LLC Vs. Sole Proprietorship: What’s the Difference?

Various business models and enterprises pose distinct challenges and offer diverse advantages. Among these setups are sole proprietorship and limited liability companies (LLCs).

This article will help you differentiate the two in terms of their management structure, tax implications, and other key factors that can affect your business.

Why the Right Business Structure Matters

Legal Liability

The business structure determines the extent of personal liability for the owners. For example, owners are personally responsible for business debts and liabilities in a sole proprietorship or partnership. In contrast, a corporation allows you to separate personal and business assets. Choosing the right structure helps protect personal assets in case of legal issues or debts.

Tax Implications

Different business structures have varying tax implications. Sole proprietorships and partnerships often pass profits and losses through to the owners’ personal tax returns. Corporations, on the other hand, may face double taxation, where the company is taxed on profits, and shareholders are taxed on dividends.

Operational Flexibility

Business structures can dictate the level of control and decision-making within the organization. Sole proprietors have complete autonomy but may face challenges in raising capital. Corporations, with a board of directors and shareholders, distribute decision-making but offer more options for capital investment.

Defining an LLC and a Sole Proprietorship

A sole proprietorship is owned by one person only. It is an unincorporated business and is the simplest option for individuals looking to start their companies. No legal distinction exists between the owner and the business in a sole proprietorship. That is why sole proprietorship owners are personally liable for the debts of their businesses.

On the other hand, a limited liability company or LLC is a separate business entity with the combined elements of sole proprietorship, corporation, and partnership. LLCs can either be single-member or multi-member entities.

Since it’s a separate legal entity, the LLC members are not personally responsible for their liabilities. This also means that the owner’s assets are separate from business assets.

Key Differences

Business Formation

Someone who operates a business on their own is considered a sole proprietor. For instance, freelancers and retailers can incorporate their entities differently to benefit their objectives and goals as sole proprietors. However, given that there is no distinction between business and personal assets in sole proprietorships, everything in the business is at risk. It is also much more difficult to attract potential investors for raising capital for sole proprietorships.

Sole proprietors will only need a DBA or a “doing business as” certificate to function if they want to operate and do their business under their own name. Depending on their business and service, they might also have to acquire specific business licenses and zoning permits. Bear in mind that operating a sole proprietorship under one’s name is perfectly legal, so it’s the owner’s personal decision if they want to do business under a new company name or use their own.

LLCs might still need a DBA on top of other business permits, but it is not a requirement. LLCs that want to operate under a trade name must file articles of organization when forming the LLC. This document creates the rights, duties, powers, and liabilities between the company and its members. More importantly, it establishes the company’s existence.

Filing fees vary across every state. If you’re filing these permits in Nevada, it will cost you $425. Other states can cost more than this.

Operation and Management Structure

A sole proprietorship has a simple management structure since only one person manages and decides on the business. Although sole proprietors hire employees, accountants, and legal experts, the owner still has to oversee business operations.

As for LLCs, the entity can have a more complex structure usually provided in an operating agreement since it can have multiple members. The agreement will contain each member’s share in the company, profile share, voting rights, and the like.

The members usually decide in proportion to their share. For instance, a 20% owner would have a one-fifth vote, while a 33% owner would have a one-third vote. The 20% owner would also get one-fifth of the profits, while a 33% owner would acquire one-third of the company earnings.

Personal Liability Protection

As stated earlier, a sole proprietorship doesn’t provide a legal distinction between the business and the owner. The sole proprietor is personally liable for the debts and finances of the business. If the business suffers bankruptcy, the owner must also file for personal bankruptcy, as the proceedings will include both personal and business debt.

Forming LLCs is best suited for protecting one’s personal assets from the business. There is a legal separation between the owner and the LLC, which frees the owner or owners from the liabilities of the LLC. Unlike sole proprietorships, owners don’t need to file for bankruptcy should the LLC become bankrupt. In the same way, the creditors of the LLC have no legal standing to come after the personal properties and assets of the owners.

However, take note that LLC owners can still be held personally liable for fraud or negligence. No business type provides absolute protection for the owners.

Financial Management

It was mentioned that in a sole proprietorship, there is no distinction between an owner and the business. This allows the owner to mix personal and business funds. However, most financial experts disapprove of this practice.

