insurance.

Of course, owners in an LLC can be held personally liable for fraud, negligence or personally guaranteed debts. There’s no business structure that offers absolute protection for owners for liabilities connected to the business.

Paperwork and compliance

The final difference between an LLC vs. sole proprietorship has to do with paperwork and compliance requirements. A sole proprietorship typically requires the least amount of paperwork. After possibly registering a trade name, a sole proprietor may only need to maintain necessary business permits and licenses and keep up with federal, state and local taxes .

An LLC has more compliance responsibilities. After filing initial articles of organization, LLCs have to file an annual report in many states. An LLC with multiple members has even more responsibilities, such as drafting an operating agreement, issuing membership units, recording transfers of ownership and holding member meetings. None of these steps are legally required, but are highly recommended for LLCs to preserve liability protection for members. In addition, since an LLC is a registered business entity, dissolving an LLC takes additional paperwork.

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Should you choose an LLC or a sole proprietorship?

Many business owners, particularly freelancers and consultants, start out as sole proprietors because of the minimal paperwork and cost. A sole proprietorship may also be attractive for new entrepreneurs, particularly those testing a business idea.

An LLC structure can be a good fit for many small-business owners, especially if they want tax flexibility or a legal separation between their business and personal assets. However, there’s typically a state filing fee to establish your LLC as well as an annual fee to keep it in good standing.

The best business structure for you will depend on many factors, and it’s best to consult a business lawyer before making this important decision.