LLCs and sole proprietorships are types of businesses utilized by successful enterprises across America. However, LLCs and sole proprietorships are most often used by certain types of businesses due to their unique benefits, requirements, and operational costs.
Let's break down the differences between LLCs and sole proprietorships to see which will be a better choice for your business.
What is an LLC?
In the United States, an LLC or limited liability company is a type of business structure that protects owners or key members from business liability. For instance, LLC business owners are protected from debt that the company takes on or from other financial burdens if the company goes bankrupt due to various causes.
This allows business owners to retain financial freedom and potentially start another business without going bankrupt themselves. LLCs are flexible, suitable for small and large businesses, and are popular business models for enterprises throughout the US.
Advantages and Disadvantages of LLCs
LLCs provide multiple advantages that make them attractive options for companies in all industries:
- For example, LLCs often save their owners and members significantly when it comes to taxes. LLCs are taxed differently and separately from business owners, as LLCs are considered distinct and separate legal entities from their executives
- Furthermore, LLCs provide significant liability protection in the event that the company goes under or acquires other liabilities due to operations or debt
- LLCs can be formed anonymously, which can protect the identities of company members or executives. This can be advantageous when trying to get away from a certain reputation
- LLCs, in another sense, add a level of business professionalism and legitimacy. After all, every LLC company must add the label "LLC" to the end of its name. This may make it easier to take out larger lines of credit or negotiate differently with certain vendors
LLCs are so popular because they only come with one real disadvantage: complexity. Compared to running a sole proprietorship or a regular partnership, LLCs are significantly more complex and require an extensive filing process to create the new company's structure. Thus, LLCs are primarily useful for groups of individuals that want to do business together over the long-term rather than individuals.
What is a Sole Proprietorship?
A sole proprietorship is another type of business model designed to benefit single commercial entrepreneurs or single business owners. Also called "sole traders" or "proprietorships", sole proprietorships are unincorporated businesses with one owner alone who is responsible for paying any income tax on profits made from business activities.
Advantages and Disadvantages of Sole Proprietorships
As with LLCs, sole proprietorships offer several advantages that could make them a good choice for your enterprise:
- Any owner of a sole proprietorship is entitled to all of the profits of the business. They don't have to share those profits with any other members
- Running a sole proprietorship is extremely simple, especially compared to an LLC. Even forming a sole proprietorship takes fewer steps and can be accomplished more quickly
- Furthermore, sole proprietorships don't have as many fees or annual costs to run in their states of operation
Of course, these advantages come with equal and opposite disadvantages:
- The business owner is not seen as a distinct legal entity from their sole proprietorship. This means that the business owner is liable for any debts or other liabilities associated with their business
- Furthermore, the sole proprietorship owner is responsible for paying higher income taxes since all income from the business is considered personal income
What is the Difference Between the Two?
The biggest difference between the two can be boiled down into two main points:
- LLCs are considered to be distinct legal entities from their owners or members. Sole proprietorships are not
- LLCs' income must be split between members in some manner, and they are taxed as distinct entities. Sole proprietorship income goes solely to the owner, but that income is taxed as personal income
In general, people form LLCs and sole proprietorships for different reasons.
Smaller or part-time businesses are more often sole proprietorships, both because it costs almost nothing to establish one and because the formation process is a lot simpler. In many cases, these smaller businesses don't have enough profits to warrant finding ways to avoid higher taxes, as well.
On the flip side, LLCs can be thought of as hybrid business structures between partnerships and corporations. They're mostly used for growing companies with multiple members or owners who intend to do business with one another over the long-term.
How Does the Startup Process Differ?
These two types of companies also differ significantly in terms of their startup processes.
Forming a Sole Proprietorship
Forming a sole proprietorship is usually quick and simple. Depending on where you work and the kind of work you do, you'll likely need to obtain work permits and licenses, which can cost up to several hundred dollars. Once this is done, however, you can simply acquire a "DBA" or "doing business as" at your County Clerk's office. This informs the office of your business’s activities.
You can then get to work almost right away. Note that if you hire employees, you'll need to obtain an EIN or employer identification number. This also allows you to open a business bank account so you can keep your work income and personal spending money separate (a practice that is recommended by most business owners).
Forming an LLC
In contrast, forming an LLC takes a lot of work and paperwork filing.
- You'll need to come up with a unique name for your LLC
- You'll need to pay multiple one-time and recurring fees for filing paperwork and for operating in your state
- You'll need to hire or choose a registered agent to operate as a legal point of contact for official documents
- You'll also often need to obtain an EIN, particularly for tax purposes
- Your company will need to create an Operating Agreement that outlines the structure of the LLC, profit distribution rules, voting rules, and more
- Your Articles of Organization will need to be filed with your state's business department to officially legitimize your LLC
It's easy to see why LLCs are most often formed by groups of individuals instead of single individuals due to the amount of work involved and the additional fees you'll need to pay over time.
LLC & Sole Proprietorship Taxation
The tax differences between LLCs and sole proprietorships are, fortunately, relatively simple:
- The income of a sole proprietorship is taxed as personal income for the business owner. Furthermore, the business owner will be considered to be self-employed, meaning they'll be taxed additionally for this attribute
- LLCs may be taxed as disregarded or distinct entities. This means that LLC income is taxed using different rules compared to the personal incomes of individual members or owners
Should You Start an LLC or Sole Proprietorship
Ultimately, both LLCs and sole proprietorships can be effective ways to structure your business or organization. In general, LLCs are better for groups of individuals who want to do business together and you are comfortable splitting the profits of their business in exchange for greater liability protection and certain tax breaks.
Sole proprietorships may be a better choice for self-employed individuals who own their businesses alone, and who may occasionally hire some employees for assistance. This is also a good choice for smaller part-time businesses that don't bring in enough income to warrant the process of forming an LLC or single-member LLC.