LLC vs Sole Proprietorship vs Partnership

Key Takeaways

• The main difference between an LLC, sole proprietorship, and partnership lies in liability protection, taxation, and ownership structure.
• Sole proprietorships are easy to form but offer no liability protection.
• Partnerships allow two or more owners to share profits but come with shared liability.
• LLCs combine the flexibility of partnerships with the liability protection of corporations.
• The best choice depends on your business’s size, goals, and willingness to manage compliance and taxes.
• Each entity type affects how income is taxed and how business debts are handled.

If you are launching a business, then you are considering a sole proprietorship or LLC partnership or corporation as the form for your business. Selecting the proper entity is an important decision that can determine whether you achieve success, failure, asset protection, and favorable tax treatment.

About Sole Proprietorships, LLCs, Corporations, and Partnerships

The ideal entity depends on a number of factors, which includes the industry, location, ownership structure, and exit strategy.

Entity 1: Sole proprietorship. Sole proprietorships are perhaps the most common and are the easiest to form. It is allowed only for businesses with one owner. Note that there is no legal distinction between the owner and the business, for asset protection and tax purposes, in a sole proprietorship.

A sole proprietorship's main benefits:

• preferable tax treatment; and
• ease of formation.

As mentioned, however, that an owner’s personal assets are not protected so that the owner can be personally compelled to use personal finances for the business’s obligations, including lawsuits against the business.

Entity 2: Partnership. Partnerships are entities owned by two or more persons run for a profit. Like sole proprietorships, partnerships are easy to form and have minimal upfront costs. Each individual partner can contribute either money, labor or skills for ownership in the business.

A partnership's main benefits:

• preferable tax treatment; and
• ease of formation.

There is, however, personal liability for business obligations. Also, it is common for partners to disagree on material issues, leading to tedious and long-running legal battles. To minimize this risk, it is recommended to create a partnership agreement.

Entity 3: LLCs. LLCs are created by and governed under state law. With respect to tax treatment, LLC owners elect how they want to be taxed by the IRS, like a sole proprietorship, partnership or corporation. Launched in Wyoming in 1977 as legal LLCs, since 1996, all states have laws that govern the formation of an LLC.

Some features of an LLC:

• Those creating an LLC do not have to be U.S. citizens or permanent residents.
• Others, including lenders, may have more faith in your business when it is an LLC.
• Note that an LLC can be have different tax treatment in different states and LLC earnings may be subject to self-employment tax in certain locales.
• Appreciated assets could be subject to tax if you decide to convert your existing business into an LLC.

Entity 4: Corporations. People create corporations, mainly, to limit shareholders and owners from many company liabilities. There is a trade-off to this feature: Corporations account for this privilege through double taxation because business profits are taxed both at the corporate level and on personal level through dividends paid to shareholders.

Comparison and Advantages

• A partnership can be viewed as the opposite of a corporation. While one person, at least, is responsible for company debts and litigation, the profits go directly to the owners, circumventing the "double taxation" issue. Partnerships are easy to form, just have two or more people who work together form a partnership, regardless of whether they acknowledge such a partnership.
• LLCs offer limited liability protection to its owners and members. What’s more, profits go directly to members because LLCs are essentially an ideal business structure.
• Corporations have a lot of mileage and are well known, thereby making the legalities of them well known. In addition, they can issue stock, providing it with the ability to more easily raise capital than a partnership or LLC.
• An S corporation structure also avoids double taxation, in some circumstances. For example, when the S corporation pays all profits to shareholders in the form of salary.
• An LLC is best for small business tax matters.

