All across the U.S., aspiring entrepreneurs drop their traditional 9-5 desk job and set out as a small business owner. Dozens of decisions must be made, though: a business name, how to advertise, getting loans, and more.
One question that demands consideration is whether or not to incorporate. Entrepreneurs who don’t incorporate operate as sole proprietorships. The most comparable incorporated option is the LLC, or a Limited Liability Company. Knowing which is right for your business can be tricky.
To make your decision easier, we’ve compared the six most important distinctions between an LLC and a sole proprietorship.
1) Forming and starting your business
Forming and starting a sole proprietorship is (usually) very simple. In many cases, all you have to do is start selling your good or service. So if you sell handmade textile products to your neighbors, then you’ve technically started a sole proprietorship.
Many sole proprietorships do not have to file any paperwork with a government office. However, you are required to get licenses and permits that apply to your industry. For example, let’s say you bake and decorate the best sugar cookies in town. Even though you operate as a sole proprietorship, you’ll need to obtain your state’s license for businesses that produce consumable goods.
Technically, the business name of a sole proprietorship is the owner’s legal name. However, many sole proprietors choose to get a DBA, or a “doing business as” registration. Many states offer this registration, allowing you to use a more traditional business name.
Forming an LLC is a little more complicated. With an LLC, you must form your business with your Secretary of State prior to commencing business. This process requires both time and money. Fees and processing times vary depending on your state.
Still, the process is relatively straightforward in most states. Ordinarly, an LLC becomes an incorporated entity when it files a document called the Articles of Organization. As part of this process, you’ll need to appoint a registered agent. This agent accepts legal process on behalf of your business. You can sometimes serve as your own agent, but many businesses elect to have a professional handle it instead.
Afterwards, the LLC’s members create an operating agreement, which establishes how the business will be run. LLCs also need to obtain any necessary licenses. Also, if you have employees, you’ll need to obtain an Employer Identification Number from the IRS as well as register for taxes.
2) Maintaining your business
To keep a sole proprietorship compliant, you have two primary requirements: financial record-keeping and renewing licenses. For your financial records, you need to keep an accurate record for tax purposes. Basically, if you are going to include a transaction as part of your tax report (deductible business expense or a profit), you need to have documentation to prove it. This proof protects you in the event that you are audited.
As a sole proprietorship, there is no legal division between your personal and business finances. That’s why you’ll want to keep your records accurate carefully so you can easily distinguish between personal expenses and business expenses.
The other requirement is renewing your business licenses as needed. You are responsible for keeping track of your own licenses since they’re usually regulated by a variety of departments. That said, some states have a Business OneStop tool that also handles licenses. If so, you may be able to see the expiration dates for all licenses and permits in one place.
The requirements to maintain an LLC are similar to those of a sole proprietorship, but there are also additional steps to complete. You must, of course, keep good records. But as an LLC, the business financial records are completely separate from your personal ones. You’ll also need to keep your licenses up-to-date.
LLCs are also required to file an annual report with the state (in most states). Your report essentially informs the state of your business’s activities for the year. It is not the same as an income report. This report usually requires a fee. How much you’ll pay depends on your state; many states charge approximately $50-100 for the report. Other states like Massachusetts and Delaware charge annual fees exceeding $500.
It’s not uncommon for LLCs to grow and change over the years. If your membership changes, you’ll need to make an amendment to your Articles of Organization. Similarly, if you change some of your business policies, you should amend your operating agreement to reflect that change.
3) Legal regulations
As a sole proprietorship, your requirements to operate a compliant business are fairly minimal. Usually, if you pay your taxes, meet your financial obligations and maintain the appropriate licenses, your business is compliant.
Each state has its own Limited Liability Company Act (or similarly titled statute). This gives you a small picture of the legal requirements for LLCs. They’re far more extensive. As we’ve alluded to earlier, you’ll need to keep records, file annual reports, get licenses and keep them up to date, and more.
For one, LLCs with employees are legally required to obtain certain types of insurance. This usually entails making unemployment insurance payments (usually in the form of a tax) and workers’ compensation.
For a full listing of the laws that will affect your business, we recommend you consult your state’s LLC Act or contact your Secretary of State.
Fundraising as a sole proprietorship can be difficult. For one thing, most external investors are hesitant to send funds to an individual person. Your business cannot issue stocks or bonds, either, which limits your fundraising options.
