Key Takeaways

  • A sole proprietorship offers simplicity and low startup costs but lacks liability protection, meaning the owner’s personal assets are at risk.
  • An LLC (Limited Liability Company) provides legal separation between the owner and the business, offering liability protection and flexible tax treatment options.
  • LLCs may face more administrative requirements, fees, and paperwork, but they are generally more credible to lenders and investors.
  • Sole proprietorships dissolve when the owner dies or retires, while LLCs can continue indefinitely.
  • Choosing between a sole proprietorship vs LLC depends on factors like liability concerns, tax preferences, business goals, and funding needs.

Understanding the difference between LLC and sole proprietorship is important when considering potential business structures for your new company. You'll need to decide on a specific business structure before beginning the incorporation process in your state of operation.

The right structure for your company will depend on factors such as:

  • Your company's Industry.
  • Your company's location.
  • How many owners the company will have.
  • An established exit strategy.

Most small businesses choose to incorporate as one of two structures:

  • Limited liability company, or LLC
  • Sole proprietorship

The LLC structure combines elements from both corporate and partnership business structures. It also excludes certain negative aspects of the corporate and partnership structures. Eventually, a sole proprietorship can convert to an LLC. Keep in mind, however, that the cost of doing so might be high. For this reason, if you think it might become necessary to convert from a sole proprietorship to an LLC, consider skipping the conversion process and simply incorporating as an LLC.

Liability

One of the biggest differences between an LLC and a sole proprietorship is the amount of liability protection each provides. If you establish your business as a sole proprietorship, you will be personally responsible for liability related to:

  • Any debt your company accrues.
  • Your company's legal obligations.
  • Any legal action taken against the company.

In contrast, incorporating as a limited liability company provides you with a certain level of protection. If any outside entities, such as creditors, take legal action against an LLC, they can't target your personal assets to settle the company's debts. It is important to note, however, that LLC members might be considered liable for company debts under certain circumstances, such as when:

  • The member in question personally guarantees a company debt.
  • The member intermingles personal funds with company funds.
  • The company has a limited amount of insurance or capitalization.
  • The company fails to pay state taxes or violates other state laws, such as committing fraud.

Taxation Differences Between Sole Proprietorship and LLC

When comparing sole proprietorship vs LLC, one of the most significant distinctions is how each entity is taxed.

  • Sole Proprietorship Taxes:
    The owner reports all business income and losses directly on their personal tax return (Form 1040, Schedule C). The profits are subject to income tax and self-employment tax, covering Social Security and Medicare contributions. Because there’s no legal separation, all profits flow directly to the owner.
  • LLC Taxes:
    By default, a single-member LLC is taxed similarly to a sole proprietorship, with pass-through taxation. However, an LLC can elect to be taxed as an S corporation or C corporation by filing IRS Form 2553 or Form 8832, offering flexibility that a sole proprietorship does not have.
    • S Corporation election can help reduce self-employment taxes.
    • C Corporation election allows for retained earnings and potential tax deferral.

This tax flexibility allows LLC owners to optimize their tax obligations based on their income level and long-term business goals.

Control

In a sole proprietorship, you have complete control over every aspect of the business, including how the company spends its financial assets. Also, you are not obligated to share business ideas with any other business or individual entity. You alone will be responsible for every decision made about company operations and the use of available resources.

When an LLC has more than one owner, other members and managers are on hand to provide valuable input in regard to managing the company. LLC owners are empowered to hire individuals from outside the company to manage it, rather than being required to handle daily affairs on their own.

Compliance and Administrative Requirements

Operating an LLC generally involves more administrative steps than running a sole proprietorship.

  • Sole Proprietorship: Typically requires minimal setup. Many owners only need a business license or local permit. There’s no need to file formation documents with the state, maintain annual reports, or pay separate state filing fees.
  • LLC: Must file Articles of Organization with the Secretary of State, pay a filing fee (ranging from $50 to $500 depending on the state), and appoint a registered agent. Many states also require annual reports and franchise taxes.

Despite the extra work, LLC compliance ensures legal protection and credibility, particularly if you plan to hire employees, secure investors, or expand operations.

