Sole Proprietorship vs. LLC – Which Should You Choose?

  • by Brandon Boushy
  • 5 months ago
  • Blog
  • 0
Woman working on LLC

When a business owner wants to choose a business structure they will normally consider the battle of a sole proprietorship vs. a limited liability company (LLC). Like two MMA fighters squaring off in the octagon, a sole proprietorship, and a limited liability company, both have their place in the business world.

UpFlip is here to help you understand the similarities and differences of a sole proprietorship in comparison to an LLC. We’ll explain what business owners should consider when choosing one business structure over another, what LLCs are best at, what sole proprietorships do best, and what they have in common.

We’ll also explore the process of converting a sole proprietorship to an LLC if you need to change the business structure. Get ready for the battle of sole proprietorship vs. LLC!

What should a business owner consider before choosing an LLC over a sole proprietorship?

There are a variety of considerations when a business owner is choosing between a limited liability company and a sole proprietorship. Some of the most important considerations include:

  • The legal protection of personal assets
  • Formation of LLC or registering the business as a sole proprietorship
  • Treatment of business income

LLC vs. Sole Proprietorship: Legal Protection of Personal Assets

The legal protection for personal assets is the number one reason that most people suggest forming an LLC over a sole proprietorship. When run properly, a single-member LLC will protect both a small business owner and their business in ways that a sole proprietorship cannot.

Before I continue, this is not legal advice. I suggest talking to a lawyer to help you create and run an LLC in a way that guarantees these benefits. Liability protection works in the following ways:

  • When running an LLC properly, your business assets cannot be included when a court considers your personal assets, but your income and profit can be if run as a pass-through entity.
  • When running an LLC properly, liability protection prevents your personal assets from being included when a court considers your business assets, as long as you were not personally responsible for the behavior that caused the court judgment.
  • The debts of the business and any personal debts are separate if you follow the requirements to provide liability protection.

Legal protection is accomplished because the business structure creates liability protection, as long as certain rules are followed. Small business owners should be aware of the following practices when seeking legal protection through an LLC:

  • Personal and business banking need to be in separate accounts.
  • If you personally do something in the course of business, an LLC will not provide personal liability protection.
  • Personal liability protection prevents being held personally liable for any debt to a business creditor.
  • A single-member LLC can offer better protection when opting to follow C-Corp requirements by filing Form 8832 and adhering to corporate law.
  • There is insurance that can add additional personal liability protection for LLCs against losses.

You can also run a multi-member LLC using the tax code for partnerships or as a corporation.

Personal liability protection is of immense benefit, but in some scenarios, it may not be as valuable.  If neither the business owner nor the business entity has substantial assets or debts, creating a separate business entity may just create extra work and costs for small business owners. If you fall into this category and operate a low-risk business with no employees, a sole proprietorship may be better.

Looking at this section, LLC takes the win!

Let’s look at the differences in the formation of an LLC vs. sole proprietorship.

LLC vs. Sole Proprietorship: Formation

The formation of an LLC and a sole proprietorship is substantially different. Let’s look at what the requirements are for each to understand the differences and similarities.

Forming a sole proprietorship

A man holding a brown notebook

A sole proprietorship is registered with the state and will require paperwork for “doing business as… ” (DBA) with a fictitious name if you wish to run the business as something other than your given name. You’ll also need any state and local business licenses, tax permits, and an Employer Identification Number (EIN) if you wish to have employees.

Some states offer sole proprietorships for free as long as you make under a certain amount. When I am just trying to test the water in a field I will register for an NV sole proprietorship using the  exemption from NVSOS.gov:

A natural person who operates a business from his or her home as defined by Chapter 76 of Nevada Administrative Code and whose net earnings from that business are not more than 66% of the average annual wage, as computed for the preceding calendar year pursuant to NRS Chapter 612 and rounded to the nearest hundred dollars. The average annual wage generally fluctuates each year. For the average Nevada wage, go to Taxable Wage Base.

If you want to be a sole proprietor, check if your state offers this option for sole proprietors.

Let’s look at how an LLC formation differs from a sole proprietorship formation.

Forming an LLC

An LLC will have several main differences when forming it including:

  • Filing cost
  • Ongoing fees
  • Operating agreement
  • Articles of organization
  • Must have an EIN
  • Does not need a DBA unless operating as something other than the LLC name.

We’ll look at the filing costs, operating agreement, and the articles of organization because they are unique to an LLC.

Filing Cost and Ongoing Fees

An LLC will also have to register with the Secretary of State but will require different applications. This will normally require a fee at the state level. None are over $500 and most are under $300, but you’ll also have to pay ongoing fees that range from $0 annually to $500 annually. The best one you have to pay ongoing fees for is Pennsylvania at $70 every 10 years.

Operating Agreement

An operating agreement is one of the documents that is required for an LLC that a sole proprietorship does not require. An operating agreement includes:

  • The creation date
  • Location
  • Owners and percentages
  • Management and voting interests
  • Investment in Business
  • How profits, losses, and assets, are distributed
  • How membership changes are handled is important for a single-member LLC because they may want to pass it on when they die
  • How to dissolve the company if there is a desire to close it
  • And anything else required by your state

This document will need to be signed and notarized to be legal. Let’s look at the Articles of Organization next.

