LLC vs. Sole Proprietorship: Which Structure to Choose?

When starting a business, one of the first big decisions is choosing which type of business entity to form. Selecting one entity over another will influence how your business operates and may even play a role in your success as a business owner. 

Small business owners typically choose to become a limited liability company (LLC) or a sole proprietorship. This guide explains the advantages of each option to help you determine which is the right choice for you and your new business. 

What Kind of Business Entity Is a Sole Proprietorship?

If you’ve started your business without forming a business entity, you’re, by default operating as a sole proprietorship, assuming you’re the only business owner. Sole proprietorships do not require registration with the state. 

In the case of a sole proprietorship, the business’s income passes through to the owner, just like in an LLC, and income is reported on the owner’s tax return on Schedule C. The key difference is that a sole proprietorship does not provide the owner with personal liability protection. 

If you’re a sole proprietor, you and the business are legally considered the same. This means that if your business has debt or is sued, you’re personally liable for the obligations of the business. This puts your assets, including your home, at risk. 

Unless you specify otherwise, the business name of your sole proprietorship is your name. However, you can register a DBA, an acronym for “doing business as,” which refers to an alternative business name you file at the local or state level. 

A DBA, also known as a fictitious or trade name, is to allow a business to operate under a name other than its official legal name. For instance, if you run “Jane’s T-shirts” and want to start selling shoes, you might file for a DBA called “Jane’s Shoes.” Creating a DBA does not impact taxes and is not a legal entity or structure like a corporation. 

However, if you operate your business as a sole proprietorship or a partnership, you must operate under your name unless you register a DBA. It’s standard in most states to file a DBA with your county or municipality where the business operates, but in some states, it’s filed at the state level. 

What Kind of Business Entity Is an LLC?

More and more new businesses are electing to form limited liability companies, and you only have to look at the beneficial characteristics of this business type to understand why. 

LLCs are formed by filing articles of organization with the state and paying the corresponding formation fee. LLCs are increasingly popular due to their many benefits. An LLC provides personal liability protection, for example, so that your assets are not at risk if your business is sued or cannot pay its debts. 

Also, an LLC is a “pass-through entity,” meaning the LLC itself is not taxed. Instead, income passes through the company to the LLC owners or members, who report it on their tax returns. LLCs also offer flexibility in management, as there are few requirements regarding organizational structure. 

LLCs offer flexibility when it comes to management and taxation. LLC members can choose their LLC’s management and operational structure and determine if they want their business to be taxed as an LLC, a corporation, or a partnership.

Forming a Sole Proprietorship vs. Forming an LLC

If you wish to start a sole proprietorship, all you need to do is begin conducting business. This is why sole proprietorships are the cheapest and most straightforward business entities to form. But it’s crucial that you first check with your state and municipality to determine whether your business requires any licenses and permits. 

As stated above, LLCs are formed by filing articles of organization with your state.

You’ll need the following information on hand:

• Your LLC’s name or DBA
• Name and address of your LLC’s registered agent
• Name(s) of the LLC’s owners

Most states require LLCs to identify registered agents, individuals, or entities authorized to receive and respond to official documents. LLCs can choose a member to be their registered agent or a separate individual. 

Generally, the requirements are that the registered agent:

• Be 18 years or older
• Have a physical address in the state 
• Be available during regular business hours 
• Be registered to operate in the state, if it’s a business 

Some states have more specific requirements, so check the rules in your state.

Registered Agent Services

Many business owners hire a registered agent service to ensure all important documents are received and addressed in a timely manner. A registered agent service also offers convenience. 

If you choose to be your registered agent, you’ll have to be available at your registered agent’s address during regular business hours. However, a registered agent service will allow you the flexibility to be wherever you need to be to run and grow your business. 

An agency also offers privacy. Since they will receive all official correspondence for your business, you would never be served with a summons for your business in front of customers or employees. 

LLC vs. Sole Proprietorship: Comparing Taxes

A sole proprietorship and a limited liability company are considered “pass-through” entities, meaning that the business itself is not taxed and does not pay taxes. LLC members may even qualify for the Tax Cuts and Jobs Act, which supports up to a 20% pass-through deduction of business income. 

LLCs are pass-through entities, which means income passes through to the member or members. If the LLC has only one member, it’s taxed as a sole proprietorship. If the LLC has more than one member, it’s taxed as a partnership. 