Raising Money

Generally speaking, a sole proprietorship will have more difficulty raising capital than an LLC. This is because sole proprietorships are typically viewed as less credible companies because the owner has not made the effort or financial commitment required to incorporate as an LLC. This lack of credibility makes it more difficult for a sole proprietorship to secure business loans and might even force you to use business assets and personal credit to raise operating capital.

An LLC might also choose to create new membership interest classes with different voting and profit options for investors. In contrast, if a sole proprietorship offers a share of ownership in the company to another entity, the business is no longer considered to be a sole proprietorship.

Credibility and Business Growth

An LLC often presents a more professional image than a sole proprietorship. Clients, vendors, and lenders tend to view LLCs as more established and trustworthy because they’re legally registered entities.

Additionally:

  • LLCs can open business credit accounts separate from the owner’s personal finances.
  • They can raise capital by adding new members or investors.
  • Sole proprietors rely primarily on personal savings, loans, or credit cards, making growth more difficult.

For entrepreneurs seeking long-term expansion or external financing, forming an LLC offers better opportunities and protection

Ownership

If you choose to form a sole proprietorship, it is owned solely by you, the founder. This means there is no legal difference between you and your company. This also means that no other entity, be it another business, trust, estate, or individual, can claim ownership in the company.

LLCs, on the other hand, can offer ownership to an unlimited number of entities, including:

  • A foreign business
  • A corporation
  • Another LLC
  • A partnership
  • Another individual

In addition, ownership interests can be sold to third parties without having to worry about disrupting the company's long-term operations.

Insurance and Risk Management

While both business types can purchase insurance, an LLC’s structure reduces personal exposure to lawsuits and business debts.

  • Sole Proprietorship: The owner’s personal assets—such as their home, car, or savings—can be seized to satisfy business liabilities.
  • LLC: Protects personal assets unless the owner personally guarantees a loan, commits fraud, or fails to maintain separation between personal and business finances.

Business insurance, such as general liability or professional liability coverage, is still advisable for both structures, but it’s especially crucial for sole proprietors who lack built-in legal protection.

Existence

A business structured as an LLC can continue operating forever, no matter who the members or managers of the company happen to be. A sole proprietorship, however, will end immediately in the event of the owner's death, retirement, or decision to sell the company.

Choosing Between a Sole Proprietorship and an LLC

When evaluating sole proprietorship vs LLC, consider these key factors:

  1. Liability Exposure: If your business carries significant financial or legal risk, an LLC offers essential protection.
  2. Tax Goals: Sole proprietorships are simpler, but LLCs can tailor their taxation to minimize self-employment taxes.
  3. Growth Plans: LLCs support scalability and continuity beyond the owner’s lifetime.
  4. Cost and Compliance: Sole proprietorships are cheaper and easier to maintain, but LLCs bring long-term advantages for credibility and protection.

If you’re unsure which structure suits your business, consult a licensed business attorney. You can find experienced counsel on UpCounsel, where lawyers from top law schools like Harvard and Yale provide guidance on formation, compliance, and taxation.

Frequently Asked Questions

1. Is a sole proprietorship the same as a single-member LLC?

No. A single-member LLC offers liability protection and tax flexibility, while a sole proprietorship does not separate personal and business assets.

2. Which business structure is better for taxes?

An LLC offers more tax flexibility since it can be taxed as a sole proprietorship, S corporation, or C corporation depending on financial goals.

3. What are the main risks of a sole proprietorship?

The owner is personally liable for all debts and legal obligations, which can put personal assets at risk.

4. Can a sole proprietorship become an LLC later?

Yes. A sole proprietorship can convert into an LLC by filing formation documents and transferring assets, but this process involves costs and administrative steps.

5. How much does it cost to form an LLC?

Costs vary by state but typically range from $50 to $500 for filing fees, plus potential annual fees or franchise taxes.

If you need help with the difference between an LLC and a sole proprietorship, you can post your legal need on UpCounsel's marketplace. Lawyers from UpCounsel come from law schools such as Harvard Law and Yale Law and average 14 years of legal experience, including work with or on behalf of companies like Google, Menlo Ventures, and Airbnb.