If you're looking to start your own business, I'm willing to guess you've already heard this question at least a handful of times: "Are you going to become an LLC, or stay a sole proprietor?"
To understand the difference between an LLC and a sole proprietorship, let's start with an example.
Let's say I recently started selling hand-carved wooden picture frames. I'm selling them online on Etsy, Facebook, and a few other sites, and I'm doing pretty well – making roughly $5,000 per year.
Of course, this isn't my full-time job. It's a side business (or "side hustle", if you will). I do it because I enjoy it, and I make roughly enough money for an extra vacation each year.
Right now, I am a sole proprietor. That's how easy it is to become one … no paperwork or special tax filing necessary.
However, there are limitations to a sole proprietorship. For one, I am liable to lawsuits, and if someone chooses to sue me, my personal assets are at stake. Similarly, if my business is in debt, creditors can go after my home, car, or other personal property.
All of which is to say, if my business grows and becomes a full-time hustle, I might want to reconsider the risks I'm willing to take by filing paperwork to become an LLC, instead.
If you're reading this, you might be at a similar crossroads where you're unsure which business entity structure is right for you. Here, let's dive into the full advantages and disadvantages of an LLC versus sole proprietorship, so you can make the best choice for you and your business.
First — what is an LLC, anyway?
What is an LLC?
An LLC — otherwise known as a limited liability company — is just what the name implies. It's a business structure that is legally separate from its owner(s) and is created under state law. It's more formal than a sole proprietorship, but it also offers more flexibility than a corporation when it comes to tax and legal requirements.
One person or multiple people can own an LLC, and the government will view the LLC as a separate entity from you. This can prove beneficial for tax purposes, which we'll discuss later.
The biggest advantage of an LLC comes down to liability protection. Simply put, if you own an LLC, your personal assets aren't at risk if someone chooses to sue you; equally importantly, if your business goes bankrupt, your personal assets aren't at risk of being taken by creditors.
Oftentimes, an LLC is a good idea if you're hoping to scale as a start-up, hire employees, and make enough profit for this to be your full-time gig. We'll dive deeper into the pros and cons later.
However, an LLC might not be necessary if you are selling products or services as a side hustle for limited additional income. If this is the case, you might just want to stay as a sole proprietor.
Let's define a sole proprietorship, next.
What is a sole proprietorship?
If you've ever sold a product or service — for instance, if you operate as a freelancer, operate an online store, or even sell dog-walking services — you're already a sole proprietor.
A sole proprietor is the simplest type of business to run, since you are the business from a legal perspective. You can continue to use your personal checking account for your business' profits, and your business will be taxed under your own tax personal bracket. However, this also means you're personally liable for any business-related debts or lawsuits.
Learn more about sole proprietorships in this post, Sole Proprietorship 101: The Easy Guide to Setting One Up.
Single Member LLC vs Sole Proprietorship
Most small business owners default to a sole proprietorship, simply to avoid the paperwork and payments required to become an LLC. And, in terms of daily management — including hiring employees or freelancers, working with accountants, etc. — a single member LLC and sole proprietorship looks largely the same.
However, a single member LLC creates a divide between the business owner and the business itself for both tax and legal matters, while a sole proprietorship does not. If you own a sole proprietorship, then you will be taxed on your personal income regardless of how much revenue you generate from your business. This can become unnecessarily costly if your household makes a considerable amount, but your business doesn't.
Additionally, you are personally liable for any risks associated with your business. For instance, if your business becomes bankrupt, creditors can take your personal possessions.
On the flip side, a single member LLC likely needs to create an operating agreement, while a sole proprietor does not. Even if it's not required by your state, an LLC operating agreement is a legal document that helps your business appear more official and will cover important topics related to the management of your company — including ownership structure, member's voting rights, capital contributions, and distribution.
A single member LLC also needs to fill out additional paperwork and pay filing fees, compared to a sole proprietor. LLC owners also have access to venture capital.
