Choosing a business entity structure for your company is one of the most important—but potentially most confusing—decisions you’ll make as a small business owner. Unless you’re a lawyer or tax expert, the differences between each type of business entity can be hard to understand in real-life terms. However, your choice of business entity does have real-world impact, such as how much you pay in taxes, how much time you have to spend on paperwork, and what happens if someone sues your company.
New business owners are often confused about the difference between a limited liability company (LLC) and sole proprietorship. In this guide, we’ll look closely at LLCs vs. sole proprietorships, and explain exactly how they differ in terms of formation, taxes, legal protection, and more.
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.
You can typically identify a business as a sole proprietorship by the fact that the owner’s name is the business’s name, though sole proprietorships can also operate under a brand name or trade name. 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.
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.
You can identify a business as an LLC because its legal name will end with the phrase “limited liability company” or the abbreviation “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. We’ll dig into what this means in more detail in a bit.
LLC vs. sole proprietorship: Formation
You might be surprised to learn that there’s nothing specific you necessarily need to do to form a sole proprietorship. In fact, you might be operating a sole proprietorship without even knowing it. Any person selling goods and services without a partner is a sole proprietor by default. Depending on where your business is located, you might need to apply for business licenses or zoning permits to legally operate your sole proprietorship. And any business, including a sole proprietorship, that operates under a trade name, needs to apply for a fictitious business name, also known as a DBA or “doing business as” certificate. However, that’s it as far as formation paperwork goes, making sole proprietorships the easiest and least expensive type of business to start.
An LLC might also need to file for business permits and a DBA (if operating under a trade name). But the most important formation document for an LLC is called the articles of organization. This document establishes your LLC’s existence and must be filed with the state in which you’re operating. The cost to file articles of organization varies by state, but generally ranges between $50 to $200.
LLC vs. sole proprietorship: Operations and management
A sole proprietorship has a simple operational and management structure because there’s just one person at the top. That owner can make any business decisions as they see fit, without input from any third party. Of course, most sole proprietors decide to hire employees, legal experts, accounting experts, and other individuals to help with the day-to-day management of the business. But a sole proprietor only has to ensure their business is operating safely and legally and that there’s enough profit to cover business debts.
An LLC’s operational and management structure is more complex and is typically outlined in an LLC operating agreement. Though only a handful of states 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.
LLC vs. Sole proprietorship: 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. The owner reports business income on a Schedule C that’s attached to 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. In addition, each member must attach a Schedule K-1 to their personal tax return, which shows their share of the business’s income.
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. Only LLC owners can choose how they want their business to be taxed. They can either stick with the default—pass-through taxation—or elect for the LLC to be taxed as an S-corporation or C-corporation. An S-corporation is a pass-through entity. If taxed as a C-corporation, the LLC will pay a flat 21% corporate income tax at the federal level (most states and some localities also levy corporate taxes).
LLCs can sometimes save money by electing corporate tax status. When a company is taxed as a corporation, dividends from the business are usually taxed at a lower rate than ordinary business income. Plus, retained earnings in a corporation aren’t subject to income tax. In contrast, LLC members can’t treat income as dividends and must pay taxes on all profits of the business, whether retained in the company or not. A corporation is also eligible for more tax deductions and credits.
LLC vs. sole proprietorship: Legal protection
In a sole proprietorship, there’s 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.
One of the best ways to protect your personal assets is to form an LLC. 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 out of their own pockets. And with some exceptions, someone who sues an LLC can’t personally sue the owners. 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.
LLC vs. sole proprietorship: Paperwork and compliance
The final difference between an LLC vs. sole proprietorship has to do with paperwork and compliance requirements. As we mentioned earlier, a sole proprietorship requires the least amount of paperwork prior to launch. After launch, a sole proprietor only needs to keep up with federal, state, and local taxes. In addition, a sole proprietor might need to renew business permits.
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.
LLC vs. sole proprietorship: Which should you choose?
Many business owners, particularly freelancers or consultants, start out as sole proprietors because it’s easy. Minimal paperwork is required at the outset, and there’s no big outlay of cost, which is attractive for new entrepreneurs, particularly those testing a business idea. Taxes are also simple for sole proprietors, since a separate business tax return need not be filed.
The rubber hits the road as your business starts growing. A sole proprietorship structure offers no legal protection for your personal assets, so you could end up personally bankrupt if your business doesn’t succeed as planned, or faces an unexpected challenge. LLC owners, on the other hand, aren’t personally liable for business debts, so you get more protection in the event of a business bankruptcy or business lawsuit.
On top of this, LLCs offer tax flexibility. Most LLC owners stick with pass-through taxation, which is how sole proprietors are taxed. However, you can elect corporate tax status for your LLC if doing so will save you more money. All 50 states recognize the LLC structure to encourage small business growth. 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. However, due to the combination of liability protection and tax flexibility, an LLC is often a great fit for a small business owner.
This article originally appeared on JustBusiness, a subsidiary of NerdWallet.