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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 more suitable for you.
What is an LLC?
A limited liability company is a type of business entity that is authorized by state law and protects owners from personal responsibility for business debts and other liabilities. This makes it an appealing choice for small business owners.
Generally, an LLC is formed by filing a document with the state agency regulating business entities — usually the Secretary of State where the business will operate. The form, frequently called the articles of organization or certificate of formation, provides basic information about the LLC.
In most states, there are seven steps to forming an LLC:
- Choosing a name and registering it
- Picking a registered agent
- Filing articles of organization
- Preparing an operating agreement
- Getting an EIN and bank account
- Obtaining a business license and/or permit
- Getting tax advice and filing any required forms
Novo has partnered with LegalZoom to make business formation easy and affordable. With a range of packages based on your business’ needs, LegalZoom has packages based on your business’ needs starting at $0 plus state filing fees. [Add link to co-branded llc lander]
Once you’re approved, the state will issue you a certificate confirming the formation of your LLC. The process and timeline may vary depending on the state where you file.
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.”
A sole proprietorship is the simplest type of company to launch, and according to the Internal Revenue Service, sole proprietorships are the most popular business entities.
You are in complete control, without any partners, officers, or shareholders to answer to. There are no government fees or forms to fill out, no annual reports required, and no necessary public disclosures. Your taxes will simply be a Schedule C (Profit or Loss from a Business).
Sole proprietorships can have employees, although it’s not as common. You may consider restructuring your business when you’re ready to hire.
Key differences between sole proprietorships and LLCs
A limited liability company is a legal entity formed at the state level. An LLC exists separately from its owners—known as members. However, members are not personally responsible for business debts and liabilities. Instead, the LLC is responsible.
A sole proprietorship is an unincorporated business owned and run by one person. This option is the simplest, no muss, no fuss structure out there. You are entitled to all the profits of the business. However, unlike an LLC, you are also responsible for all of the liability.
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.
- 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.
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 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.
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. Plus, ownership is non-transferable.
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:
- 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.
- Is it your own business, or do you share ownership with someone else? A sole proprietorship cannot have more than one owner or member.
Novo has partnered with LegalZoom to make business formation easy and affordable. With a range of packages based on your business’ needs, LegalZoom has packages based on your business’ needs starting at $0 plus state filing fees. [Add link to co-branded llc lander]
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 professional 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
Starting a business can be an intimidating process, but it doesn't have to be. If you take it step-by-step, you'll soon have your dream business up and running. If you need additional help, there are plenty of educational resources that can help you along the way.
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.
Why choose LegalZoom?
LegalZoom can help you start an LLC quickly and easily. Get started by answering a few simple questions. They will assemble your documents and file them directly with the Secretary of State.
Novo has partnered with LegalZoom to make business formation easy and affordable. With a range of packages based on your business’ needs, LegalZoom has packages based on your business’ needs starting at $0 plus state filing fees. [Add link to co-branded llc lander]
They’ve got you covered in all 50 states. Have peace of mind knowing LegalZoom's documents have been legally recognized in every state—and you'll never need to leave home to work with a lawyer.
Flat-rate fees. No hourly charges. No surprises. Really.
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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