Choosing between a sole proprietorship or an LLC business structure is one of the most important decisions business owners make. Find out which option is better here.
When comparing sole proprietorship vs. LLC, one of the primary benefits considered is the limited liability protection you get as a business owner if your business structure is an LLC. This means you are not personally liable for your business debts. As a sole proprietorship, your personal assets like your home and cars are liable for your business debts.
As such, once you decide to take professional development into your own hands, the next major decision is choosing your business structure. But understanding the differences between different business structures is confusing if you are not a tax expert or a lawyer.
This post seeks to understand and compare sole proprietorship vs. LLC business structures. Let's dive in.
An LLC is a flexible business structure that combines the elements of a sole proprietorship, corporation, and partnership with the abbreviations LLC put at the end of the business name to show that the business structure for that organization is under the LLC business entity.
This legally separate business entity allows the business owners to determine their management structure, tax treatment, and operational processes, making it easier to maintain and manage than other corporations.
For instance, you can start your business as a single-member LLC or multiple-member LLC. If you start your business as a single-member LLC, you can choose to be taxed as a sole proprietorship, C Corp, or an S Corp and enjoy the self-employed tax benefits.
Many business owners prefer starting an LLC because creditors cannot come after their personal assets since it offers its members limited liability protection from commercial obligations, debts, or lawsuits. Nonetheless, you should ensure you never co-mingle your personal assets with your business assets to prevent the court from piercing the corporate veil.
Apart from getting a high level of market credibility, starting an LLC is also beneficial for business owners because it makes it much easier to obtain debt financing, business credit score, and equity for your business. You can get leases, trade credit, and business loans quickly with an LLC as well.
The only drawback of forming an LLC is that you’re required to have state-related paperwork, annual state filings, and high costs for completing the LLC tax return. These are personal, local, state, federal, self-employed, unemployment, and state business taxes.
Sole proprietorships are the most common business structures chosen by small business owners in the United States, even though they are the riskiest option. Typically, a sole proprietorship is an unincorporated business entity owned by one person known as the sole proprietor, meaning there is no legal separation between the business owner and the business.
For instance, if you start an online retail business, you'd consider yourself a sole proprietor. It is common for most sole proprietors to use their names as the business name, but you can also come up with a trading name or a business brand name.
Many business owners prefer sole proprietorships because they require no paperwork other than licenses and permits. They have no annual state filings, and the tax filing process is simple. Additionally, all of the losses and profits made by a sole proprietorship pass to the business owner's personal tax return filed on a Schedule C tax form.
A sole proprietor might also enjoy the self-employed tax benefits like utilizing the self-employed retirement plans, deducting particular business expenses, or writing off business travel costs, business expenses like marketing costs, and client entertainment costs.
However, being a sole proprietor means having no limited liability protection, like your personal bank account, and your personal assets are not protected from your commercial debts, obligations, or lawsuits.
Also, it becomes more challenging to build business credit or get a startup business loan to sustain, grow, and develop a sole proprietorship. Many investors shy away from the business structure because they view the loan as a personal request rather than a business request.
If you choose to operate under your name rather than a business trade name, your sole proprietorship will have lower credibility in the market. But you can use ongoing fees to establish a "Doing Business As" name (DBA) with your secretary of state or state's department of revenue to get the market credibility, which means more fees for your business.
The process of forming a sole proprietorship is easy. All you need to do is create a business name and get the necessary permits, licenses, and zoning clearances, depending on your business type. You also need to get an employer identification number (EIN) for tax purposes.
But forming an LLC is much more involved since you must create and confirm your business name is not a trademark then choose a registered agent to represent the business. If your LLC is a single-member LLC, you become the registered agent by default. But if your LLC is a multi-member LLC, one of your business partners can become the registered agent.
Additionally, you need to file the articles of incorporation, get an EIN, pay a filing fee, and create your business operating agreement before running an LLC.
Compare sole proprietorship vs. LLC in terms of financing, and you'll determine that an LLC requires higher costs even though every business structure requires capital. However, immersing capital for a sole proprietorship might be more challenging since most business owners use their income to finance it.
But when starting an LLC, especially one with multi-members, sources of capital can vary, like getting investors or contributions from different business partners. Therefore, while the cost of starting an LLC might be higher, it might be much easier to immerse the capital needed to form an LLC than it is to create a sole proprietorship.
Also, keep in mind that either business structure can use other financing options like crowdfunding or getting a bank loan to finance the business.
The business owner in a sole proprietorship has the authority to make any business decision as they please since they own the entire business regardless of whether they hire business experts like accounting experts.
