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If you’re setting up or developing your business, you may be faced with the question: which is better when it comes to sole proprietorships and LLCs?
These two structures are rather different, and each one offers potential benefits and drawbacks for your business.
As such, it’s a worthwhile exercise to explore how and why they can impact your goals.
In this article, we’ll cover:
- What a sole proprietorship is
- What an LLC is
- How they affect the way your business operates
- Which structure is right for you
- An LLC confers limited liability to its owner, which means that the owner and business are legally distinct. Only the business is liable for debts incurred.
- Sole proprietors are business owners who run an unincorporated business.
- Both LLC owners and sole proprietors pay tax on their business earnings as part of their personal tax returns.
- Sole proprietorships require less paperwork to register with your state, but both sole proprietorships and LLCs are less onerous to establish than corporations.
A sole proprietorship is when a small business is run by only one owner who pays personal income tax on the business’s earnings.
Sole proprietorships only have one owner – hence the “sole” part of the structure’s title!
This is distinct from a corporation, whose owners are the collection of shareholders who each own a stake in the business.
Sole proprietorship is a path many startup founders, entrepreneurs, or contractors take when they set their business up as a small or local enterprise and want to establish or develop a brand for themselves while retaining complete control.
It’s important to note again that a sole proprietor pays tax on the profits and losses of their business as part of their personal tax returns so there isn’t a corporate tax rate attached to a sole proprietorship.
A sole proprietorship is not a separate entity to its owner, so there is no liability protection conferred by this structure.
Limited Liability Company (LLC)
The first thing to understand about an LLC is that it is a separate legal entity in which the owners are referred to as “members”.
Members can be anyone from individuals to other businesses or LLCs.
In most cases, a sole owner can have charge of an LLC as its only member, but it’s just as common to have multiple members.
An LLC is separate from its members, and as such, provides limited liability protection.
That means that the individual members are not able to be pursued by the LLC’s creditors.
This is one of the significant features that separates an LLC from a sole proprietorship.
LLCs do not have shareholders; instead, the members share in the profits generated by an LLC.
Since the owners of an LLC can be individuals or other businesses, it’s not uncommon to see businesses set up an LLC to trade in a specific market or location.
In this arrangement, the profits generated would funnel back to the owning member whether that be an individual, a corporation, or another LLC.
LLC members also pay taxes on their business profits and losses as part of their personal tax returns, though they can apply to pay a corporate tax rate in some instances.
What’s the difference between a sole proprietorship and LLC?
|Does not confer limited liability to the owner of the business
|Confers limited liability protection to the members of the LLC
|Only one owner, hence “sole” proprietorship
|Can have multiple owners, referred to as “members”
|Owner pays taxes on profits and losses through their personal tax returns
|Members usually pay taxes as part of their personal returns but may apply for a corporate tax rate
Advantages & Disadvantages
There are advantages and disadvantages of both sole proprietorships and LLCs, and understanding how they work can help you make an informed decision on what is right for you.
The major advantage of a sole proprietorship is that you are the only owner and decision maker, meaning anything that happens is your call.
This makes a sole proprietorship flexible to change and react to market demands.
It also means that when you’re ready to wrap things up, you can close a sole proprietorship easily.
An LLC has multiple members that each have a share of decision-making power.
This means there is a greater need for consensus building and split responsibility.
One advantage of an LLC is that you have limited liability protection, meaning you will not be on the hook for business debts personally.
LLCs are more complex to set up and require more detailed and formal paperwork.
How to choose between an LLC and a sole proprietorship
Deciding whether an LLC or a sole proprietorship is more useful for you is going to come down to a question of your goals and business requirements.
If you’re looking for a flexible business structure in which you are in charge from top to bottom, a sole proprietorship may be the best option.
Plumbers, electricians, small producers, and other local businesses are most likely to be sole proprietorships.
If you’re looking to stand something up with co-founders and perhaps trade further beyond your hometown, an LLC might be the better choice for you.
The limited liability protection of an LLC can be ideal for those undertaking bigger enterprises with employees and equipment.
Sole proprietorship vs. LLC: Which option is best for you?
Now you understand the distinctions between sole proprietorships and LLCs, you may have come to the realization that there is no one-size-fits-all approach.
Instead, the decision you make will depend entirely on your circumstances and goals.
Go with a sole proprietorship if you are looking to be a single owner-operator working both in and on your business with flexibility.
On the other hand, choose an LLC if you’re looking to expand more, take on employees, and share responsibilities with other members.
Is an LLC taxed like a sole proprietorship?
Largely, yes. Both sole proprietorship owners and LLC members pay taxes on business profits through personal returns.
However, an LLC may apply for a corporate tax rate.
Can you convert a sole proprietorship to an LLC?
Yes, you can. The process is the same as setting up a new LLC from scratch and requires detailed registration paperwork.
Is a single-member LLC the same as a sole proprietorship?
No, a single-member LLC runs like an LLC and has all the same advantages and drawbacks.
Just because it has only one member does not make it the same as a sole proprietorship.