Difference Between Sole Proprietorship and LLC: Everything You Need to Know
The difference between a sole proprietorship and an LLC is an important distinction for business owners to understand.10 min read
The difference between a sole proprietorship and an LLC is an important distinction for business owners to understand. There are advantages and disadvantages to each form of doing business.
Limited Liability Company
Limited Liability Companies (“LLCs”) are a very popular form of business and for good reason. Limited liability companies are often considered the middle ground between corporations and partnerships that incorporates the best elements of each. An LLC, like a corporation, protects the business owners from personal liability for business operations. Like a partnership, the LLC affords its owners the option of pass-through income taxation. A limited liability company can be structured to exist as long as its owners desire — forever if they choose.
Advantages of an LLC
The biggest benefit of choosing the LLC as a business entity over a sole proprietorship is that the LLC, like a corporation, shelters its owners from personal liability because it is considered a separate legal entity, distinct from its owners. Operating as an LLC provides the owners of the company with limited liability protection against company debts and obligations. Creditors and those who sue an LLC cannot go after the limited liability company owner's personal assets as compensation for business-related debts. This means that the owners of a limited liability company are not personally liable if the company runs out of funds.
To ensure that this limited liability protection applies, LLC owners must carefully maintain separation of their personal and business finances and records. Failure to do so could result in losing limited liability protection.
The limited liability protections provided by an LLC can defend the company's owners from a variety of legal situations. It's important to understand, however, that these protections are not comprehensive. This means there are some circumstances where the owners of a company can be sued. For example, the member of an LLC can stand to lose the money that they have contributed to the company. So, while an owner's personal assets cannot be pursued in a lawsuit against the LLC, it doesn't mean there isn't some risk for loss.
While maintaining the limited liability protection of a corporation, LLCs allow for the operational flexibility of a partnership. LLC owners are allowed — and usually required — by law to create an operating agreement that lays out how the business will operate. Unlike corporations, limited liability companies have great flexibility in how they structure the management of their business.
While LLCs require more paperwork than a sole proprietorship, they require far less ongoing paperwork than a corporation. This makes it easier and less expensive for LLCs to take action than corporations, which are required to document almost every major action and often need to hire an attorney to draft the documents to ensure that they are in compliance. Having some paperwork requirements actually benefits the LLC because it helps ensure that the LLC maintains pertinent records and makes the entity more attractive if it is offered for sale.
LLCs provide tax flexibility, as well. If LLC owners take no action, an LLC, by default, will be taxed on a “pass-through” basis. This means that the owners will pay taxes on their personal income statements. This benefits the owners because they are taxed only once, at the personal level, instead of the “double-taxation” that corporations are subjected to where income is taxed both at the corporate level and the individual level. In limited circumstances, it is advisable to be taxed like a corporation, and LLCs offer their owners the option to be taxed in this manner.
Another benefit of LLCs is that it is easier for an LLC to raise funds from investors than for a sole proprietorship to do the same. LLCs have more options for raising funds than sole proprietorships. LLCs often have multiple owners and members who can reach a larger pool of potential investors by reaching out to their combined contacts. LLCs can offer ownership interest in the business in exchange for money to fund the company's growth and expansion. An LLC may have as many owners as it wants. Its owners can be individuals or other foreign or domestic businesses.
Investors are more attracted to LLCs than sole proprietorships because they have the assurance that they are not personally liable for company debts. While venture capital funds tend to only invest in corporations, it is still advisable to start up as an LLC because an LLC can be converted to a corporation right before the closing of a venture fund raise.
Another strength of limited liability companies is these entities can have an unlimited amount of owners or be owned by a single person. Also, owners of an LLC can be other types of business entities, including:
- Foreign businesses
- Other LLCs
If you're interested in starting an LLC but don't have business experience, forming a multi-member LLC can be a good choice. Forming your LLC with other people will allow you to learn from their experience and collaborate on important business decisions. With multiple members, you can also share marketing and management duties. With multiple member LLCs, raising start-up capital is also easier, as several people will contribute finances to the business.