But with an LLC, the business operations and management are first outlined in the LLC operating agreement to ensure multiple members know their stake and role in the business. For instance, one business member might have greater voting rights than the rest or a more significant profit share.
This means that the management of an LLC depends on each member's ownership stake in the business. For instance, in an LLC with five members, two members might share a 30 percent ownership stake, and the remaining three might share 20, 10, and 10 percent stakes of ownership.
Taxes for a sole proprietorship and an LLC will pass through the business owner's personal tax return. But when both are compared, the LLC offers more tax flexibility. Thus, it provides a better opportunity for saving money.
For instance, if the LLC is taxed as a corporation, the tax rate on the dividends is lower, and the earnings are not subjected to the income tax. Sole proprietors will file business income and expenses, and the net profit from the business will pass through the owner's personal tax return.
A single-member LLC will be treated as a sole proprietorship meaning it is taxed just the same as a sole proprietorship. However, the business owner in a single-member LLC can choose to file taxes as a corporation after filing additional requirements like getting an S Corp status approval.
Keep in mind that both a sole proprietorship and LLC can qualify for a Qualified Business Income (QBI) deduction of 20 percent, and an employer you will pay a self-employment tax. Additionally, some states require LLCs to pay a business tax, franchise tax, or an LLC tax.
Because there is no separation between the business and the owner in a sole proprietorship, all the business debts, lawsuits, or obligations become your responsibility as the business owner. This means that creditors can take your personal assets, including your cars and house, to pay off your commercial debts.
And if your business goes bankrupt, you have to file for bankruptcy as well. But with an LLC, you have limited liability protection as the business owner. The protection extends to all the members of your business as well. This means that your personal property is protected from any commercial debts or obligations.
For creditors to sue business owners personally in an LLC, they have to prove that the business members commit fraud or negligence. The same can occur if any member guarantees the business debts personally.
The paperwork required to start a sole proprietorship is minimal, and the requirements after launch are state, federal, and local taxation requirements and permit renewals. But with an LLC, the compliance requirements before and after launch are more numerous.
For instance, LLC members must file articles of organization, operating agreement, and an indication of member shares prelaunch. After launch, activities like transferring ownership and meeting minutes throughout the year require documentation. Taxation for an LLC requires additional paperwork.
Generally, the LLC tax rates are lower than the sole proprietorship. Nonetheless, the IRS taxes single-member LLC and sole proprietorships equally, and they file their taxes on Form 1040, Schedule C. But if you have a multi-member LLC, then you'll file your taxes as a partnership or a corporation.
Also, the IRS treats an LLC as a pass-through, meaning taxes are filed with the business owners' personal tax returns. The IRS also expects a quarterly tax payment report. If the LLC is a multi-member business entity, members can file taxes as a corporation or a partnership.
If all your business members choose to file for taxes as a corporation, you must report your profit shares under the personal tax returns. The expense allocation should additionally be included when filing taxes.
For instance, many states require payment of the business renewal and registration fees as part of the business expenses deducted from a member's tax returns. But no deductions are made on social security, Medicare, and other tax expense categories.
Still, when comparing sole proprietorship vs. LLC in tax payments, sole proprietorships are taxed at a higher rate by states since LLCs separate salary from business profits, thus avoiding double taxation.
It solely depends on you and what you want for your business. For instance, starting a business as a sole proprietor is easy since it is mostly straightforward. However, if you plan to break the glass ceiling as a business owner, changing your business from a sole proprietorship into an LLC would be prudent. Why?
An LLC provides better business options for sustainability and growth. With an LLC, you have a better chance of getting a business loan, building your business credit, or getting investors. Besides, an LLC ensures your personal assets are protected from commercial debt. Therefore, while you don't need an LLC as a sole proprietor, it is an important decision to consider.
Comparing and choosing between a sole proprietorship and an LLC is a matter of choice. Nonetheless, the cost of starting the business, the tax implications of the business structure, the liability protection, and the government regulations determine the option to pick.
For instance, if the startup cost for your business is an issue or you want minimal paperwork and no business partners, then the sole proprietorship is the ideal option for you. But if you want a business structure that protects your personal assets, provides the potential for investors and fast business growth and sustainability, and other supporting members, then an LLC is the option for you.
Or start as a sole proprietorship and keep an open mind about changing your business structure into an LLC later into the future.
Also, if you want a business partner that will take the hassle of starting, running, and growing a business for you, get started with Hoist.
Hoist will help you set up your home painting business, get leads, and market your services locally and internationally.
About Schedule C (Form 1040), Profit or Loss from Business (Sole Proprietorship) | Internal Revenue Service
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