Since tax is one of the biggest differences between an LLC and sole proprietorship, let's dive into that, next.
Tax Benefits of LLC vs Sole Proprietorship
Disclaimer: The information provided in this blog article does not, and is not intended to, constitute financial or legal advice. You're encouraged to speak with an attorney, advisor, or accountant before choosing your business entity structure and/or filing any taxes related to your business.
Simply put, if you're operating as a sole proprietor, you don't need to file separate tax returns for your business — instead, you will simply report any money you make off your business in your personal tax returns.
As a sole proprietor, the revenue you make from your business is taxed at your personal tax bracket. You will also need to pay a self-employment tax.
If you're not making too much additional income from your business, then it might be more cost-effective to remain a sole proprietorship, since filing a second tax return can result in additional costs (including the costs for filing the return, as well as any costs associated with hiring an accountant). Additionally, if you choose to file as an LLC, you will have to pay annual state filing fees, which range between $40 and $500.
It's also important to note — If you operate under a sole proprietorship, you can still create a DBA ("Doing Business As"), which enables you to get a federal tax ID number (EIN) and allows you to open a separate business account. A business account can offer its own liability protection by keeping your business funds separate from your personal account.
So … what's the difference between an LLC and sole proprietorship in terms of taxes?
Well, by default, not much. Both an LLC and sole proprietorship are "pass-through entities", which means both income gets taxed at the owner's personal income bracket. However, an LLC owner can elect for their LLC to be taxed as a C-corporation, which means you would only need to pay the flat 21% corporate income tax at the federal level, rather than your personal income bracket.
You also don't have to pay self-employment taxes, which saves you the money you were paying for FICA, social security, medicare, etc.
All of which is to say — if you're making a good amount of money off your business, an LLC might be the way to go. An individual who makes $100,000, for instance, needs to pay 24% income tax plus the 15.3% for self-employment. Compare that to the 21% you'll pay for corporate income tax if you're an LLC, and you can begin to see major differences in cost.
Pros and Cons of LLC Versus Sole Proprietorship
Okay, so we've covered a lot of information in this post — but, when it comes down to it, which option is best for you? Let's quickly cover the pros and cons of each so you can make the best decision for your needs.
Advantages of an LLC:
- Owners aren't personally liable for debts or lawsuits
- Easier to obtain equity, small business loans, or venture capital.
- You have the flexibility of choosing how you file your taxes — including as an S-corporation or C-corporation — which could save you money depending on the amount of revenue your business generates.
- If you have multiple owners of a business, this is an easier option than filing as a corporation.
Disadvantages of an LLC:
- There are additional fees and paperwork associated with setting up an LLC, including state licensing, annual filing fees, etc.
- It might be more difficult to raise capital compared to a corporation.
- If a member leaves the company, the LLC must be dissolved and the remaining members must deal with the obligations required to terminate the business. The remaining members will then need to file for a brand new LLC.
- Members of an LLC are responsible for paying Social Security and Medicare taxes based on the business's total pretax profits (compared to an S-corporation, in which members pay taxes only on actual compensation).
Advantages of Sole Proprietorships:
- It's the easiest type of business to form — the second you sell a product or service, you are a sole proprietor.
- As sole owner, you are entitled to all the profits of the business.
- No partners or members to deal with — you make all decisions when it comes to your business, which means complete control and flexibility.
- No annual filing fees, state licensing fees, etc.
- Don't have to pay corporate tax.
Disadvantages of Sole Proprietorships:
- You are personally liable for all business debts, which means creditors can go after your personal assets to pay off business debt.
- You are also personally liable for lawsuits.
- More difficult to receive loans, establish business credit, raise capital, etc.
- Can be seen as unprofessional compared to other types of businesses.
Ultimately, choosing the right business structure for your needs is incredibly important for your business' long-term success, so take the time to weigh your options before determining which one is the best fit for your goals, lifestyle, and business structure.
If you're just starting out, take a look at How to Start a Business: A Startup Guide for Entrepreneurs [Template].