Congratulations! You’re starting your own business. That was likely your first big decision. The second one is figuring out how to structure your business. Two of the most popular forms are a sole proprietorship or a limited liability company (LLC).
Soft-serve or hard ice cream? Dish or cone? Neither is wrong — it just depends on what suits your taste. The same is true with sole proprietorships and LLCs.
We’ll get into more details, but a simple way to differentiate them is that an LLC may protect your personal assets, like your home and savings, while a sole proprietorship won’t. While it may seem that an LLC is the best choice, there are some other features of both to consider.
Sole proprietor — Starting as a sole proprietor can be as simple as just starting work. That’s one of the big advantages - you don’t have to register a sole proprietorship with the state. Depending on what you do and where you do it, you also may need licenses, permits, or other approvals and certifications, so check with your local and state governments.
If you hire independent contractors, each one should complete a Form W-9, and you’ll likely need to send them a Form 1099-NEC in January of the following year, showing their income. This is also true for LLCs.
Most sole proprietors use their name for their business (e.g., Ed Grasso Carpentry). However, if you have a great name for your business (e.g., You Nailed It Carpentry), you may be required to register for a “fictitious business name,” or DBA (doing business as) with your state. This has other advantages related to financing and branding that we’ll cover later in this article.
Another item to consider is getting an EIN (employer identification number) from the IRS, which will make tax reporting easier and is helpful if you have any employees.
LLC — Setting up an LLC is relatively easy, but it does require additional paperwork and costs. First, to register as an LLC, you’ll need to have that great business name and make sure someone else isn’t already using it. Another benefit of registering as an LLC is that it can help protect your business name in your state.
Next, you’ll need to create an operating agreement. This document specifies the company’s members and managers, along with their rights and responsibilities. Your business information, articles of organization, and other forms, will need to be filed with a state agency — usually the Secretary of State.
The good news is if you have a business plan you’ll be off to a good start as some of the information you need for it will be included there.
You’ll need to choose a registered agent for your LLC. That’s simply someone who can accept legal documents for the company. The registered agent must live in the state where the LLC is registered. It can be you or one of the other LLC members.
You’ll also need your checkbook. There are fees that go along with the state filing that can range from $50 to $500. Plus, an LLC must file annual or periodic reports that also come with their own separate fees.
This is often the key factor that influences a decision between a sole proprietorship and an LLC.
Sole proprietor — Legally, you are the business and the business is you. You’re fully entitled to all of the profits, but you’re also fully responsible for any and all obligations, debts or claims against your business. That means personal assets such as your home, cars, and bank accounts could be at risk.
LLC — As the name indicates, an LLC offers you limited liability. In general, only your business assets can be touched in debt collection or legal claims. In most states, and under most circumstances, your personal assets are protected.
With either a sole proprietorship or an LLC, you can't always predict what will happen. The best way to protect yourself and your business is with the right business insurance.
Say you're the carpenter mentioned above and you’re building a new back deck for a customer. Even though you asked them to stay off the structure until you were finished, they misunderstood your request and wandered onto the deck. While descending the stairs, which were not finished, a plank collapsed and they fell and broke a bone.
If you don’t have insurance, you could be paying out of pocket for your customer's hospital bills and any legal fees associated with the accident. That could be a substantial amount of money that many businesses couldn’t afford to lose.
Get an affordable & customized policy in just minutes. So you can get back to what matters: Your business.Start Here >
There are more similarities here than differences, which is good news. Business profit or net income for sole proprietors and LLC members is considered “pass-through income” by the IRS. It’s taxed on your individual tax return at your individual tax rate.
In both instances, if you expect to owe at least $1,000 in taxes, you may need to pay quarterly Estimated Tax payments to the IRS. If you have employees, you’ll need the EIN mentioned above, and you’ll need to withhold and pay payroll (FICA) taxes.
One thing to note for an LLC is if you’re the only LLC member, you’ll be taxed like a sole proprietor. If there are other LLC members, it might be a bit more complicated to determine each person’s share of the taxes.
On the plus side, an LLC offers additional tax options. Depending on elections made by your LLC and the number of members it has, your LLC can be treated as either a C Corporation or an S Corporation. This could help reduce your self-employment tax burden.
Even though profits in both a sole proprietorship and an LLC pass through to your personal tax return, it is a good practice to not mix business and personal accounts and assets. When filing taxes as an LLC, you complete several forms with your personal tax return, including Schedule SE: “Self-Employment Tax”; Schedule 2: “Additional Taxes”; and a Schedule C: “Profit or Loss From Business.”
From a legal point of view, an individual and a sole proprietor are one and the same, so it’s not technically mixing, but many business experts recommend against it.
Not mixing funds is even more critical in an LLC. Members need to keep personal funds and transactions separate from the company’s. You’ll need to keep accurate accounting records for your LLC or you will run the risk of losing the limited liability protection that the LLC offers. Along with good accounting practices, having dedicated LLC bank and credit accounts is also important.
As with many considerations related to taxes and finance, the right choice often depends on specific aspects of your business, including state and local tax requirements. It’s a good idea to consult an accountant, tax, or financial professional.
Getting your business off the ground and getting it to thrive often requires money. That can come from you, friends and family, outside investors, or from small business loans. When it comes to fueling your business, the options differ between a sole proprietorship and an LLC.
