One of the first decisions you'll face when deciding to start a new business is also one of the most important: which business structure to choose. Among the available options, many small business owners favor two structures—limited liability companies and sole proprietorships.
Before you choose between the two, it's important to understand the advantages and limitations of each.
LLC vs. sole proprietorship: Quick facts
An LLC may be better for you if you value:
- Limited personal liability: Because an LLC exists as a separate business entity, it's an excellent choice in any situation where you may face lawsuits, such as selling products, maintaining a physical location, or hiring employees. Rather than risking your personal assets, any lawsuit will be limited to the LLC's assets and property.
- Raising capital: LLCs are often much more attractive to investors because of the ability to add members and sort those members according to their individual interests.
- Flexible taxation: Depending on the preferences of its members, an LLC can opt to be taxed as a corporation—something that may net considerable tax benefits depending on your circ*mstances.
- Growth and longevity: As multi-member entities, LLCs are typically more scalable than even the most successful sole proprietorship.
- Professional credibility: LLCs may help you build credibility and rapport with investors, other businesses within your supply chain, partners, and even customers due to their more formal business structure.
A sole proprietorship may be better for you if you value:
- Simplicity and low cost: Because there's no need to file formation documents with the state where you work (unless a DBA is required), starting a sole proprietorship is generally simpler and cheaper than forming an LLC.
- Direct control: Since there are no other members in a sole proprietorship, you'll retain complete control over all business decisions.
- Easy tax filing: Depending on the type of taxation you choose, a sole proprietorship may allow you to report your business income and expenses on your personal tax returns.
- Less paperwork: Due to their limited nature, sole proprietorships often face fewer state regulations and paperwork than LLCs, which may need to file annual reports.
- Personal tax deductions: Although you won't benefit from many tax incentives involved with forming an LLC, a sole proprietorship may allow you to deduct expenses such as health insurance premiums.
What's the difference between an LLC and a sole proprietorship?
In 2023 alone, nearly 5.5 million new business applications were filed, breaking the previous record by nearly half a million. Of these businesses, a huge percentage were structured as either LLCs or sole proprietorships—and for good reason.
Long recognized by small business owners and entrepreneurs as two of the simplest and most flexible options for starting a business, both structures offer considerable—but distinct—advantages.
What is an LLC?
Short for “limited liability company," an LLC is a legal entity formed at the state level and run by one or more owners, referred to as "members." Regardless of whether they're run as a multi- or single-member LLC, each LLC functions as a separate legal entity in the eyes of the government, meaning that its members are insulated from personal liability in the event of a lawsuit or attempt to collect outstanding business debts.
In terms of taxation, the outstanding flexibility of an LLC's structure means it can be taxed as either an S corporation or C corporation, depending on which will save its members as much money as possible when tax season comes around. For those considering a single-member LLC, however, remember that your business will still be taxed as if it were a sole proprietorship unless you deliberately choose otherwise when filing.
What is a sole proprietorship?
A sole proprietorship is an unincorporated business owned and run by one person and generally serves as the simplest, most effortless business structure possible. While a sole proprietorship means that you are entitled to all of your business's profits, it also means that you are responsible for all of its liability; unlike with an LLC, you and your business are not regarded as separate legal entities.
Another key point to remember is that operators of a sole proprietorship are typically required to pay self-employment taxes. These taxes, which sit at 15.3% (12.4% for Social Security and 2.9% for Medicare) for 2023 and 2024, often mean that a sole proprietor will need to make quarterly payments to avoid extra fees and will pay considerably more overall than a standard employee.
5 key differences between an LLC and a sole proprietorship
Despite being two of the most common small business structures, there are several key differences between an LLC and a sole proprietorship to consider before choosing which is best for you. We've outlined the five most important.
1. Management structure
Managing an LLC
In an LLC, the business can be owned by one or more members. Its members usually manage an LLC, but they can also appoint a manager to handle the day-to-day operations.
And, while it may be slightly more complex than managing a sole proprietorship, the multi-member, diversified nature of an LLC offers considerable upsides—especially as a business grows.
Simply put, more hands make for lighter work, and in situations where many or all of an LLC's members actively contribute to daily operations, the company often grows much more quickly than it would if it were entirely run by a single individual.
That said, this structure also requires more thought regarding profit distribution. Typically, the members of an LLC will form an operating agreement upon joining the company, which is a document that outlines expectations, obligations, and compensation (which may or may not correlate with each member's ownership percentage).
