LLC vs. Sole Proprietorship: Which is Right for You?
Whether you choose to operate your business as an LLC or a sole proprietorship will depend on several factors, like your tolerances for risk and paperwork. LLCs provide liability protection but require paperwork and fees—sole proprietorship is low maintenance but leaves your personal assets vulnerable. Let’s weigh the benefits and drawbacks of each as you form your business and look to its future.
Defining LLCs and Sole Proprietorships
Before we dive into the details, let’s establish some basic vocabulary.
What is a limited liability company (LLC)?
In the United States, limited liability companies are a type of business entity that provides strong liability protection to its owners. By default, LLCs are taxed as pass-through entities. This means owners pay taxes on profits on their personal tax returns instead of paying the corporate tax rate, like a corporation. To start an LLC, you file paperwork with the state and pay a fee ranging from $35 to $500, depending on your state.
What is a sole proprietorship?
A sole proprietorship is the simplest type of business. When you start selling a product or providing a service without formally registering with the state, and you’re the only owner, you become a sole proprietor. If you do this with a partner or partners, your business is a general partnership. Sole proprietors are also taxed as pass-through entities, but they don’t benefit from any personal liability protection.
Comparing LLCs with Sole Proprietorships
By design, LLCs and sole proprietorships have a lot in common. Limited liability companies developed as a hybrid model between a sole proprietorship and a corporation in order to offer small business owners the best benefits of each. However, they also differ in a few key ways that may help you decide which is right for your business.
Limited Liability Companies
VS
Sole Proprietorships
Limited—corporate veil shields personal assets from business debts.
Unlimited—the owner is individually responsible for all business debts & obligations.
Multiple owners allowed, can be member-managed or manager-managed
Single owner responsible for all management of business
Pass-through by default, with options to elect a corporate tax status.
Pass-through only
Filing Articles of Organization varies by state, from $35-$500
Ongoing compliance requirements, like annual reports and/or franchise taxes, also vary by state
Local required licensing and permits only; may be one-time or incur regular renewal costs
Liability
Limited liability companies are named for their most beneficial asset: limited liability. Because an LLC is a legally distinct entity from its owners, a so-called corporate veil protects members’ personal assets in the event of a lawsuit or bankruptcy. The corporate veil is a term used to illustrate the legal separation between a business owner and the business itself.
Unlike corporations, LLCs have relatively few operational requirements, making it far more difficult to pierce that veil. Typically as long as members are careful to keep their business assets separate from their personal assets, the veil remains intact.
Unfortunately for sole proprietors, your liability is unlimited. This means that you and your business are legally considered one and the same. If your business falters and bills start piling up, or if misfortune strikes and you find yourself facing a lawsuit, every personal asset in your name is potentially on the line to repay business debts and other obligations.
Ownership Management and Structure
In most states an LLC can be owned by one person, just like a sole proprietorship. Unlike a sole proprietorship, an LLC can be owned by many individuals or other businesses, including other LLCs, corporations, and foreign entities.
LLCs have a lot of management flexibility as outlined in their operating agreement. An LLC’s operating agreement is basically a contract defining how an LLC will be owned and manged—and LLC owners have the power to define roles and procedures in this document. In a member-managed LLC, members decide the day-to-day operations of the LLC themselves. In a manager-managed LLC, the members hire managers to make those choices.
A sole proprietor has just the one owner—you—responsible for all business decisions. These run from daily operations and hiring choices all the way up to long-term goals and strategies.
Taxation Options
Limited liability companies are taxed as pass-through entities by default. The LLC itself doesn’t pay taxes; instead, members pay federal taxes as part of their own tax returns. However, LLCs can opt into different tax classifications: S-Corp or C-Corp.
LLCs can choose to be taxed like C-Corporations instead. You’ll file IRS Form 8832 and choose the option to be classified as an association taxable as a corporation. Then, your LLC will file Form 1120, the U.S. Corporation Income Tax Return, to pay federal income tax at the corporate tax rate of 21%. Members will then pay additional earned income tax on their personal tax returns.
