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hen starting a business, you have many important decisions to make. One of the most important is what business structure to choose. Is it better to run your business as a sole proprietorship or form a limited liability company (LLC)? The answer may lie in how you prefer to manage your business and how urgently you need to separate your business and personal assets.
In this article, we will explain what a sole proprietorship and LLC are, the benefits and disadvantages of each, and how to decide which is suitable for you.
What is a sole proprietorship?
A sole proprietorship is an unincorporated business owned by one individual. This individual pays personal income tax on any earned profits. While it can be run under your name, you can also run it under another trade name as long as you file a DBA, which stands for “doing business as.”
According to the latest census data, sole proprietorships account for the majority of businesses. For freelance workers, gig workers, and home-run businesses, sole proprietorships are a common choice.
Sole proprietorships can have employees, although it’s not as common. You may consider restructuring your business when you’re ready to hire.
Pros of a sole proprietorship
- Complete control: When you’re a sole proprietor, you’re the only person in charge of the business. You can run your business as you see fit.
- Simple to set up: Of all the business structures, forming a sole proprietorship requires the least amount of paperwork. You don't have to obtain an employer identification number (EIN) – you can just use your Social Security number (SSN) – and you don’t have to file separate business tax returns.
- Fewer fees: Many business structures, including LLCs, require that you register your business and pay annual fees in the state where they are formed. That's not the case as a sole proprietor.
- Easier banking: Legally, you do not have to use a business checking account if you’re a sole proprietor, though separating your business and personal finances is always a good idea.
- Tax advantage: Sole proprietorships are only taxed once – you will report your income and expenses on your personal tax return and pay income tax and self-employment taxes on the profit.
Cons of a sole proprietorship
- No protection: In a sole proprietorship, there's no separation between personal and business assets, and you're responsible for all business debts. Creditors can legally go after personal assets to recover debt tied to your business or if your business is sued.
- One tax filing option: LLCs can be taxed as a sole proprietorship, partnership, or corporation to potentially save money. Sole proprietors do not have this option.
- Fewer financing options: Sole proprietors may struggle to receive financing as banks are less likely to lend to this type of business. The only financing option that may be available for sole proprietors is to take out a personal loan for their business.
What is an LLC?
A limited liability company, or LLC, is a legal business structure in the U.S. that protects its owners from personal responsibility for business debts and other liabilities.
LLCs can either have one owner, forming a single-member LLC, or multiple owners. These members can manage the LLC themselves or appoint one individual to run day-to-day business operations. Generally, members create an operating agreement that lays out how the business will be run.
You can file for an LLC through your state, typically through the Secretary of State or another state agency. Forming an LLC may include the following steps:
- Creating a business name
- Selecting a registered agent (or statutory agent)
- Obtaining a business or vendors license, if required by the state
- Filing articles of organization
- Creating an operating agreement
- Getting an EIN
Members of an LLC are required to file articles of organization with the state in which they will operate. Articles of organization include details like:
- Business name
- Business address
- Registered agent name
- Names and signatures of all members
- Purpose of the business
- Rights, powers, duties, liabilities, and other obligations between each member of the LLC and between the LLC and its members
Once you’re approved, the state will issue you a certificate confirming the formation of your LLC. The process may vary depending on the state where you file.
Pros of an LLC
- Added protection: Operating as an LLC limits your personal liability as a business owner. Creditors will have a harder time seizing your personal assets if you operate as an LLC.
- Flexibility: LLCs can have one member or multiple members. These members can manage the LLC if they want to have a say in decision-making or can appoint an individual to manage day-to-day business operations. Generally, members create an operating agreement that lays out how the business will run.
- Tax benefits: LLCs don’t have their own tax classification. Instead, owners can elect to be taxed as a sole proprietorship, corporation, or partnership, providing ultimate flexibility.
Cons of an LLC
- Fees: You must pay a fee when first registering an LLC. You are also on the hook for an annual or biannual fee to maintain your LLC status in your state. These annual or biannual fees can range widely. For example, Kentucky only charges $40, while Massachusetts charges $500.
- Complex tax returns: If your LLC is taxed as a corporation, you will have to file two tax returns, a personal return, and a business return. Also, some states, like California, charge an extra tax if you have an LLC. This tax generally costs between $100 and $800.
- More complex structure: When there are multiple members involved, you will need to specify the ownership stake, voting rights, and profit share for each member. This will be outlined in your operating agreement.
- Non-transferable ownership: In an LLC, unless all members agree, you can’t add new members. You may need to dissolve the LLC and create a new one if members leave or join.
Key differences between sole proprietorships and LLCs
The biggest difference between a sole proprietorship and an LLC is liability. LLCs offer much more legal protection to business owners than sole proprietorships. If your business cannot pay its debts or if it is sued for negligence, an LLC will provide more protection than a sole proprietorship.
Which is right for you?
Sole proprietorships tend to be the structure of choice for small, low-revenue, low-risk businesses. If you're just starting out, a sole proprietorship might make more sense since there's not much you need to do to set it up. Once your business becomes bigger or more complicated, or you find yourself exposed to new risks, you can switch to an LLC or other business entity.
Answer the following questions to decide the best course of action:
- Is it your own business, or do you share ownership with someone else? A sole proprietorship cannot have more than one owner or member.
- Do you have personal assets that you don't want to be mixed with your business assets? Your house, car, and other personal assets may be fair game if you carry business debt and don’t pay it back. Getting an LLC might be worth any registration or annual fees.
- Do you plan on growing your headcount? You can still hire employees as a sole proprietor, but as your business grows, switching to an LLC provides more liability coverage.
FAQs
Q: How do I form an LLC?
A: The steps to form an LLC include choosing and reserving a name for your business, registering for an EIN, and filing articles of organization with your state. A lawyer, accountant, or registered agent can help you with this process. Depending on your specific business, you may also have to apply for licenses and permits. You should also open a business bank account to separate your business expenses from your personal expenses. (Novo offers no-fee business checking accounts!)
Q: Can you convert a sole proprietorship to an LLC?
A: This process may vary from state to state. In most cases, you will follow the same steps you would if you were creating a new LLC. You may also need to revisit contracts you have entered as a sole proprietor and cancel your DBA if applicable.
Q: Is an LLC or a sole proprietorship better for taxes?
A: When you have an LLC, you have the flexibility to adapt the tax status of a sole proprietorship, corporation, or partnership. This flexibility can help you save on taxes. Sole proprietors do not have these options. Talk to a tax accountant about which strategy will help you the most.
Q: Do sole proprietors need an EIN?
A: Sole proprietors do not always need an EIN. Check to see if you meet the criteria.
Takeaways
In many cases, choosing between a sole proprietorship and an LLC is a personal choice. If you’re at any risk of being sued, then an LLC makes the most sense. But if you’re just starting out and want to minimize costs, structuring your business as a sole proprietorship can be fine for the moment.
If you’re having trouble figuring out which one to choose, you may want to get legal advice from a qualified source. If you're thinking of incorporating your business, Novo can help. Novo has partnered with LegalZoom to save you time and money when forming your business entity.
Novo Platform Inc. strives to provide accurate information but cannot guarantee that this content is correct, complete, or up-to-date. This page is for informational purposes only and is not financial or legal advice nor an endorsement of any third-party products or services. All products and services are presented without warranty. Novo Platform Inc. does not provide any financial or legal advice, and you should consult your own financial, legal, or tax advisors.
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