Managing a sole proprietorship
By definition, a sole proprietorship means that an individual has complete control over all decisions made for the business without needing to consult any partners or members as they would within an LLC. While this type of freedom may appeal to some entrepreneurs, it's important to remember the risks and added burdens associated with a sole proprietorship.
Put simply, opting for a sole proprietorship structure often means a high-risk, high-pressure experience where a business's success—or failure—depends almost entirely on the individual at its head.
2. Personal liability protection
Protection within an LLC
With an LLC, one of the most attractive benefits is personal liability protection. Because the business is treated as a separate legal entity with its own assets and debts, individual members of an LLC typically cannot be sued or held responsible for the business's debts.
And, while most businesses don't plan on being sued, many of the moves necessary for a company to grow will also open that company up to potential litigation, including hiring employees, maintaining a physical location, or simply selling goods and services.
Protection as a sole proprietor
In a sole proprietorship structure, there is no separation between you and the business. While this means that you are entitled to 100% of your company's profits, it also means that you can be held personally liable for any debts, lawsuits, or other obligations associated with your business (including the actions of any employees).
In the event that a business's assets cannot cover a debt or lawsuit, a sole proprietor's personal assets may be seized to cover the difference.
3. Mixing personal and business funds
Mixing funds as an LLC
When you structure your business as an LLC, it is absolutely crucial to maintain a careful separation between personal and business banking records, both to keep things above board with any other members the LLC may have and to protect yourself from liabilities.
In cases where LLC members combine personal and business funds, they may lose the limited liability protection that the LLC provides in the first place.
Mixing funds as a sole proprietor
Unlike with an LLC, sole proprietors don't have to worry about mixing business and personal accounts from a legal standpoint. This is because, in the eyes of the law, a sole proprietor is regarded as one and the same with their business.
That said, mixing funds is still discouraged by most experts as it can complicate taxes (and any potential audits that may happen).
4. Registering a business
Registering an LLC
State regulation of LLCs includes required words that must be included in an LLC name—for example, "LLC" or "limited liability company" might be required at the end of an LLC's name. Registering your LLC does give your name protection within your state.
Registering a sole proprietorship
Sole proprietors don't face the same requirements. However, if the business owner plans on operating under a company name instead of under their own name, they will need to register for a "fictitious business name," or DBA ("doing business as"), in their home state.
5. Tax considerations
Taxation in an LLC
By default, all profits made by an LLC are only taxed once, a process known as pass-through taxation. As the owner, the tax liability belongs to you and passes through to your personal tax return. For multi-member LLCs, pass-through taxation occurs for all members according to the amount of profit they received from the company that year.
To file taxes, you report your operating results, including profit or loss, by submitting Profit or Loss From Business (Sole Proprietorship) (Form 1040, Schedule C) with your personal 1040 tax return. An LLC is very flexible and can also be taxed as a sole proprietorship, a partnership, or a corporation.
Both LLCs and sole proprietorships are required to collect and remit local sales taxes where appropriate.
Taxation in a sole prorpietorship
A sole proprietor also benefits from pass-through taxation, so you'll report your business's income or loss in the same way. Unlike with an LLC, sole proprietors don't have the option to file as a corporation.
You're also not required to pay taxes on the full amount of your sole proprietorship's income. Instead, you'll only pay taxes on the profit of your business.
Finally, sole proprietors are typically required to pay self-employment taxes, which, in turn, usually necessitate quarterly payments. These extra taxes make it especially important for sole proprietors to maximize deductions wherever possible.
How to activate each structure for your business
Once you've decided between a sole proprietorship and an LLC, you'll need to actually "activate," or form, your business.
Activating an LLC
While slightly more involved than the process regarding a sole proprietorship, forming an LLC is still a fairly straightforward process. To do so, you'll need to file articles of organization, sometimes called a certificate of organization, with the state where your business intends to operate.
Remember that the required paperwork and process can vary significantly by state, so it's often best to work with a dedicated LLC service to ensure everything is done properly.
In addition to registering your LLC, it's typically wise to also draft an operating agreement for your LLC. This document outlines the rights and duties of members and managers within the LLC.
Finally, you should also expect to file certain forms with your state agency, usually the Secretary of State, and pay an initial filing fee that can range from $50 to $500. LLCs also have to file annual or periodic reports, so keep careful records throughout the year.