Sole proprietor — As with most aspects of a sole proprietorship, financing falls on the owner's shoulders. A sole proprietorship can’t raise money by selling stock, and investors generally shy away from a business that isn't registered as a legal business entity, such as a corporation or an LLC.
The same can be true with some banks and other commercial lenders. They may categorize your loan as “personal” rather than “business,” which could mean lower limits on the amount you can borrow.
One thing to consider is registering a DBA for your business. A DBA enables you to open bank and credit card accounts, as well as apply for small business loans, under your assumed name.
LLC — An LLC is a more formal business structure than a sole proprietorship, so it can give you more credibility with lenders. You’re still restricted from selling stock to raise capital, but you can add additional members who can invest their money and assets into the company. Just remember, you’ll be sharing part of your profits in return.
As we mentioned at the beginning, how you structure your business is a big decision, and there are a lot of factors to consider. It may be a good idea to discuss your business plans with a lawyer, accountant, or financial advisor who can help you with these big decisions. We’re also publishing a series of blog posts on sole proprietorships and LLCs that go into more detail about costs, insurance, what to look out for, and more.
To help you get started, here are some signs to get you moving in the right direction when deciding between starting an LLC vs. a sole proprietorship.
Maybe you have a hobby like photography or a side hustle such as blogging. Having a passion for what you do is a great asset in starting your own business, but even the most dedicated business owners face challenges to get their dream off the ground.
Factors like timing, location, competition, and how much you can afford to invest all play a role in how successful you’ll be. A sole proprietorship is a quick, low-risk, and relatively inexpensive way to see if your business can fly.
This may sound a bit strange; nobody wants to go into business to make a small amount of money.
Because the profits from a sole proprietorship are taxed at your personal tax rate, and you have to pay the full FICA taxes (Medicare and Social Security), taxes can become a burden as your business becomes more profitable.
Much like low profits, this isn’t your ultimate goal. However, many sole proprietorships start out by selling to friends and family and getting referrals from there. It’s a good way to see how well you can scale your business while minimizing financial risk.
Think about what could go wrong. For example, a tree service runs the risk of bodily harm or property damage if an accident occurs. On the other hand, a music teacher typically has low risk of those scenarios.
Also consider financial risk. Will you need to purchase inventory or a lot of equipment or tools, like the tree service? If that results in having creditors, remember that they can make claims against your business and personal assets.
All business owners know there’s a risk in starting a business, but some come with more risk than others. If the thought of putting your home, car, and savings on the line has you walking the floor at night, an LLC might help you sleep.
As we’ve mentioned, typically only your business assets are subject to claims and legal judgments against your business. For even more restful sleep, take a look at how the right business insurance can eliminate a lot of that nighttime (and daytime) worry.
If you expect to pull in a lot of profit in a relatively short time, an LLC may offer more tax flexibility than a sole proprietorship.
For example, you may be able to elect to treat your LLC as an S corporation to lower your FICA tax. Talking with a tax professional who understands your particular business can provide more insight on this.
Going after larger customers often involves contracts and meeting specific vendor requirements. In many instances, you may need to be an LLC to be considered.
An LLC is often seen as being a more reliable, responsible business partner than a sole proprietor. You look more like a bigger fish in a bigger pond. There’s also a more practical reason. An LLC is seen as a business entity.
That can be important for your customers. It shows the IRS and other government agencies that you’re not an employee of that corporation. That's often important for larger customers who need to clearly differentiate employees from contractors to ensure their records accurately reflect paying the correct payroll taxes and other benefits.
If you’ve been running your own show for a while and your business is booming, so “well done.”
Now, the advantages of a sole proprietorship that got you off and running may need to be replaced by those of an LLC. This is perfectly natural, generally painless, and often the right thing to do.
In addition, being recognized as an LLC shows a healthy evolution of your business that strengthens your brand and credibility with customers, creditors, and the community.
If you’ve read all the way to here, you hopefully know more about sole proprietorships and LLCs than you did before. However, you still may not know which one is best for you. Full disclosure: that’s intentional.
The best choice when deciding on an LLC vs. a sole proprietorship depends on which one is best for your type of business and for where your business is in its development and growth. In general, the limited liability offered by an LLC is hard to argue against.
At the same time, it may make more sense for certain types of businesses to be run as sole proprietorships, especially if the added costs and paperwork of an LLC outweigh the advantages.
While federal law is consistent regarding LLCs across the country, each state has its own laws that may or may not be as advantageous to your particular LLC business. States also vary in their view of the difference between single-member LLCs and sole proprietors. Understanding how your state looks at LLCs and sole proprietorships can also play a role in your decision, so you may want to talk to an expert on the matter, such as an accountant or lawyer. You may also want to contact your state’s division of corporations or secretary of state’s office.
The other thing to bear in mind is that the choice you make now doesn’t have to be the choice you’ll work under forever. Like a healthy individual, your business will grow, and its needs will change as well — meaning both a sole proprietorship and an LLC can be the right choice.
As a 9-year-old at summer camp, I hated it — especially after being pulled screaming from the pool during the swimming competition. While this left me without an aquatic achievement patch, it also inspired the letter to my parents that got me an early release from Camp Willard. That showed me the power of writing. I’ve done my best to use it only for good ever since, such as writing for small business owners.
This content is for general, informational purposes only and is not intended to provide legal, tax, accounting, or financial advice. Please obtain expert advice from industry specific professionals who may better understand your business’s needs. Read our full disclaimer
28 November 2018 • 6-minute read
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