When opening up a new small business, setting up an online store or starting a freelance side gig, you’re faced with the question of whether an LLC or sole proprietorship is the right legal formation for you and your needs. These two business models can make a significant difference in how you run your company from a legal, tax and management perspective. Here’s what you need to know about what sole proprietorships and LLCs do and how to choose the best option for your needs.
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At a Glance: Sole Proprietorship Vs. LLC
Sole proprietorships and limited liability companies (LLC) are two of the most common business structures for individuals and small businesses. A sole proprietorship is the simplest and requires minimal paperwork. An LLC requires upfront paperwork and costs but could provide your business long-term benefits that make the investment worth it. Legal protection and potential tax advantages are two big factors to consider when choosing between a sole proprietorship and an LLC.
What Is a Sole Proprietorship?
A sole proprietorship is an unincorporated business that’s owned by the individual running it. A sole proprietorship is the default choice for anyone who runs a business but hasn’t set up another formal business structure like an LLC. As a sole proprietor, there’s no separation between your personal and business assets and expenses. You are personally responsible for all your business’s debts and obligations.
A sole proprietorship can only have one owner. If you take on a business partner, your unincorporated business will become a general partnership.
Individuals that do a lot of contractual work, such as freelancers, consultants and personal trainers often choose to file their taxes as sole proprietors. This is the easiest way to go if you’re just starting out or you’re not yet making enough profit to justify the costs of an LLC. However, even if you’ve been in business for decades, a sole proprietorship may still be the best option, depending on the type of business you run. It’s all going to depend on your income, business type and your personal management preferences.
What Is an LLC?
An LLC is a business entity that’s created by filing paperwork with your state. An LLC can have one owner (known as a “member”) or many owners.
Once formed, an LLC has its own legal identity that’s separate from you, the owner. Because of this, a business creditor cannot legally go after your personal assets if your business is sued or unable to pay its debts. Additionally, an LLC’s bankruptcy is considered separate from the owner’s. If you have employees, an LLC can also help shield you from liability for your employees’ actions.
By default, single-member LLCs are taxed in the same way as sole proprietorships. But an LLC can also elect to be taxed as an S Corporation or a C corporation. This tax flexibility allows LLC owners to choose the most cost-effective tax structure for their particular business. For some businesses, the corporate taxation option is a major reason to form an LLC.
When Should You Open an LLC?
There are a few reasons to open up an LLC instead of operating as a sole proprietorship:
- You want to expand the company to more than one owner in the future, which is easy with an LLC
- You want to protect your personal assets from potential financial and legal liability
- You want to take advantage of any applicable local, state or federal tax benefits that come with forming an LLC
In summary, setting up an LLC could position you for growth and protect you from liability. People also consider opening up an LLC when they reach a certain income threshold in their business and the additional fees and paperwork make sense from a tax perspective. This varies by state and the type of business, so it’s a good idea to speak to your accountant and compare the taxes you’ll be paying with each business structure.
Running Your Business as a Sole Proprietorship Vs. LLC
There are a few distinctions in operating a business as a sole proprietorship vs. an LLC. As a sole proprietor, there’s no separation between you and your business. You’re not obligated to separate your personal and business bank accounts and credit cards. However, opening up a different checking account for your business will make it easier to identify business expenses when it comes time to file your taxes.
With an LLC, it’s important to keep your business finances completely separate from your personal ones. You’ll need a business bank account, and you’ll sign documents and contracts on behalf of the business, not as yourself personally. Keeping things separate preserves your liability protection because it shows that the LLC truly has its own separate identity.
Taxwise, an LLC offers more options than a sole proprietorship. All sole proprietors are self-employed. You’ll list your business income and expenses on Schedule C of your personal tax return and you’ll pay personal income tax on your profits. You’ll also be responsible for paying your own Social Security and Medicare taxes, otherwise known as “self-employment taxes.”
Single-member LLC owners are automatically treated like self-employed sole proprietors for tax purposes. But an LLC can also elect to be taxed as a corporation. With corporate taxation, an LLC owner can be an employee of the company rather than being self-employed. Some business owners find that taxation as an S corp saves on self-employment taxes and enables them to put away more for retirement. If your solo business is starting to make a significant profit, talk to an experienced accountant about the best tax status for your company.
Finally, some people choose to open up an LLC because it gives their business a sense of legitimacy. You’d be operating your business as a company, send payments from the company, and your clients will see the “LLC in your company name. With an LLC, you’ll also be able to establish business credit in a way that you couldn’t with a sole proprietorship.
Sole Proprietorship Vs. LLC: Formation and Registration Costs
Whether you choose a sole proprietorship or an LLC, the formation process and its associated costs will largely depend on your state. For a more detailed look at what you can expect on the LLC side, you can check out our guide on the subject. And many of the providers in our best LLC services guide can help you find companies that make the registration process fast and easy no matter what you need.
Frequently Asked Questions (FAQs)
Is an LLC better for taxes?
An LLC can have tax advantages that aren’t available to sole proprietors, but any benefits will depend on your specific situation and it isn’t necessarily always the case, especially when you factor in the fees associated with operating an LLC. Whether an LLC is better for taxes depends on multiple factors, including your profit, expenses, and the type of work you do.
Can you convert a sole proprietorship to an LLC?
Yes, it’s possible to convert a sole proprietorship into an LLC. Typically, this will involve submitting your LLC application with your state’s Secretary of State, Business Bureau or Business Agency. Learn more about how to set up an LLC.
Can you convert an LLC to a sole proprietorship?
You can, but it requires you to dissolve the LLC first, which is known as a dissolution. The steps involved include getting approval from all members of your LLC and filing your dissolution documents with the state agency that you filed your articles of incorporation with, which was likely the secretary of state. Then, you have to alert all of your creditors that you are dissolving the LLC so that you can receive your final bills from them and pay them. You must also file all tax forms with the federal government as well as on the state and local levels if necessary. The final steps include transferring any assets that you have to the sole proprietorship, publishing your dissolution, such as in your local newspaper or a posting on your social media sites, and transferring all business licenses from your LLC to your sole proprietorship.
How much does it cost to open an LLC?
You’ll have a few expenses when forming an LLC. First, there’s a one-time formation fee, which costs anywhere from about $50 to a few hundred dollars, depending on your state. You may decide to hire a lawyer or online LLC filing service to prepare and file the paperwork for you. The fee for this varies and is separate from your state filing fee. And if you use a registered agent company to act as your registered agent, you’ll pay anywhere from about $50 to $300 a year for that service.
In many states, you’re required to file an annual report and pay an annual fee or tax. This varies by state but, on average, ranges from $10 to $300 per year (with exceptions like California, where the annual tax totals $800).
Do you need to register your business name?
Registering your business name can be a useful way of protecting your company’s intellectual property. For more information on what this process looks like, you can check out our guide to trademarking a name.
How do I form an LLC?
You create an LLC by filing paperwork with your state and paying a filing fee. Visit the website for your state’s secretary of state or other agency in charge of business filings for information, forms, and instructions specific to your state. You can also form an LLC with the assistance of an accountant, lawyer or online business formation company, such as one of the best LLC filing services.