In an LLC, the company has a separate account to prove that the owners and the LLC are independent financial entities. Creating a separate account lets owners handle the finances of the LLC better and avoid losing its limited liability protection.

Taxes

A sole proprietorship and single-member LLC are pass-through entities, meaning the taxes are directly passed to the owners. The taxes are paid by the owners instead of the business. Also, the owner’s tax return includes a Schedule C to report earnings from the company.

A multi-member LLC can also pay taxes as a pass-through entity. However, a multi-member LLC must file a business tax return using Form 1065. Each member’s tax return should also include Schedule K-1 to show their share of the company earnings. Some states also require franchise, business, or LLC taxes. Businesses with employees need to pay payroll taxes. Sales taxes apply to those businesses that sell taxable goods or services.

But what’s the primary difference between LLC and sole proprietorship taxes?

Between the two entities, only an LLC can choose corporate tax status. Instead of filing Form 1065, LLC owners must file Form 1120 under the Internal Revenue Service (IRS) rules. Hence, LLC owners can choose between pass-through taxation through the S-corporation status or corporate tax through the C-corporation status.

Pass-through taxation requires the sole proprietor and members to pay taxes on all profits. On the other hand, corporate taxation imposes a lower tax rate on dividends. Also, the IRS does not subject a corporation’s retained earnings to income tax. Moreover, an LLC with a C-corporation status can enjoy more deductions and credits.

Paperwork and Compliance

As established earlier, an owner of a sole proprietorship will only have to apply for a DBA certificate. After that, the sole proprietor must pay federal, state, and local taxes. Moreover, the owner must renew business permits to operate legally.

On the other hand, an LLC has more responsibilities when it comes to paperwork. An LLC must file annual reports in some states. Moreover, it is highly recommended that multi-member LLCs prepare documents for compliance concerning the following:

• Operating Agreement
• Membership Units
• Transfers of Ownership

Frequently Asked Questions

Are there any specific formalities or paperwork required to establish an LLC compared to a sole proprietorship?

Yes, forming an LLC involves more formalities and paperwork than starting a sole proprietorship. To establish one, you must file articles of organization with the state, create an operating agreement, and obtain an EIN. In contrast, a sole proprietorship requires only the necessary licenses and permits for the specific business.

Do both LLCs and sole proprietorships require a separate business bank account?

While it is not legally required for sole proprietors to have a separate business bank account, it is highly recommended to maintain clear financial separation between personal and business transactions. For LLCs, a separate business bank account allows them to maintain the limited liability protection that the business structure provides.

Is an LLC better for taxes?

LLCs are known for their flexibility in taxation, allowing members to choose between pass-through taxation, where profits and losses are reported on individual tax returns, or corporate taxation, which may be advantageous in certain situations.

Do you need to register your business name for both LLCs and sole proprietorships?

For a sole proprietorship, registration requirements for a business name depend on the locality, but in many cases, a business owner can operate under their legal name without formal registration. In contrast, an LLC often requires the registration of a business name with the state as part of the articles of organization.

Can a sole proprietorship be converted into an LLC and vice versa?

Yes, it is possible to convert a sole proprietorship into an LLC without losing business history. This process involves transferring assets, contracts, and licenses to the newly formed LLC. Conversely, an LLC can be converted into a sole proprietorship by dissolution, though the exact process may vary by jurisdiction.

Which Is Better: An LLC or a Sole Proprietorship?

Most freelancers and new business owners would often start as sole proprietorships due to the simplicity of the entity. However, the sole proprietorship setup can start to have issues once the business starts to grow and scale up. This is why LLCs are better options in the long run since owners are protected from business liabilities and have more taxation options.

Setting up an LLC in Nevada is even better since you won’t have to worry about franchise tax, operating agreements, stock transfers, and other taxation and additional red tape.

Contact a business startup specialist if you want expert recommendations on LLC formations, asset protection strategies, and other business matters. At NCH, you will get expert assistance from people who have been helping business owners for over 30 years.

DISCLAIMER: The above material has been prepared for informational purposes only, containing opinions of the provider and is not intended to provide, and should not be relied on for, tax, legal, or accounting advice. Please consider consulting tax, legal, and accounting advisors before engaging in any transaction.