Sole Proprietorship vs. LLC: Key Differences

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 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 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.