Activating a sole proprietorship
Unlike an LLC, no formal action is required to form your sole proprietorship if you are operating under your own name. If you want to use a different name, you will need to file for a DBA.
You may also need to acquire any mandatory licenses or permits, and these requirements vary by region, state, and industry.
Who should form an LLC?
If you're still unsure where you land on the sole proprietorship vs. LLC debate, take a moment to think about the nature of your business. Ask yourself the following questions. If you answer yes to one or more, an LLC might be the right choice.
- Does your business include meaningful risk? If your business is in retail, manufacturing, involves physical activity, or handles high-value assets, the personal liability protection of an LLC may be worth it.
- Are you looking for investors? Almost as a rule, investors prefer LLCs over sole proprietorships when looking for investment opportunities.
- Do you plan to operate in multiple states? While it's entirely possible to operate a sole proprietorship in different states, an LLC provides more consistency and structure, making it simpler to navigate varying state regulations.
- Do you have partners (or will you in the future)? If you intend to run your business in cooperation with one or more partners, an LLC (and clear operating agreement) may be necessary to keep things running smoothly.
- Does your business' image matter to you? Regardless of whether you choose a sole proprietorship or an LLC, it's entirely possible to run a successful, respectable business. That said, many people in the professional world view LLCs as more formal or stable than a sole proprietorship—and that view may help your business thrive.
Who should form a sole proprietorship?
Despite the substantial benefits offered by an LLC, it's possible that a sole proprietorship is enough for your business's needs. In order to make sure, ask yourself the following questions. If you answer yes to one or more, you might be able to get by with a sole proprietorship for a while longer.
- Is my business low-risk? If you're in a line of work or industry with relatively low risk and exposure, such as freelance writing or consulting, you may not need the personal liability protection of an LLC.
- How far along is your business? For business owners and entrepreneurs in the early stages of their business (or those simply testing an idea), it may be more efficient to stick with a sole proprietorship until your business is more developed. Remember, you can always convert your sole proprietorship to an LLC later on.
- Is your business seasonal or short-term? If your business primarily deals with seasonal work, such as a side hustle as a wedding planner, a sole proprietorship could very well suit your needs without having to form an LLC.
- Do you plan to self-fund your business? One of the main benefits of forming an LLC is the potential to attract investors. Conversely, those intending to fully self-fund their business may be fine with a sole proprietorship that avoids the need for external investors.
Frequently asked questions
How much does forming an LLC cost?
The cost of forming an LLC varies depending on your state, but it will typically cost between $50 and $500, which will be paid to the state itself. Beyond governmental fees, you may want to enlist the services of a lawyer or legal service to help with your registration and any operating agreement you plan to put in place, and the cost of these services can vary widely.
How much does forming a sole proprietorship cost?
One of the key benefits of choosing a sole proprietorship structure for your business is the lack of formation fees. Because you aren't registering with the state, "forming" a sole proprietorship is technically free.
Still, keep in mind that you'll need to pay self-employment taxes, which come out to an extra 15.2% between Social Security and Medicare.
Which structure is better for taxes?
Both LLCs and sole proprietorships offer different advantages when it comes to taxes, but it's widely agreed that an LLC will give you greater flexibility and options when tax season comes around. Additionally, keeping business and personal finances separate via an LLC can make filing taxes clear and more straightforward.
For a sole proprietorship, make sure to keep careful track of any extra deductibles, such as your healthcare premiums. Also, consider keeping separate accounts for personal and business finances in case of potential audits.
Can you switch an LLC to a sole proprietorship (or vice versa)?
For businesses currently operating as sole proprietorships, converting to an LLC is as simple as filing the correct paperwork and registering with your state—the same as if you were forming a brand new business.
When attempting to convert an LLC to a sole proprietorship, the process is more complicated. First, you'll need to gather written approval from each member of the LLC. Then, you must file for a formal dissolution of the LLC with the same state in which it was registered.
Finally, you'll need to resolve any outstanding debts and any applicable business licenses to your new sole proprietorship.
Why is an operating agreement important for LLCs?
When forming a multi-member LLC, a clear, iron-clad operating agreement ensures that everyone is on the same page from day one. Not only will this agreement outline each member's involvement and ownership percentage, but it also stipulates what percentage of the company's profits each member is due.
By taking the time to build a proper operating agreement, you circumvent countless misunderstandings or issues later on.
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