Starting a new business is an exhilarating venture, but before you jump right into the day-to-day operations, it’s important to decide on your business structure.
The choice between forming a sole proprietorship vs. LLC can profoundly impact everything from your personal liability protection to how you file income tax returns. Let’s get into the specifics of each to help business owners like you make informed decisions.
What Is a Sole Proprietorship?
Sole proprietorship is the default option for many entrepreneurs starting a new business. If you haven’t yet filed your articles of organization or paid an incorporation filing fee, you’re operating as a sole proprietor. In this unincorporated business structure, you and the business are one and the same.
What does that mean? Your business income, expenses, and debts are all personally yours. While that may seem convenient for business tax purposes (Schedule C on your personal tax return, for instance), it also means you are personally responsible for the business’s debts and liabilities.
The IRS sees no distinction between your personal assets and business assets, making you vulnerable to personal liability. It’s straightforward but comes with some financial strings attached, especially when it comes to self-employment taxes like Social Security and Medicare.
Sole proprietorships are generally chosen by individuals who are doing a lot of contractual work — think freelancers, consultants, and personal trainers. It’s a low-risk option if you’re just testing the waters with your startup, and it doesn’t require a separate business bank account or operating agreement.
What Are the Pros and Cons of a Sole Proprietorship?
A sole proprietorship might be your go-to business structure if you’re a freelancer, consultant, or just dipping your toes in the entrepreneurial waters.
Here’s why:
Pros
Some of the advantages of a sole proprietorship are as follows:
- Simplicity: It’s the most straightforward business type. No formal filing or fees are required to start. You are the business, and the business is you.
- Low Cost: Running a sole proprietorship is inexpensive. You won’t have extra costs like incorporation fees or annual reports. Your main expenses will be your business license and taxes.
- Total Control: You make all the decisions. You’re the boss, the manager, and the employee all in one.
- Pass-Through Taxation: Your business income passes through to your personal income tax return (Schedule C). This aspect simplifies filing taxes and can be advantageous depending on your income.
Cons
That said, there are some noteworthy potential disadvantages of a sole proprietorship, too. These include:
- Unlimited Personal Liability: This factor is the biggest downside. Your personal assets (house, car, savings) are not separate from your business. You could lose everything if your business gets sued or goes into debt.
- Difficulty Raising Capital: Lenders and investors often view sole proprietorships as riskier, making it harder to get business loans or attract investors.
- Less Credibility: A sole proprietorship might not be as credible as an LLC or corporation. Some clients and customers may prefer to work with businesses that have a more formal structure.
What Is an LLC?
If the term “limited liability company (LLC)” sounds like a fortress of legal protection, that’s because it often is. An LLC is a separate legal entity formed by filing paperwork, specifically articles of organization, with your Secretary of State.
This business entity type offers distinct advantages, especially when it comes to personal liability protection. If the business incurs debts or is sued, your personal assets — like your home or car — are generally off-limits to creditors.
One of the standout features of an LLC is its flexibility in tax treatment. By default, a single-member LLC is taxed as a pass-through entity, similar to a sole proprietorship. This means business profits and losses are reported on your personal income tax return.
However, LLC owners also have the option to elect corporate tax status, either as a C corporation or an S corporation, depending on their business needs and tax advantages.
Multiple owners, or “members,” can partake in the LLC, each protected by the business entity’s liability protection shield. You’ll want to hash out the details in an LLC operating agreement to avoid future misunderstandings.
The type of business you’re running, your income, and your long-term business plan are factors that might make an LLC the more prudent choice for you.
From the compliance angle, Mosey can help you manage all the business formation and operational intricacies, right down to state-specific requirements. Because, let’s face it, whether you’re a single-founder startup or a scaling enterprise, navigating the labyrinth of legal requirements can be complicated (and time-consuming).
What Are the Pros and Cons of a Single-Member LLC?
Need more protection for your business than a sole proprietorship offers? Consider a single-member LLC/limited liability company. It blends the simplicity of a sole proprietorship with some other key advantages:
Pros
With a single-member LLC, some of the main advantages include:
- Limited Liability Protection: This effect is the main draw. Your personal assets are generally safe from business debts and lawsuits. That means your house, car, and savings are not on the line if your business faces financial trouble.
- Pass-Through Taxation (Default): Like a sole proprietorship, your business income passes through to your personal income tax return. You file Schedule C and pay personal income tax on the total amount.
- Tax Flexibility: You have the option to change your tax status. You can be taxed as a C corporation or an S corporation, which can sometimes lower your tax burden.