Your best option for getting funds from an external source is probably to obtain a bank loan. However, you should keep in mind that your business and personal finances are linked; if you have a poor credit score, a bank may decline your application.
Since LLCs are incorporated entities, they have more options for fundraising. Of course, an LLC cannot sell stock, but it can offer other securities (such as bonds). Private investors are more likely to invest funds in an incorporated business. Additionally, banks are more likely to make a loan out to a business than to an individual.
As a sole proprietorship, you will not pay any business income taxes. Instead, your business income tax will be reported on your personal tax return. As a result, you’ll pay the personal income tax rates (often lower than corporate income taxes). So rather than filing a separate return, you’ll just add a step to your personal taxes.
That said, you are responsible to pay self-employment taxes such as social security taxes, medicare taxes, and more. You can find more information on these taxes here. With traditional employment, your employer takes care of these taxes. But since you are your own employer, you’ll need to pay them yourself.
Some independent businesses choose to hire an accountant to handle this step so they can focus on running the business itself.
Taxation as an LLC is flexible. You can elect to be taxed like a sole proprietorship (single-member LLCs), a partnership (multiple members), or as a corporation. If the LLC is taxed as a pass-through entity, then you’ll report all the business’s income on your personal tax return.
LLCs that are taxed as corporations will pay the corporate income tax to both the federal and state governments. The federal rate is 21%, and the state rate will depend on your location. The corporate income rates are usually higher than individual rates. However, if taxed as a corporation, the business itself pays the taxes. So the dollar amount of taxes is higher, but the personal tax burden is smaller because the members aren’t paying the tax. This is why some multi-member LLCs choose this taxation option instead.
6) Liability protection
Liability protection is probably the most important distinction between a sole proprietorship and an LLC. For many businesses, liability protection is the primary motivation to incorporate.
In a sole proprietorship, there is no division between your personal and business finances. As a result, if your business is involved in a lawsuit or defaults on a loan, then you have to pay them. If you cannot, your personal assets (i.e., your house, your car, etc.), could be taken as compensation.
An LLC allows for personal asset protection. An LLC is treated as a legal person, and it will be prosecuted and expected to pay its own debts. The assets of the owner(s) cannot be taken if the entity is sued or fails to pay a loan. This division is commonly referred to as the corporate veil.
As a result of this protection, the entity must keep the finances of the business and the personal finances of each owner separate. Failing to do so could destroy your corporate veil and your protection.
How Important is Liability Protection for Your Business?
Getting or skipping the personal liability protection is ultimately your decision, but it may be wise to get it by forming an LLC. Whether or not you need it ultimately depends on the good or service you sell, as well as how many debts or loans your business takes on.
For example, if a customer gets sick or injured while interacting with your business, they could sue you. Let’s go back to our sugar cookie shop example. You’re a sole proprietorship. A customer gets debilitating food poisoning from a bad batch of cookies, and they sue. You can’t pay the whole settlement from your personal funds, so the court orders your car to be taken in order to pay the rest. An LLC would not have this problem.
Some low-risk businesses might not need this protection, though. Take Etsy craft shops, for instance. Many of these crafters are sole proprietorships. But since there is little risk of injury from handcrafted products, the liability protection’s importance drops.
If you do not anticipate taking out a hefty loan to finance your start-up costs or to fund a capital investment, then you may not need to worry about the protection, either.
Which is Right For You: LLC or Sole Proprietorship?
If you’re not sure which entity type is right for you, then you’re in good company. This decision is critical, and taking your time to weigh your options is wise! Legal professionals advise that, if you’re in doubt, it’s better to form an LLC because of the protection it provides. Additionally, LLCs offer greater potential for growth, especially if you want to bring another person into business with you.
That said, a sole proprietorship could be right for you. It’s a better option if you want to test your business concept. The filing fees of an LLC could also be too burdensome of an investment for a start-up with low capital. You don’t encounter those fees with a sole proprietorship. You can always start out as a sole proprietorship and convert to an LLC later, too. It’s easier to convert into an LLC than vice versa.
You can also get legal advice to help you weigh the exact pros and cons of your business situation. Your business is unique, so what works for one business might not work for yours. A business lawyer can help you pick the type that will set your business up for success.