When forming a multi-member LLC, writing an operating agreement is usually a good idea. In your operating agreement, you can outline the needs and responsibilities of each owner, hopefully reducing the likelihood of future disputes.
In addition to tax flexibility, LLCs provide management flexibility that isn't available with other business entities. If you wish, the members of your LLC can manage the company. Member management is typically a good choice for small companies that are just getting off the ground. On the other hand, you could hire an outside management team to help you with day-to-day business operations. Many large LLCs are managed by professional managers, and this option is also a good choice for operations where the members are only interested in investing in the business.
The great thing about an LLC is it can last forever, regardless of your management structure or members. These entities even have the ability to last after the death of an owner, assuming there is a procedure in place to transfer the deceased member's ownership percentage.
Disadvantages of an LLC
Starting and running a Limited Liability Company is more time-consuming and expensive than a sole proprietorship or partnership. There is a formal process for forming an LLC and registering it with the state. To form an LLC, business owners must file articles of organization that form the entity with the state and must pay a fee to the state. Exact requirements and fee amounts vary slightly from state-to-state.
It is advisable — and sometimes required — for an LLC to also draft an operating agreement that sets out where the business will operate, how and by whom it will be managed, how long it will exist, and other important information. Operating agreements will be looked at if there is ever a dispute. If there are multiple owners and managers, the operating agreement will also set out the relationship between the owners, managers, and the LLC. For example, the LLC Operating Agreement will include information about each owner's duties, required and optional financial contributions, and entitlement to profits of the LLC. It is often advisable to hire an attorney to help with drafting the agreement, which is another expense.
Most states require some form of annual filing and an associated fee to keep the LLC in good standing. In some states, like California, New York, and Texas, LLCs are also required to pay an annual tax to the state they are formed in or operate in. How the tax is calculated depends on the state but usually involves consideration of some combination of revenue, profits, number of owners, and/or capital in the state.
The costs of forming and maintaining an LLC are offset in part by lower insurance costs than with a sole proprietorship or partnership. They are also offset by the lower risk of having personal assets garnished by business creditors.
Starting an LLC
If you want to start an LLC, there are a few steps you will need to complete to form your company. Most importantly, your LLC members need to register your company in the state where you intend to do business. In most cases, you will register your LLC with the Secretary of State. Some states have an LLC office that is dedicated to the registration of these business entities.
Setting up your company requires drafting a document known as the Articles of Organization, which covers important information about your company and must be filed with your state. When filing your Articles of Organization, you will also need to pay a filing fee. Depending on your state, this fee can cost hundreds of dollars or more. Research the fees and registration requirements in different states so you can be sure to choose the right location for your LLC.
When you file your Articles of Organization, make sure the document includes the following information:
- The name of your LLC
- The address of your principal office
- The names of your LLC members
- How long you expect your LLC to last
- Other information required by your state
If you are forming a multi-member LLC with more than two members, you should hire an attorney to help you form your company. Besides helping you with filing requirements, an experienced attorney can help you write a strong operating agreement that will cover several important topics:
- Duties of LLC members
- Members' capital contributions
- How the company will distribute profits
Although it takes more time and money to form an LLC than it does a sole proprietorship, the advantages that you will receive will be well worth the effort. Besides your Articles of Organization, you may be required to file a Certificate of Formation. Every document that you file to form your LLC will require a filing fee.
A sole proprietorship is the default business structure for an individual who operates a business alone without business partners or co-owners of any kind. When a person starts running a business alone and takes no other steps to form a structure, they are automatically considered a sole proprietor. In a sole proprietorship, the owner and the business are one-and-the-same. Sole proprietorships are the most popular form of business.
Advantages of Sole Proprietorship
A sole proprietorship is the easiest and cheapest type of business to form and operate. A sole proprietorship can be formed without complying with any formal organizing procedures — there are no state filing requirements and no fees. A sole proprietorship can be formed without any type of written agreement. Many people start operating sole proprietorships without even knowing it!