If your LLC qualifies, you can be taxed as an S-corporation by filing IRS Form 2553. The major benefit here is avoiding that double-tax—S-corporations are treated as pass-through entities—while also reducing tax liability for financial distributions that aren’t counted as earned income. Be sure to consult with a legal advisor to make the best choice for your business.
Sole proprietors can only be taxed as pass-through entities. The technical term the IRS uses is “an entity disregarded as separate from its owner,” which is a fancy way of saying that the owner (or sole proprietor) and the business (the sole proprietorship) are legally the same entity. You’ll file Schedule C as part of your personal annual tax return.
Costs
LLCs cost more to form and maintain than sole proprietorships. Filing your articles or certificate of organization with your Secretary of State can run between $35 in Montana to $500 in Massachusetts before any service fees, and in Tennessee you’ll pay per number of members up to $3000 ($300 minimum). Some states require you to file an initial report too.
Most states have ongoing compliance requirements, like annual or biennial reports. A few have additional franchise tax payments due each year—California LLCs pay $800 annually in franchise taxes. You’ll also need all the same business and occupational licenses and permits as a sole proprietor.
Sole proprietors have it significantly easier. Since there’s no formal registration or formation requirement, you just need to acquire the right permits and licenses for running your business. Check with your city, county, and state to cover all your bases.
Registered Agent Requirement
Registered agents ensure that service of process and other legal documents reach the right hands. Every state requires registered businesses like LLCs to maintain one. While members can elect to take on this role, many limited liability companies hire a professional registered agent service for perks like increased reliability, privacy, and a superior customer experience. For example, Registered Agents Inc files our clients’ annual reports for them.
Sole proprietorships aren’t registered businesses, so owners don’t need to worry about registered agent requirements.
BOI Reporting Requirement
Limited liability companies must file a Beneficial Ownership Information report unless they fall into an exempted category. Required by the Corporate Transparency Act, this report contains information about the individuals who own at least a quarter of the LLC or otherwise exercise substantial control over it.
Sole proprietors don’t qualify as reporting companies, so they don’t need to submit a BOI report.
Note: On December 26, 2024, the U.S. Court of Appeals paused the BOI reporting requirement, citing constitutional concerns. While it’s not mandatory for now, we’re still ready to assist you. Check back for more updates and future filing deadlines as they become available.
From Sole Proprietor to LLC
If you’re a sole proprietor considering changing over to a limited liability company, you’re in good company. Making the switch can help you access funding—banks and investors tend to see LLCs as more credible—and grow your business, and there are only a few steps you’ll need to take.
- Appoint a registered agent
Every state requires LLCs to maintain a registered agent or equivalent, so choosing one first makes filing your formation paperwork that much easier. - Form your LLC
File your articles or certificate of organization and an initial report where required, and pay your filing fees. We have guides to walk you through the process for each state. - Get an EIN and a business bank account
You’ll want a new EIN to differentiate your LLC from your sole proprietorship, and establishing a business bank account helps maintain the corporate veil. - Cancel or withdraw your DBA
If you were using a DBA (“doing business as” name, trade name, or fictitious business name) for your sole proprietorship, cancel or withdraw it. - Update your customers
Celebrate your next steps in your marketing materials—your website, social media profiles, business cards, email newsletters, etc. Now’s also a great time to establish a professional email and phone line, and get a custom domain name if you need one.
Choosing the Right Option for Your Business
Understanding the costs and benefits of LLCs and sole proprietorships can help you make informed decisions about your business’s present and future. An LLC offers increased protection through limited liability and more tax flexibility. On the other hand, a sole proprietorship offers simplicity and low-cost entry. The right choice ultimately depends on your own business goals.
Need help forming your business? Give our experts a call. With over 15 years of industry experience, we’re ready to help you turn your vision into a thriving enterprise.