LLC vs Sole Proprietorship | Which One Should You Choose?
If you’re planning to start a business, you have to determine which type of management structure is best suited to your company's needs.
An LLC and sole proprietorship are two options you can consider when launching a small business.
As a Mergers and Acquisitions specialist who assisted several individuals with business formation, I became familiar with the benefits and limitations of an LLC and sole proprietorship.
In this article, I’ll share my insights based on the filing procedure, ownership and management, liability, and taxation to help you make an informed decision.
Quick Summary
- An LLC is a business structure owned by several individuals referred to as members, while a sole proprietorship is owned and managed by only one person.
- Members of an LLC benefit from personal liability protection, while a sole proprietor is liable for business debts and obligations.
- As of 2020, there are over 28 million sole proprietorships and 21 million LLCs in the United States.
- In my experience, a sole proprietorship is the best way to establish a new business before expanding into an LLC or a corporation.
At a Glance: LLC and Sole Proprietorship
An LLC is a type of business entity that offers personal liability protection to its owners, benefits from pass-through taxation, and features a flexible management and operational structure. With an LLC, there is a clear distinction between the company’s finances and the members’ personal assets.
A sole proprietorship is a type of business structure owned by one person which is the simplest and least expensive entity to form [1].
However, sole proprietorships do not offer members protection from personal liability for legal obligations or debts, since there is no distinction between the individual member and the business itself.
Considering the dynamic nature of the business landscape, it's noteworthy that between March 2021 and March 2022, 1.4 million US establishments were launched, reflecting the growing trend of entrepreneurship and the increasing need to choose the right business structure.
"The best time to support small businesses is always today."
– Gisele Barreto Fetterman, Activist, Philanthropist, and Non-profit Executive
Key Differences
An LLC and a sole proprietorship are business structures that vary in certain aspects, such as the following:
1. Filing Procedure
An LLC needs to file Articles of Organization, appoint a registered agent, draft an operating agreement, apply for licenses and permits, and obtain an EIN.
I always advise clients to apply for an EIN directly on the IRS website, since it’s free of charge.
A sole proprietorship requires individuals to register a business name, obtain business permits, and acquire an EIN. By default, the owner’s name automatically becomes the business title.
2. Ownership and Management
Limited Liability Companies are owned by individuals referred to as members. The members have the option to manage the company collectively or appoint a professional service to handle operations [2].
A sole proprietorship has only one owner and the entity can be more flexible in management structure.
Manager-managed LLCs have managers that make company decisions separate from the membership.
A sole proprietorship has only one owner (or a married couple) who owns all or most of the business or the owner's personal assets.
That means that sole proprietors don't have the personal liability protection that LLCs have. Any personal assets can be used if you owe money on business debts or get sued.
3. Liability
Members are not personally liable for any debts or obligations incurred by the business since their finances are legally separate from the company’s funds.
Although this is the case, I strictly advise clients to open a separate business bank account to clearly put a distinction between company funds and personal assets and to avoid piercing the corporate veil.
Sole proprietors don't have the personal liability protection that LLCs have since their personal assets are not separate from company finances.
Read More: How to Change From Sole Proprietorship to LLC
4. Taxation
LLCs and sole proprietorship are not taxed at the corporate level and benefit from pass-through taxation. The business entity is not subject to corporate taxes, but are levied on their individual tax returns.
What are the Advantages and Disadvantages of an LLC
Here are the advantages and disadvantages of starting an LLC:
1. Advantages
- Personal Liability Protection: The assets of an LLC is separate from the finances of its owners. This affords the members’ personal liability protection since any debts, lawsuits or other obligations are confined to the company.
- Pass-through taxation: An LLC benefits from pass-through taxation which means that the company is not obligated to pay taxes on a corporate level. Members’ pay taxes on their individual returns.
- Flexible management and organization: An LLC may be member-managed or manager-managed. The members have the option to operate the company or appoint a professional individual or service to run the LLC. For clients new in the industry, I recommend hiring an experienced manager for at least a year.
- Less compliance requirements: LLCs have less compliance requirements compared to other forms of businesses. Most states require limited liability companies to submit annual reports and pay franchise taxes.
2. Disadvantages Of An LLC
- Transfer of ownership: If a member of an LLC decides to leave, retire, or passes away, the transfer of ownership for that member has to be approved by all company owners.
- Limitation of existence: An LLC may operate on limited tenure based on the purpose of the company.
What are the Advantages and Disadvantages of a Sole Proprietorship
The following are the benefits and limitations of a sole proprietorship:
1. Advantages of Sole Proprietorships
- Fewer formation requirements: Registering a sole proprietorship entails fewer formation requirements. Individuals only need to apply for an EIN, licenses and permits to operate their business legally.
- Pass-through taxation: Sole proprietors do not pay taxes on the corporate level; instead, owners are taxed on their individual returns.
- Simple management: Since a sole proprietorship has only one owner – management, decision-making, and operations are simplified. Most of my business associates started as sole proprietors before transitioning into an LLC.
2. Disadvantages of Sole Proprietorships
- No liability protection: A single owner of a sole proprietor company does not benefit from the separation of his business entity and his personal assets.
FAQs
Is a Single-Member LLC the Same as a Sole Proprietorship?
No, a single-member LLC is not the same as a sole proprietorship. A single-member LLC benefits from personal liability protection while a sole proprietorship does not.
Can a Sole Proprietorship Be Converted Into an LLC Later On?
Yes, a sole proprietorship can be converted into an LLC later on by filing formation documents with the Secretary of State or its equivalent agency.
References:
- https://www.irs.gov/businesses/small-businesses-self-employed/sole-proprietorships
- https://www.irs.gov/businesses/small-businesses-self-employed/limited-liability-company-llc