In addition to the ease of creation, owners of a sole proprietorship have full control over the business, including how the company uses its profits. This is one of the biggest advantages of a sole proprietorship. The owner has sole control of management, marketing, financing, and determining the policies and direction of the business. A sole proprietor does not have to consult with or receive prior approval from other owners on business-related decisions. This often means sole proprietorships can make decisions and get things done more quickly than LLCs that have multiple owners.
Sole proprietorships are not exempt from all fees and rules. Sole proprietorships are still required to comply with applicable laws and obtain the required permits. If the business is being operated under a name other than the sole proprietor's name, the business usually must file a “DBA” statement with the county or state that it is operating in. “DBA” stands for “doing business as” and refers to the name the company is doing business under. For example, Mary Smith, a sole proprietor, may be operating her cupcake business under the DBA “Mary's Cupcakes.” Registering a DBA usually requires paying a fee to the government and publishing notice of the DBA in a local publication which also costs money.
There is no easier way to launch a business than as a sole proprietor; you simply have to start working. It is simple and inexpensive to change the name of the business to something other than its legal name by filing a “Doing Business As,” or DBA, name in the states in which the company is engaging in business.
Since the sole proprietor and the business are the same in the eyes of the law, business income is taxed on the owner's individual income tax return. The owner will pick up all the profits and losses of the business on their individual tax return and does not need to file a separate return for the business. The owner can choose whether to keep profits or reinvest them. Sole proprietors are taxed at the lowest rate of all of the business entities.
Disadvantages of Sole Proprietorship
The biggest disadvantage of a sole proprietorship compared to other business forms is that the owner of a sole proprietorship is personally responsible for business debts. Sole proprietorships do not have limited liability protection like LLCs do. Instead, the business owner has personal liability for all of the debts and legal liabilities of a sole proprietorship.
There is no limit on a sole proprietor's individual, personal liability for the business's debts including money owed to creditors and legal judgments against the business. This becomes a problem when the sole proprietorship's business assets are insufficient to pay its debts. In such a case, creditors can pursue the owner's personal assets, like their home and personal bank account funds, to satisfy the debt.
Sole proprietors can guard against some of the risks of personal liability by obtaining insurance. However, insurance does not cover all scenarios, and where insurance is unavailable, the business owner has no protection for their personal assets.
Another difficulty with sole proprietorships is that they are often viewed as less credible because the owner did not expend the time and money of forming an LLC. In certain industries, this lack of credibility from not having a formal entity can make it more difficult for the business to gain customers. Customers are more cautious when making payments to individuals, like sole proprietorships, rather than to formally registered business entities, like LLCs. Additionally, lack of credibility can make it more difficult for a sole proprietor to obtain private loans and may force them to rely on personal assets and friends and family.
Sole proprietorships have very few funding options. Most sole proprietors' funding comes from their own savings or consumer loans. Unlike other business entities, sole proprietorships cannot sell equity, or ownership interest, in their business in exchange for funding. Establishing a line of credit or receiving loan approval from a bank or other lending institution may be a daunting challenge for a new entrepreneur operating as a sole proprietorship. Investors do not invest in sole proprietorships. Banks giving loans to sole proprietorships require a personal guarantee to ensure the loan is repaid.
A sole proprietorship lacks the management and ownership structure options of an LLC. A business can have only one person acting as the company's owner in order to earn treatment as a sole proprietorship. Once a new owner is added, the entity is no longer a sole proprietorship. Unlike an LLC, sole proprietorships cannot continue on once the business owner retires, dies, or becomes legally incapacitated.
Sole proprietorships are more difficult to sell than LLCs. Each asset, including accounts, licenses and permits, contracts, and intellectual property, must be individually transferred to the purchaser. Tax identification numbers must be obtained for a sale.
If you still have questions about whether an LLC or a sole proprietorship is a better option for your business or want help forming your business, post your legal need on UpCounsel's attorney marketplace. There are licensed, experienced attorneys who come from top law schools and have experience working with some of the largest companies in the country like Google and Menlo Ventures, waiting to assist you.