When you’re ready to turn that idea or side gig into a fully-fledged business, how should you set it up legally? Should you work as a sole proprietor or form a limited liability company (LLC)? This article examines the advantages of an LLC vs sole proprietorship and what you need to know to make an informed decision.
What is a sole proprietorship?
A sole proprietorship is a business owned and operated by one person. All assets and income of the business belong to the proprietor. Legally, there is no distinction between the proprietor and the business entity.
Your name is the name of the business by default. Profits of the business are included in your personal income and taxed through your individual tax returns.
According to the Small Business Administration, roughly 87% of small businesses with no employees are sole proprietorships. Yet among small businesses with employees, that share drops to 14%.
Advantages of a sole proprietorship
The main advantage of sole proprietorship is its stunning simplicity.
- Easy and inexpensive to form: You don’t have to form a legal entity in order to set up shop as a sole proprietor. The only paperwork you need to worry about is any business licenses required to conduct your operations, which vary based on your location and the nature of your business. You can file a "doing business as" (DBA) name, but it is generally not required so long as you are operating under your own name. Beyond doing your due diligence on business license requirements, you can start working with very little hassle or fanfare.
- Simpler paperwork: Even after your business is launched, it takes far less paperwork to maintain a sole proprietorship than any other business structure. Taxes are managed through your personal tax filings. It really couldn’t be simpler.
Disadvantages of a sole proprietorship
For legal and tax purposes, the sole proprietor and the business are one. That keeps things very tidy, but it also brings risks.
- Legal liability: If you’re working as a sole proprietor, any lawsuits filed against your business are filed against you personally. While you can buy liability insurance to cover specific risks, every policy has limits and exclusions. Your personal assets can be seized to make up the rest.
- Financial liability: In its 2019 , the Fed Small Business collaborative found that 64% of small businesses faced financial challenges, and more than two-thirds used personal funds to address them. Mingling personal and business assets leaves the owner without a personal safety net should the business suffer financial hardship or enter bankruptcy.
What is a limited liability company?
An LLC is a business entity formed and owned by one or more members. Unlike a sole proprietorship, whose owner is personally liable for any claims against the business, an LLC is a legal entity with its own income, assets, and liabilities. This is the main difference between sole proprietorships and LLCs.
Advantages of an LLC
The main advantage of an LLC vs a sole proprietor is the legal and financial protection it provides for its members. An LLC also provides greater flexibility in ownership and taxation.
- Limited liability: If someone sues an LLC, the defendant is the business, not the business owner. If an LLC falls on financial hard times, creditors can come after the assets of the business, but not of its members. For example, consider an HVAC business that installs a boiler in a commercial building. The boiler leaks, flooding the building and causing major property damage. The building sues the contractor for faulty installation. If the business is a sole proprietorship, the owner’s home, personal cars, and bank accounts are at risk of being liquidated to pay any resulting judgments. An LLC, on the other hand, takes your personal assets right off the table.
- Flexible ownership: Sole proprietorships are owned by a sole owner, but LLCs may be owned by multiple members. Ownership may be split evenly or in specific shares based on each owner’s investment.
- Tax options: LLCs are taxed as sole proprietorships or partnerships by default, which means profits pass through to the owners’ personal income based on their share of ownership. An LLC can also choose to be taxed as an S corporation or C corporation by filing an election with the Internal Revenue Service. This can provide savings on employment taxes, but it is generally advantageous for larger firms. Seek guidance from your financial advisor to determine which structure results in the best tax rates for your business.
Disadvantages of an LLC
While LLCs provide very welcome protections and flexibility for small businesses, there are some drawbacks to consider.
- Complexity: LLCs are more complicated to set up and run than sole proprietorships. To form an LLC, the business will need to conduct a name availability search to see if there are competing businesses with the same name and to ensure that the name meets any state regulations for the specific business type. The business will also need to file formation documents with the state and appoint a registered agent to receive legal notices and other official documents. In many states, the business will have ongoing filing requirements such as annual reports. Greater tax options further add to the complexity.
- Costs: To establish an LLC, you can expect to pay state fees ranging from $50 to $300, along with additional fees for ongoing filings. You’ll also need to invest time in completing the filings or pay a service to handle the paperwork for you. All of this adds up to greater administrative costs to set up and maintain the business entity.
How to decide between a sole proprietorship and an LLC
Both sole proprietorships and LLCs are relatively simple business structures. Which structure is best for you depends on the nature of your work, your risk tolerance, and your vision for your business. When weighing your options as a sole proprietor vs LLC, consider the following:
Conduct a realistic and comprehensive risk analysis of your business. Do you have premises frequented by clients or vendors? Do you provide products or services that can cause physical, financial, or emotional harm? Think of the worst errors you could make, and then imagine being sued for the damages.
Your insurance agent and your legal advisor can help you assess your risk and determine the best ways to address them. Bottom line: An LLC is the way to go to protect your personal assets from creditors and lawsuits.
Both sole proprietorships and LLCs are pass-through entities, with profits from the business passing through to the owners’ personal income tax.
This simplifies small business tax filings and qualifies the owner for the 20% qualified business income (QBI) deduction provided by the 2017 Tax Cuts and Jobs Act. An LLC can also choose to be taxed as a corporation, however.
This allows the owners to take some profits as personal income in the form of salaries and other profits as shareholder dividends, reducing taxable wages. Generally, electing to be taxed as a corporation becomes favorable as a small business grows larger.
Control of the business
As a sole proprietor, you get to call all the shots. Then again, when things go wrong, you have to take all the shots, too. An LLC opens up the possibility of splitting ownership between one or more members.
This provides great flexibility, but also profoundly changes the nature of the business, from business development to succession planning. If you like the idea of sharing the challenges and excitement of business ownership with a team, an LLC can let you do so.
Another factor to consider is the extra regulatory requirements for LLCs. If you decide to form an LLC, you will need to complete periodic filings to maintain the legal entity in your state of formation and possibly in other states where you do business.
That takes time and money, and sometimes additional professional services and advice.
Find the ideal structure for your business
Clearly, there are many factors to consider when choosing the best legal structure for your business. For cost, simplicity, and control, the sole proprietorship is the clear winner. But the LLC has the edge for risk management and flexibility.
Both structures qualify for pass-through taxation, with additional tax options available to LLCs. If you consider all of these factors, and talk them through with your financial, insurance, and legal advisors, you can ensure that your small business has a firm foundation for your biggest plans.