Sole Proprietorship vs. Single-Member LLC

When starting a business, one of the first big decisions is choosing which business entity to form. Two popular options are a sole proprietorship and a limited liability company (LLC). If you’re the business’s sole owner and you form an LLC, you’ll have a single-member LLC, as LLC owners are known as members.

This handy guide will explain that sole proprietorships and single-member LLCs have several significant similarities and differences.

What Is a Sole Proprietorship?

If you’ve started your online 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. However, the critical 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. 

What Is an LLC?

Also, an LLC is a “pass-through entity” in taxes, meaning that 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. 

Entity Formation

As stated above, a sole proprietorship does not require registration with the state. To start a sole proprietorship, you simply need to start doing business. There is no cost. 

An LLC, on the other hand, requires filing articles of organization with your state. Then, depending on the state, you’ll be required to pay a fee ranging from $40 to $500. 

You’ll also need to appoint a registered agent for your business and include their information on the articles of organization, along with the business name, address, and other information. A registered agent is a person or company authorized to accept and respond to official correspondence on behalf of your business, such as legal, tax, or financial documents. 

As the sole member of the LLC, you can choose to be your registered agent, appoint another person, such as an attorney, or hire a registered agent service. 

Taxes

Single-member LLCs are, by default, taxed as sole proprietorships. However, both are pass-through entities, as mentioned above, so income from the business passes through to the member or owner to be reported on their tax return. 

But LLCs are unique because 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. You can choose to be taxed as a C-Corp or an S-Corp.

C-Corp status means income is taxed at the current rate for corporations (21% as of late 2022), which is lower than the usual individual taxpayer rate. But keep in mind that C-Corp shareholders – who are members in the case of an LLC – must also pay taxes on their distributions. This is called double taxation. 

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 are more significant than those additional expenses. 

Management

Single-member LLCs and sole proprietorship owners have full control of their business and can manage it however they see fit. 

But with a single-member LLC, the LLC is its entity and can enter contracts, take on debt, and purchase property separately from its owner. This creates personal liability protection, as the obligations are on the LLC, not the member. 

With a sole proprietorship, you and the business are legally viewed as the same, so when you enter contracts or take on debt, the debt is yours, and you’re personally liable. 

Personal Liability Protection

Again, 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.

Annual Requirements

A sole proprietorship does not have to file reports with the state. It may need to obtain and renew business licenses and permits, but no documents need to be filed to form the business entity. 

On the other hand, an LLC must file annual or biennial reports in most states. These reports come with a fee, which varies by state. 

Single-Member LLC or Sole Proprietorship – Which Is Right for You?

A single-member LLC and a sole proprietorship are similar, but the latter is less expensive and involves less paperwork. The disadvantage, however, is that it does not provide the crucial liability protection offered by an LLC. While you expect your business to succeed and never face serious troubles or debt, it can and does happen and would present a much greater risk for a sole proprietor.

The choice is yours, and if you’re unsure, you should consult an attorney and tax advisor. You must make the best decision for you and the future of your business.