- Enhanced Credibility: An LLC can make your business look more professional and established than a sole proprietorship, which can help attract customers and investors.
Cons
Conversely, some of the disadvantages associated with single-member LLCs are as follows:
- Formation Costs: Starting an LLC requires filing paperwork (articles of organization) with your state and paying a filing fee. There may also be ongoing fees like annual reports.
- Compliance Requirements: LLCs have more rules to follow than sole proprietorships. You must separate your business and personal finances and follow your state’s LLC regulations.
- Pierce the Corporate Veil: If you don’t follow the rules, a court could “pierce the corporate veil.” This means you could lose your limited liability protection and become personally liable for business debts.
How To Decide Between a Sole Proprietorship and a Single-Member LLC
Deciding between a sole proprietorship and a single-member LLC? Let’s break down the key differences to help you choose the right fit for your business.
Liability
With a sole proprietorship, you are personally liable for all business debts. That means your personal assets are at risk if your business is sued or can’t pay its bills.
With a single-member LLC, your personal assets are generally protected. The LLC is a separate legal entity, so only its assets are at risk.
Formation
No formal paperwork or filing fees are required for a sole proprietorship. You automatically become a sole proprietor when you start doing business.
With a single-member LLC, you must file articles of organization with your state and pay a filing fee. There may also be ongoing fees.
Taxes
You report business income and losses on your personal income tax return (Schedule C) with a sole proprietorship. You’ll pay self-employment taxes (Social Security and Medicare).
With a single-member LLC, by default, you’re taxed the same way as a sole proprietor. However, you can elect to be taxed as a C corporation or S corporation, which could offer tax benefits.
Ownership and Management
Sole proprietorships and single-member LLCs have one owner with complete control over the business, so there is no major difference along this dimension.
Finances
A separate business bank account is not required for a sole proprietorship, but keeping your personal and business finances separate is a good idea.
With a single-member LLC, it’s strongly recommended that you open a separate business bank account to maintain the legal separation between you and your LLC.
Raising Capital and Building Credit
With a sole proprietorship, it can be harder to get business loans and establish business credit because your personal finances are intertwined with your business.
With a single-member LLC, raising capital and building business credit may be easier since your LLC is a separate entity with its own financial history.
Credibility and Dissolution
With a sole proprietorship, you may be seen as less established than an LLC.
With a single-member LLC, offers more credibility and a professional image. Dissolving an LLC requires formal filing with the state.
Which Business Structure Is Right for You?
A sole proprietorship might be a good fit if you have a low-risk business (like freelancing or consulting) and want a simple, inexpensive option — but if you want to protect your personal assets, are concerned about liability, or plan to grow your business, a single-member LLC might be better.
What Are the Differences Between a Sole Proprietorship and an LLC?
When deciding between a sole proprietorship and an LLC, it’s important to know that each has its own merits and drawbacks. Additionally, you’ll likely feel committed to it for a while — so, let’s dissect the main differences to help small business owners make that key choice.
Ownership Structure
In a sole proprietorship, you’re the boss, the worker, and the janitor — all rolled into one. It’s a one-person show. There’s no distinction between business owners and the business entity, so your personal assets and the business’s debts are practically joined at the hip.
With an LLC, things get a bit more corporate — but in a laid-back way. The LLC can have one or multiple owners, and it exists as a separate legal entity. That means your personal assets aren’t automatically up for grabs if the business hits a rough patch.
Business Filing Requirements and Costs
To start a sole proprietorship, you don’t need to file articles of organization or pay an incorporation fee. If you want to do business under a name different from your own, you might need to register a DBA (doing business as) trade name, but that’s usually it.
The IRS will know you by your Social Security number unless you opt for an employer identification number (EIN) for other business purposes like hiring employees.
Forming an LLC requires a bit more legwork. You’ll need to file articles of organization with the Secretary of State and pay a filing fee. An operating agreement is generally recommended, and some states require an annual report. You’ll also need an EIN for tax identification.
Credits and Loans
Getting business loans as a sole proprietor can be tough. Financial institutions often consider it riskier because there’s no separate business entity to protect their investment. Your personal credit score and assets are on the line.
Business owners operating an LLC often find it easier to secure loans and credits. That’s because the LLC is a separate legal entity with its own business credit score. Plus, it’s generally easier to attract investors when you’re an LLC.
Operational Costs
Low operational costs are one of the main draws of a sole proprietorship. Outside of your regular business expenses, the only added costs might be a business license and, of course, self-employment taxes for Social Security and Medicare.