Articles of Organization

The Articles of Organization are very similar to the operating agreement but need to be submitted to the Secretary of State’s office. They include:

  1. Company name
  2. Description of the company
  3. Mailing address
  4. Name and address of the registered (or statutory) agent
  5. Information about company owners, managers, and officers

The most common reason for these to be rejected is they are using a name that has already been taken.

A sole proprietorship wins the round on formation, but there are still plenty of rounds to go. Let’s look at taxes next.

LLC vs. Sole Proprietorship: Taxes

A pen and a white notebook on a desk

Both sole proprietors and single-member limited liability companies can pay personal income tax on a personal tax return because they are both by default pass-through income. Sole proprietors and limited liability companies acting as a pass-through entity will also have to pay self-employment taxes, which are 15.3% broken into 12.4% for social security and 2.9% for Medicare.

LLCs can also follow the tax code for partnerships if there are two or more members. These are similar to a single-member LLC because they still have to pay self-employment taxes and only file a personal tax return with the Internal Revenue Service. Unlike a sole proprietor, an LLC can also file as a C Corporation or an S Corporation by filling out the appropriate documentation. Read up on LLCs on the IRS website to learn about their tax treatment.

In addition, pass-through LLCs can deduct 20% of net income before being taxed, while a sole proprietor does not have that option.

For anyone wondering “do LLCs pay more taxes than sole proprietorships?”

The answer should be no. The benefit of an LLC from a tax standpoint is the ability to choose whether filing like a sole proprietor or corporation is best for the business owner. This means you should be able to find a way to pay less in taxes.

This round goes to the LLC for their diversity of options when paying taxes. Avoid taxes like Floyd Mayweather dodging punches. Get ready for the next round, business income.

LLC vs. Sole Proprietorship: Business Income

Business income is treated as personal income for a sole proprietor, but an LLC can either be treated as personal income or corporate income and the business owner as an employee.

The difference can matter in several ways:

  • A sole proprietor has to claim the income if it is not spent on expenses in that year, while an LLC filing as a corporation can retain the profits and only pay the 21% tax rate for corporations. This makes the income easier to reinvest than a sole proprietor.
  • A limited liability company can pay dividends to the owners, which may create a more favorable tax consequence. A sole proprietorship cannot.
  • A limited liability company can borrow money from its owners at a fair market rate, while a sole proprietorship cannot. This allows you to get returns on your investment until it is paid off, which qualifies as interest income for the person and a business expense for the LLC. When the LLC pays off the investor, the original capital is not taxable.

An LLC definitely has perks that a sole proprietorship doesn’t have when it comes to business income. That means that LLCs take this round.

Sole Proprietor vs. LLC: Franchise Tax

A franchise tax is paying for the right to do business in the state. States have different requirements regarding the franchise tax. The best way to find out the requirements for your state is to talk to the local Small Business Administration. You can find local offices on sba.gov.

At the time of writing, the following states have a franchise tax: Alabama, Arkansas, California, Delaware, Georgia, Illinois, Louisiana, Mississippi, New York, North Carolina, Oklahoma, Tennessee, and Texas. In addition, Washington DC has a franchise tax.

Sole proprietors are not subject to this so they win this round.

LLC vs. Sole Proprietor: Operations

Sole proprietorships are tied directly to the owner’s personal tax return and the owner has to be involved in the operations of a business. Operations will also end when a sole proprietor dies.

Meanwhile, if your own business is an LLC, you can specify a manager in the LLC operating agreement and collect the profits. When you file articles of organization and the operating agreement, you need to specify how ownership is transferred, making it where an LLC can survive an owner’s death.

Which is better LLC or sole proprietorship? The benefits of LLC vs. sole proprietorship win out on this one.

Compliance

When wondering about the benefits of an LLC vs. sole proprietorship, compliance isn’t one of them. Sole proprietorships don’t need a separate bank account for a new business, nor do small businesses have to update the formal business structure of a sole proprietorship.

If you already own a business under a sole proprietorship, you don’t have to register for a new business because both businesses will be tied to the owner’s personal assets. This makes it really easy to try new ideas.

Single-member LLCs will have increased compliance requirements for an LLC owner because they will need to have a separate business bank account, keep the business’s debts separate, business expenses separate, and build a business credit score. Small businesses will also have more filing requirements than sole proprietors.

Compliance is a meaningful difference between LLC and sole proprietorships. In this category, sole proprietorships take the win.

It’s a Tie Between LLCs and Sole Proprietorships 

A chart showing a draw between sole proprietorship business of LLC

After comparing the differences between an LLC and a sole proprietorship, we come to a 4 – 4 draw. Ultimately, people choose LLCs to put a barrier of protection between themselves and their business liability, but they pay for that liability in additional compliance and filing fees.

In addition, there are potential tax benefits to LLCs that may be of interest once you reach a point in which your taxable consequences are more than 25%. You can change to an LLC later if you want to get started first as a sole proprietor

Whichever you choose, make sure to consider your goals and industry before making the decision. What business structure are you using to start or run a business?

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