However, LLCs are unique in that they can elect to be taxed as a corporation if the members decide it makes financial sense. This is done by filing an election form with the IRS. In addition, you can choose to be taxed as a C-Corp or an S-Corp.

For corporations, the business income is taxed at the current rate for corporations (21% as of late  2022), which is lower than the usual individual taxpayer rate. But remember that corporation shareholders must also pay taxes on their distributions. 

However, members are subject to self-employment tax in an LLC that is taxed by default as a sole proprietorship or partnership. Once such LLC switches to being taxed as a corporation, self-employment taxes no longer apply. 

Similarly, self-employment taxes do not apply to members with S-Corp status, which is the main advantage of electing S-Corp status. 

With S-Corp status, members are generally paid as company employees, which means more accounting and payroll expenses. Therefore, S-Corp status is only beneficial when the self-employment tax savings exceed those additional expenses. 

LLCs and sole proprietorships are required to pay employee payroll taxes, collect state and local sales tax, and pay self-employment taxes. It’s important to remember that some states and localities collect other taxes for LLCs, so reviewing your state and local laws is critical. 

LLC vs. Sole Proprietorship: Comparing Management 

Management of a sole proprietorship is relatively straightforward: the owner controls all business aspects and functions. This means the owner can hire and fire employees, accept debt, and conduct and manage day-to-day operations. 

LLCs with just one member enjoy the same freedom as sole proprietors. But when an LLC has more than one owner, management becomes more complicated. For example, in a member-managed LLC, members handle all management duties, while in a manager-managed LLC, non-member employees oversee operations and management. 

Note that with a manager-managed LLC, a member can be a manager, but only in cooperation with another manager who is an employee, not a member. Member-managed LLCs generally work best for LLCs with few members, all of whom can take an active role in day-to-day operations. 

Manager-managed LLCs are best for LLCs with multiple members, some of whom want to be “silent” or passive members and not involved in daily operations.

To deal with this complexity, an LLC with more than one member should create an operating agreement. An operating agreement is not required in most states, but it’s a crucial document for smooth LLC operations. 

Keep in mind that it does not get filed with the state but is stored and mainly used internally. 

The operating agreement will outline the members’ ownership percentages and how profits and losses are distributed. 

Those are its most essential elements, but it should also include the following:

• Each member’s rights and responsibilities
• Management structure and roles of members
• Voting rights of each member
• Rules for meetings and voting
• What happens when a member sells their interest, becomes disabled, or dies
• How disputes between members are resolved

You can find operating agreement templates online from services like ZenBusiness, which will provide standard legal lingo and allow you to fill in the blanks. You’ll probably be able to find free templates online as well, but it’s best to stick with a professional service.

Having a strong operating agreement in place can help avoid potential disputes due to the ownership and management structure of the LLC being clearly defined in writing.

LLC vs. Sole Proprietorship: Comparing Liability 

Personal liability protection is the key difference between an LLC and a sole proprietorship. With an LLC, if the business cannot pay its debts or is sued, the member’s assets are generally not at risk.

In a sole proprietorship, if the business cannot pay obligations or is sued, the owner’s assets, including their home, are at risk since the business and the owner is legally the same.

LLC vs. Sole Proprietorship: Comparing Legal Requirements and Regulations

Sole proprietorships involve minimal work to stay legally compliant. Sole proprietors are only required to file annual taxes and renew their business licenses and permits; there are no additional management requirements. 

LLCs involve mandated documentation and more paperwork requirements, including the articles of organization to form the business. In addition, LLCs with more than one member must hold regular meetings that follow the operating agreement’s guidelines.

We recommend that LLC members seek assistance from an attorney to create a robust operating agreement to ensure that all bases have been covered and all members’ interests taken into account. 

Several states also require annual report filings from LLCs. Additionally, a business owners must fill out the related paperwork if they wish to dissolve their LLC. 

Which Entity Type Should You Choose for Your New Business? 

Sole proprietorships are created by default, so many entrepreneurs start their businesses under that entity type. But in the longer term, the liability represents a significant disadvantage. If something were to go wrong, it could leave you and your assets at risk, including your home. 

This is why more and more startups choose an LLC because of the notable advantages of liability protection and taxation options. Even though an LLC will cost you more time and money to start, many entrepreneurs find it worth knowing their assets are safe and protected.