Starting a company is an exciting time, especially when it comes to choosing a business entity. It means you're officially a business!
But how do you choose which business entity is best for you? For many business owners, the choice between LLC and sole proprietorship isn't always self-explanatory.
In this article, we'll review what an LLC is, what a sole proprietorship is, the main differences between the two, and how to protect yourself and your business, whichever you choose.
If you're a business owner in any profession, it's likely that you're familiar with LLCs, because you've seen those three letters tacked at the back of company names.
But what is a limited liability company (LLC), actually?
An LLC is a Limited Liability Company, which is a business entity formed at the state level.
As a business owner, when you form and own an LLC, you become a "member" of the company.
If something were to happen that could put your business at risk, the liability would not fall to you as a member, but to the company as a whole. This means that your personal belongings, like your house, car, or other assets, likely wouldn't be in jeopardy. Hence the "limited liability" aspect of the name.
So let’s say that John Doe owns a company named Doe's Carpentry, LLC. If one of John's customers sues because of the work he did, they will be suing Doe's Carpentry, LLC, and not John Doe directly.
Later on, we'll discuss more about how being an LLC usually affects the way risks and liabilities are processed.
Now that we've covered your question, "What is an LLC?", let's talk about sole proprietorships.
When considering a sole proprietorship, the word you should focus on is "sole," because as a sole proprietor, it means that you and you alone are the business owner and representative of the company.
A sole proprietorship doesn't need to be officially formed like an LLC does, which we'll expand on later. Business owners who choose to be a sole proprietor accept the merging of their personal and business finances — a decision which has both advantages and disadvantages.
In this example, if John Doe's customer sued Doe's Carpentry, they'd be suing John Doe himself, so he could be at risk to lose assets like his car or house.
When starting your small business, the process you take to form an LLC is different than if you wanted to be a sole proprietor.
When starting an LLC, a business owner will need to name a "registered agent." A registered agent is a person close to the business owner, such as a spouse, lawyer, or friend, who agrees to accept legal communications or other official documents in the business owner’s absence.
Once a small business owner names a registered agent, they need to prepare an "operating agreement." An operating agreement details how the business will operate, who will have the power to make decisions (if the business has co-founders or employees), how profits will be allocated, and more.
Keep in mind that not all states require an operating agreement to be filed. If you're a small business owner starting an LLC, check with your Secretary of State's office to make sure that you're following the state's specific laws around filing your operating agreement.
Once an operating agreement is drafted, the small business owner typically must file "Articles of Organization" with the state, which is a collection of documents, such as the registered agent’s information, a business plan, and more.
There is a filing fee to register your small business as an LLC. The fee amount differs, depending on which state you're in, and can usually range from $45 to $500.
In addition to the filing fee, business owners need to pay a separate fee, which is typically charged every one to two years. Again, these prices depend on the state and can change, depending on the business’s revenues.
Once you've completed the above, you will receive a certificate from the state, you can register for a tax ID with the IRS, and then you're all set to do business. Moving forward, to maintain your LLC, you typically must keep your personal assets and accounts separate from your small business.
Forming a sole proprietorship looks a little different.
While many small business owners who are sole proprietors choose to register a business name, you can operate your business under your own name. For example, let's look at the example of the business owner we discussed earlier.
If John Doe wanted to start a business, he could register his business name "Doe's Carpentry" as a DBA, or "doing-business-as" name. So when he registers the "Doe's Carpentry" name, it will be registered under a fictitious name.
If he were to invoice a customer, the small business signature would read: John Doe, DBA. Doe's Carpentry.
Unlike LLCs, a sole proprietorship can mix their business and personal assets.
While it’s a smart idea for a sole proprietorship to also have a business plan, there aren't any documents to file like there are with LLCs. However, there are separate required tax forms, which we'll cover in #3 below.
Another difference between LLCs and sole proprietorships is how a small business owner is held liable in the case of an accident.
You may be thinking that if a business owner is starting out, they don't face many risks. But unfortunately, that isn't always the case.
A survey found 43% of small business owners reported being threatened with or involved in a civil lawsuit. LLCs and sole proprietorships are also subject to risk. How they handle the aftermath of a situation looks differently.
When a small business owner of an LLC is sued, the business's accounts and assets are put at risk. In the case of John Doe and Doe's Carpentry, LLC, this means that a lawsuit could impact Doe's Carpentry LLC's financial standing, but not John Doe's personal assets. Being an LLC means that all liability rests on the company’s shoulders.
When a sole proprietorship is sued, however, both personal and business assets are put at risk because they're one-and-the-same. It is the sole proprietor's responsibility to take on liabilities. This could have devastating consequences for a business owner; they could potentially lose their home, car, or other valuable property.
This is why having small business insurance is a viable consideration for small business owners. There are two common types of small business insurance both LLCs and sole proprietorships may want to consider: general liability insurance and professional liability insurance.
General liability insurance is coverage that can protect your business from risks such as:
Professional liability insurance is coverage that can protect your business from risks like:
Let's look at how these types of coverage could help LLC versus sole proprietorship business owners.