An LLC is generally costlier to maintain. Aside from the filing fees for business formation, you’ll have to manage more complex accounting and legal requirements.
However, the LLC business structure offers unique tax benefits and flexibility, which can offset those costs. For instance, an LLC can opt for corporate tax status, which could offer tax advantages depending on your business profits and structure.
Ultimately, your decision should be influenced by your long-term business plan, the level of personal liability you’re comfortable with, and how you wish to be taxed. Whether it’s the ease and low cost of a sole proprietorship or the liability protection and flexibility of an LLC, each option has its merits. Choose the one that aligns best with your entrepreneurial vision.
What Are the Tax Differences Between LLCs and Sole Proprietorships?
Now it’s time to talk about taxes. The IRS has different rules for LLCs and sole proprietorships, and they impact everything from how you report business income to the types of deductions you can claim.
Reporting Business Income and Tax Forms
If you’re a sole proprietor, your tax life is pretty straightforward. You’ll report your business income and expenses on Schedule C of your personal tax return. Your profits get added to any other income you have — like wages from another job or income from investments — and you’ll pay personal income tax on the total.
For a single-member LLC, tax reporting starts off similarly. The business income is considered “pass-through,” meaning it passes through the business entity directly to the LLC owners. However, an LLC has the option to elect corporate tax status.
This opens up the possibility of being taxed as a C corporation or an S corporation, which might offer some tax advantages, such as reducing self-employment taxes.
Self-Employment Taxes
As a sole proprietor, you’re responsible for both the employer and employee portions of Social Security and Medicare taxes, often referred to as “self-employment taxes.”
Just like sole proprietors, single-member LLC owners are on the hook for self-employment taxes unless they elect to be taxed as an S corporation. In that scenario, the LLC owner can become an employee of the business, potentially saving on Social Security and Medicare taxes.
When Should You Form an LLC?
Now that we’ve covered the basics, here are a few tips regarding when it might be best to form an LLC:
- Planning for Growth: If you’re planning to have multiple owner chairs at your business table in the future, an LLC makes it easy to bring new members on board.
- Asset Protection: In a litigious society, personal liability protection has its perks. An LLC keeps your personal assets separate from your business debts.
- Tax Benefits: With the possibility of choosing different tax statuses, an LLC offers a more tailored fit for your tax wardrobe. Consult your accountant for your specific circumstances.
- Legitimacy: When you operate as an LLC, it’s like having a seal of approval. Your clients will likely perceive your business as more established and serious.
Now that you have these insights, the ball is in your court. Whether you’re looking for a business structure that supports growth, provides stronger liability protection, or offers tax benefits, an LLC could be the vehicle that propels your business to the next level.
Can an LLC Become a Sole Proprietorship?
It is possible for an LLC to become a sole proprietorship, but it’s not as straightforward. Legally converting an LLC to a sole proprietorship involves dissolving the LLC, which means filing specific forms with the Secretary of State and settling any business debts. You would also forfeit the benefits that come with being an LLC, such as limited liability protection.
Keep in mind that this is generally a one-way road; you’ll need to re-establish the LLC if you decide you want those benefits back.
Is an LLC or Sole Proprietorship Best?
Choosing between an LLC and a sole proprietorship is no minor task — it’s about understanding your business goals, weighing the pros and cons, and choosing the business structure that will serve you best. With Mosey, you’re not navigating these waters alone.
Mosey offers an intuitive platform geared toward helping entrepreneurs like you make informed business decisions. From accessing valuable resources after business formation to providing customized advice on payroll and tax benefits, Mosey is the co-pilot you want on your side.
The Bottom Line
When you’re deciding how to structure your business, one decision you’ll likely have to make is whether to structure your business as a sole proprietorship or an LLC. While both have their pros and cons, the choice ultimately depends on your comfort with risk, your desire for tax benefits, and how you’d like to run your business.
While you can always change from one to the other later on, making the right decision at the beginning can help set your business up for success. For guidance on everything from payroll tax to local regulations, check out Mosey’s other resources.
Read more from Mosey:
- What Is a Foreign Corporation? FAQs Explained
- What Is a C Corporation (C Corp)?
- What Is Payroll? A Guide for Small Business Payroll
- What Is a Legal Entity? Definition & Examples
- What Is SUI? State Unemployment Insurance FAQs
- HR Compliance Checklist: 16 Items To Consider
- LLC vs. S-Corp: What Are They & How They Work
