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One of the first decisions you need to make as a new business owner is to decide on an organizational structure. Two common types are sole proprietorships and limited liability companies (LLCs). Both of these business structures have their own advantages and costs. We at the MarketWatch Guides team prepared this comprehensive guide to help you determine which one is right for you.
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What Is an LLC?
An LLC is a flexible business structure that provides its owners (called members) with limited personal liability for business debts while offering pass-through taxation. It is established under state-specific laws and offers high flexibility in management and operation. For instance, business owners can tailor their LLCs to how they want to conduct business and even how they want to be taxed. This versatility makes LLCs appealing to a wide range of entrepreneurs, whether a single individual forming a one-person company or a group of people creating a multi-member organization.
The most significant advantage of an LLC is the protection it provides to its owners, known as members. This protection acts as a shield, separating the owners’ personal assets from the company’s liabilities. In general, the members’ personal wealth is safeguarded if the business faces financial troubles or legal issues. Creditors and litigants typically can’t reach beyond the business assets to the personal holdings of the LLC’s members.
What Is a Sole Proprietorship?
A sole proprietorship is the most basic business structure, characterized by a single owner running the entire operation. It’s the default business structure for individuals who start selling goods or services without formally establishing with the state government. This applies to a wide range of entrepreneurs, from freelancers to e-commerce sellers. The simplicity and low cost of setting up a sole proprietorship make it an attractive option for many small business owners.
The key characteristic that distinguishes a sole proprietorship is the lack of legal distinction between the owner and the business. This means that the proprietor has complete control over the business but also bears full responsibility for its financial obligations. While many sole proprietors simply use their own name for business purposes, they can also choose to operate under a brand or a distinct business name by creating a “Doing Business As” (DBA) name. However, this doesn’t change the owner’s personal liability for business debts.
LLC vs. Sole Proprietorship Comparison
Below, we compare LLCs and sole proprietorships across four major considerations: ease of formation, tax structure, legal protections and ongoing compliance requirements.
Ease of Formation
Forming a sole proprietorship is significantly faster and simpler than creating an LLC. A sole proprietorship can be established instantly, as it is the default business structure when an individual starts operating a business without formally registering it. There are typically no formal registration requirements or costs, though you may need to obtain certain licenses or permits depending on your location and industry.
In contrast, forming an LLC is a more complex process that usually takes several days or weeks, depending on the state. The cost of forming an LLC varies by state but generally ranges from $35 to $500 in filing fees. The process requires filing Articles of Organization, a form that asks questions about how the business will operate.
LLCs are also required to select a registered agent to receive service of process and state communications on behalf of the company. Many choose to hire a professional service, which can cost around $100 to $250 per year.
While it’s possible to form an LLC without professional assistance, many entrepreneurs choose to pay for LLC services to access experts who can help with the Articles of Organization and other compliance obligations. This additional complexity and cost are balanced by the benefits of liability protection and potential tax advantages that LLCs offer.
Tax Structure
By default, single-member LLCs and sole proprietorships are treated as pass-through entities for tax purposes, meaning the business income is reported on the owner’s personal tax return. However, LLCs have the unique advantage of tax flexibility. Unlike sole proprietorships, LLCs can elect to be taxed as S corporations or C corporations. This flexibility allows LLC owners to choose the most advantageous tax structure for their situation, potentially leading to tax savings.
How does electing to be an S or C corporation save LLCs money? Sole proprietors must pay self-employment taxes on their entire net business income. On the other hand, LLCs can potentially reduce self-employment taxes by electing corporation status. That way, owners can pay themselves a reasonable salary and take the rest of the revenue as distributions, which aren’t subject to self-employment taxes.
In sum, if an LLC and a sole proprietorship earn the same amount of money, the tax burden could be different if the LLC chooses an alternative tax status. However, if both are taxed as pass-through entities, the tax amount would generally be the same, assuming all other factors are equal. The state-tax implications for each structure also vary depending on state-specific laws.
Legal Protections
The legal protections offered by LLCs and sole proprietorships differ significantly. LLCs have a clear advantage in terms of personal assets. In the event of a lawsuit, a sole proprietor would face a much higher risk to their personal assets compared to an LLC member.
If a sole proprietorship were sued and lost the case, the owner’s personal assets, including their home, savings and other possessions, would be vulnerable to seizure to satisfy the judgment. This is because there’s no legal separation between the sole proprietor and their business, making the owner personally liable for all business debts and obligations.
In contrast, if an LLC were sued and lost, the plaintiff would generally be limited to pursuing the business’s assets, leaving the LLC members’ personal assets shielded from the judgment. This “corporate veil” provided by the LLC structure is a significant advantage, as it allows business owners to operate with reduced personal financial risk.
However, it’s important to note that this protection isn’t absolute; LLC members can still be held personally liable in cases of fraud or negligence. LLCs can also forfeit liability protection if they combine personal and business funds. This is why it’s critical to use a separate business bank account. Nonetheless, the LLC structure emerges as the clear winner in a standard lawsuit scenario.
Ongoing Compliance Requirements
Sole proprietorships and LLCs have distinct ongoing compliance requirements. Sole proprietors generally don’t need to file any regular reports with state or federal agencies. They simply report their business income and expenses on Schedule C of their personal tax return. As mentioned previously, some sole proprietorships may need business licenses or permits. For the ones that do, renewal is usually required on an annual basis.
LLCs may also have licenses or permits that require annual renewal. Apart from that, their ongoing compliance requirements are usually more extensive. Most states require LLCs to file annual or biennial reports, often called statements of information, which update the state on any changes made to business operations (e.g., if there’s a new member or the registered agent is different). Failure to file these reports can result in late fees or even dissolution.
Additionally, multi-member LLCs treated as partnerships for tax purposes have certain tax filing obligations. They must file an annual informational tax return (Form 1065) with the IRS and prepare a Schedule K-1 form for each owner.
The Bottom Line
The choice between a sole proprietorship and an LLC depends on various factors. Sole proprietorships are easy and affordable, ideal for small or new ventures. At the same time, LLCs provide legal protection and tax flexibility at the cost of more complexity and initial expense. The decision should be based on the business’ specific operations, goals, risks and growth plans.
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Frequently Asked Questions
There is no universally “better” option between starting a sole proprietorship or an LLC, as the choice depends on your specific business needs and goals. Sole proprietorships are simpler and less expensive to set up and maintain, making them ideal for operating low-risk, small-scale businesses or testing new business ideas. However, LLCs offer personal liability protection and more flexibility in management and taxation, which can be advantageous for businesses anticipating growth, seeking investor funding or operating in high-risk industries.
By default, single-member LLCs and sole proprietorships are taxed similarly. They are treated as a pass-through entity, which means all business income is reported on the owner’s personal tax return. However, LLCs have the advantage of tax flexibility, allowing them to elect to be taxed as S corporations or C corporations. This may lead to reduced self-employment taxes or other tax benefits.
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