When starting your own business, you want to ensure that you make all the right decisions so that your business has every possible opportunity to succeed. One important decision will be around whether or not to operate as an LLC or as a sole proprietorship.LLCs and sole proprietorships are two ways of classifying a business structure. This designation is important for tax purposes, but it also needs to be reported to the state to satisfy requirements for legal operation. If you’re not sure what the difference is between an LLC and a sole proprietorship, we’re here to help. This article will differentiate between the two business types so that you know which one is right for your business.
What is an LLC
An LLC is a limited liability company that protects the personal assets of owners and investors from being affected by any of the debts or liabilities that a business incurs. LLCs combine elements of sole proprietorship and partnerships but add limited liability protection to the business structure. LLC are pass-through businesses so owners, called members, can still file taxes under their own name. Registering as an LLC puts that company in a protected legal and tax bracket, thereby encouraging investors to fund the company. LLCs have more leeway come tax time, as they can also file as an S Corporation and receive many tax breaks. Additionally, LLC ownership is not restricted in the same that a sole proprietorship is. An LLC can be owned by an individual, corporation, foreigner, foreign entity, or another LLC.
What is a Sole Proprietorship?
A sole proprietorship is one of the simplest forms of a business structure. A sole proprietorship is owned and operated by one individual and is unincorporated. For legal and tax purposes, there is no difference between the business and the owner. No formal action needs to be taken in order to be considered a sole proprietorship; often sole proprietors operate using their personal name. All the taxes for the business are filed under the owner’s personal income taxes, and the owner is also liable for all of the business’s debts and liabilities. Regulations vary from state-to-state, but for the most part, you should obtain a license to operate as a sole proprietor. You can use license and permit search tools to identify what licenses and permits your sole proprietorship needs to operate on the local, state, and federal levels. If you choose to operate as a sole proprietor but under a different business name, such as any name other than your own name, then you will have to file a DBA or a fictitious name form in order to “Do Business As” that other name.
Major Differences Between an LLC and a Sole Proprietorship
The biggest difference between a Sole Proprietorship (typically known as self-employment) and an LLC is that an LLC member’s personal assets are not held liable in the case that the business goes bankrupt or incurs debts and other liabilities. Additionally, LLCs can seek other tax breaks.
For tax purposes, both an LLC and a sole proprietorship are considered a pass-through entity, which means that the profits, losses, and expenses are not filed separately from the owners’ or members’ personal taxes. Filing taxes as a sole proprietorship is relatively easy. All of the taxes are filed under the owner’s personal income tax and generally, business income and losses are reported on Schedule C and the standard Form 1040 (See: IRS Publications and Forms for the Self-Employed). Self-employed individuals are required to withhold and then pay income taxes such as self-employment tax and estimated taxes. LLCs, on the other hand, are slightly different. LLCs are still considered pass-through, so each owner (called a member) will be able to report their own profits and the company’s losses on their personal tax return. But, an LLCs can file as an S Corporation in order to seek tax breaks. A tax calculator can identify how much your business would save if it was an LLC that is able to file as an S Corp; depending on how much the business earns, how much the members are paid, and other details, filing as S Corp could save your company thousands of dollars each year.
One of the main reasons why a business might become an LLC is to seek limited liability benefits. Unlike a sole proprietorship who is 100% liable for the debts and liabilities that the business incurs, an LLC will protect the personal assets of those business investors and members. If you are operating as a sole proprietorship and you are ready to bring on additional investors, by definition you can no longer operate as a sole proprietor. A sole proprietorship can only operate as a single individual so anyone who contributes money to a sole proprietorship must do so by donation and are not able to become a partial owner.
Business Ownership and Management
LLCs and sole proprietorship operate differently based on the number of owners that the business has and the liability. If you are a sole proprietor or a single-member LLC, you are the only owner. If you are running a business with multiple owners, you want to become an LLC so that the business structure and liability is established, and powers and organizations can be established through the Operating Agreement.Sole proprietors who wish to bring outside investors will need to at least become a single-member LLC, which adds limited liability protection to all the personal assets of invested members. LLCs might have more than one member. Member powers, rights, and the income that they receive (whether it is in proportion to their investment or not) are all laid out in the Operating Agreement.
Advantages and Disadvantages to an LLC and a Sole Proprietorship
There are advantages and disadvantages to operating as both an LLC or a sole proprietorship. The biggest disadvantages of upping the business classification structure are the LLC registration fees and additional paperwork. LLCs are required to file an Articles of Organization with the state that they register to establish the LLCs governance structure. They should also complete an Operating Agreement, but it is not required to be filed with the state. Both a sole proprietorship and LLC can file taxes under the owner’s personal tax return, but an LLC can also reap tax breaks by filing as an S Corporation. There are taxes associated with both the LLC and a sole proprietorship, and usually, companies only catch tax breaks when they file as an S Corporation. If you are operating a business on your own and are not concerned over the potential debts of the company, staying a sole proprietorship is the simplest and most affordable option. If you’d like to take a risk as a company, you can consider getting limited liability protection as a single-member LLC. If you are working with someone on an informal basis, creating an LLC will solidify that business relationship and bring more credibility to your company.