John Doe's business, Doe's Carpentry, LLC, builds a new deck for a customer who is pleased with the work. Weeks after the project is completed, though, the customer sues the business after their child steps on a nail, allegedly left by Doe's Carpentry.
The customer is suing for the cost of the injured child’s ER medical bills.. Without LLC insurance coverage, Doe's Carpentry, LLC, could be responsible for paying those fees from the business's account.
With LLC insurance, Doe's Carpentry could be covered with a general liability insurance policy for the cost of the medical bills, as well as legal fees for their defense, up to their policy limit.
Jane Doe has a business for her marketing consultancy, with the DBA, Doe the Right Thing; she is a sole proprietor. Jane consults a client on their marketing plan and is later sued when the client claims that Jane led them to believe they'd make more money by following her advice.
In this case, without sole proprietorship insurance, Jane Doe would personally be responsible for paying for legal defense, as well as paying for the required fees. Jane's business account and personal accounts are tied together, so she'd have to pay out-of-pocket for the claims, which could impact her personal credit and savings.
With sole proprietorship insurance, Jane Doe could use her professional liability insurance policy to help cover her legal fees and required fees she needs to pay, up to her policy limit.
In both of these cases, without LLC insurance or sole proprietorship insurance, John Doe and Jane Doe could suffer financial losses.
Fortunately, the process of getting small business insurance for your LLC or sole proprietorship is easy with Simply Business.
We've made it easy for you to compare quotes for free here. You'll be able to choose a policy that's best for your business and its bank account.
When tax season comes around, the difference between having an LLC versus a sole proprietorship is a big motivator for small business owners.
Tax season isn't fun for anyone, but as a business owner starting your company, taking into account how you'll be taxed is important.
As the business owner of a sole proprietorship, you'll file your business taxes, along with your personal taxes. When tax season rolls around, you'll typically file a Profit or Loss From Business (Sole Proprietorship), which is Schedule C (Form 1040).
As a sole proprietorship, taxes are paid based on the profit from your business, rather than the entire income of your business. Depending on how well your business does financially in a given year, you will usually owe fewer taxes.
As a sole proprietor, you may be eligible for certain tax deductions. We suggest consulting a tax expert or accountant to learn more about which deductions you can take.
For LLC business owners, there are several options, because the Internal Revenue Service (IRS) doesn't have a special tax classification. You can choose to be taxed as a :
Keep in mind that if your LLC has more than one member, you cannot file as a sole proprietorship.
If you choose your LLC as a "disregarded entity," your business income will be treated as your personal income, and you'll be taxed the same as a sole proprietorship.
If you choose a different LLC status, such as a C corporation, then your income will be taxed differently.
Beyond how income is taxed, many business owners take advantage of tax deductions. LLC business owners may be able to deduct 20% of their net income, for example, referred to as a Qualified Business Income deduction.
Additionally, LLCs can choose to deduct the purchase of equipment or goods they'll use within a one-year period. Depending on your profession, these capital expenditure deductions can benefit your business.
To learn more about which tax deductions may benefit you, consult a lawyer or tax expert on your specific filing requirements.
When comparing an LLC vs. sole proprietorship, it's easy to think of tax deductions and liabilities. What many business owners may not consider, though, is how the decision of a business entity impacts their ability to secure financing and build business credit.
Just as an individual you build personal credit, your business also has a credit score.
As a sole proprietor, your business credit score and personal credit score will be harder to differentiate, since your accounts are considered the same. As an LLC business owner, however, you may find it easier to build business credit.
Having good business credit is an important consideration, as your score could contribute to your likelihood of getting financial assistance. For example, if you apply for a loan as a sole proprietor, a financial institution is likely to categorize your request as a personal loan rather than a business loan.
As an LLC, though, it will likely be an easier process to apply for financial assistance if you need it.
There are many differences between an LLC vs. a sole proprietorship. We covered the difference in how liabilities are usually handled by each entity type, but despite the difference, the two have one thing in common: protection with business insurance could benefit both of them.
Whether you're a sole proprietor or an LLC with several members, you'll want to know how much business insurance costs, and we understand that! It's a smart business decision to account for as many expenses as you can up front.
Unlike the cost to file for an LLC in each state, getting LLC insurance or sole proprietor insurance can't be determined with an exact amount, since business insurance depends on a variety of factors, including:
Compare quotes for free using our quote comparison tool here.
Every business owner faces decisions that can impact their business down the road, and choosing your business entity is an important step toward success.
When weighing your options between choosing an LLC vs. sole proprietorship, there are several factors to consider, including how risk will impact your business and personal assets.
One thing that both entities have in common is the protection they could gain from having business insurance.
If you're curious about other ways you can protect and grow your business, head to Simply U, our blog for business owners.
I’ve told stories since I learned to talk and written since I could hold a pen. As a small business owner myself - I'm a freelance writer and yoga teacher - I love contributing to the entrepreneurship community in different ways (including writing for Simply Business!). When I’m not drafting articles for SB, I can be found on my yoga mat, perusing an indie bookstore, and writing (with my cat nearby of course).
Allison writes on a number of topics such as small business leadership, business structures, and employee training.
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
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