Key Differences: LLC vs Sole Proprietorship vs Partnership

When comparing an LLC, sole proprietorship, vs partnership, the key differences revolve around liability, taxation, and management structure:

• Liability Protection:
  • Sole proprietors and general partners are personally liable for business debts and lawsuits.
  • LLC members have limited liability, meaning their personal assets are generally protected from business liabilities.
• Taxation:
  • Sole proprietorships and partnerships are pass-through entities; income and losses are reported on owners’ individual tax returns.
  • LLCs can also elect pass-through taxation by default, but they have flexibility to be taxed as a C corporation or S corporation if beneficial for tax planning.
• Ownership and Formation:
  • A sole proprietorship has a single owner.
  • A partnership requires at least two people.
  • An LLC can have one or multiple members, including individuals, corporations, or other LLCs.
• Compliance Requirements:
  • Sole proprietors and partnerships have few formalities.
  • LLCs require filing Articles of Organization and often an Operating Agreement. Some states also require annual reports or franchise tax payments.

Choosing between these entities often depends on whether you value ease of formation or legal protection more highly.

Small Companies

LLCs are ideal for small companies. Corporations are required to hold annual shareholder meetings, which is not ideal for small companies due to the annual filing fees. Also, if complex corporate formalities are not followed to the letter, shareholders might be required to forfeit their limited liability status, thereby being held personally liable for the corporation’s debts and obligations.

Because LLCs cannot issue stock, LLCs might find it difficult to attract multiple investors due to investors typically wanting a physical certificate as proof of ownership.

Also note that certain types of businesses, e.g. a bank, cannot create an LLC.

Which Structure Is Best for Small Businesses?

For many small business owners, the choice between LLC, sole proprietorship, and partnership depends on balancing simplicity, cost, and protection:

• Sole Proprietorship:
  Ideal for freelancers, consultants, or home-based businesses with minimal risk. It’s inexpensive and simple to start but exposes owners to personal liability.
• Partnership:
  A good option for businesses with multiple founders who share management duties. However, each partner’s personal assets are at risk unless they form a Limited Partnership (LP) or Limited Liability Partnership (LLP).
• LLC:
  Preferred for small businesses seeking protection without the complexity of a corporation. It offers limited liability, operational flexibility, and customizable tax treatment. LLCs are also more credible to investors and lenders than informal entities.

According to small business experts, an LLC is often the best middle ground for entrepreneurs seeking simplicity with legal safeguards.

Tax Implications and Liability Comparison

Understanding the tax and liability consequences of each business structure is crucial before registering your company:

• LLCs can deduct expenses such as rent, marketing, and equipment, and may reduce self-employment taxes by choosing S corporation taxation.
• Sole proprietors pay self-employment taxes on all earnings.
• Partnerships must file an informational return but profits flow directly to partners’ individual tax filings.

When to Convert to an LLC

If your business started as a sole proprietorship or partnership, you may later convert to an LLC when:

• The business grows and you want liability protection.
• You’re entering contracts or hiring employees.
• You’re seeking funding or credibility with lenders.
• You want tax flexibility to elect corporate status.

Converting to an LLC can help preserve your personal assets, add credibility, and simplify ownership changes without significantly altering daily operations.

Frequently Asked Questions

1. What is the main difference between an LLC and a partnership?
   An LLC protects owners’ personal assets from business debts, while in a general partnership, each partner is personally liable for the business’s obligations.
2. Can a sole proprietor have employees?
   Yes. Sole proprietors can hire employees, but they must obtain an Employer Identification Number (EIN) and comply with employment and tax laws.
3. Which business type pays the least in taxes?
   It depends on income level. LLCs can often reduce self-employment taxes by electing S corporation status, while sole proprietorships and partnerships pay taxes on all net profits.
4. Is it expensive to form an LLC?
   LLC formation fees vary by state but generally range from $50 to $500, plus annual maintenance fees or franchise taxes.
5. Can I change my business type later?
   Yes. You can convert from a sole proprietorship or partnership to an LLC or corporation by filing formation documents with your state and updating tax registration and business licenses.

If you need help with determining what corporate form is best for your business, you can post your legal need on UpCounsel’s marketplace. UpCounsel accepts only the top 5 percent of lawyers to its site. Lawyers on 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.