Starting a new business can be exciting, not to mention occasionally overwhelming. There are tons of decisions to make beyond determining your price points, how you’ll market yourself, and what customers you’ll target. One critical decision involves registering your business as a sole proprietorship vs. an LLC (limited liability corporation).
This important decision determines how you will handle your taxes and business risks. Follow along while we walk you through five of the key differences between sole proprietorships and LLCs to help you determine which type of structure will be best suited for your business.
What is a sole proprietorship?
A sole proprietorship (SP) is a single-person business and requires that you report your net income and losses when you file personal income taxes. SPs are unincorporated, which means the sole proprietor is personally liable for any debts or liabilities attributed to the business, whether in the form of financial obligations or liability claims.
While a sole proprietorship is relatively easy to set up, it’s important to keep in mind that this type of structure does not establish the business as a separate entity from you, the business owner.
Sole proprietor vs. independent contractor
It’s worth noting that an independent contractor and a sole proprietor are not the same things. An independent contractor usually provides a service, whereas a sole proprietor typically sells a product they create or purchase wholesale and resell in a retail environment.
On the other hand, independent contractors are hired to work for someone else, but not as an employee. They may be brought in to consult or help on a specific project and will provide their client with a contract prior to beginning work.
What is a limited liability company?
An LLC creates a legal division that separates the business owner(s) from their company’s liabilities. Unlike a sole proprietorship, an LLC creates a barrier between you as an individual and the business itself, shielding you from liability while also acting as a pass-through for tax purposes.
In other words, with an LLC, lawsuits, debts, and liabilities stop with the separate business entity and do not extend to your own personal property or finances.
Sole proprietorship vs. single-member LLC
Unlike a multi-member limited liability corporation, a single-member LLC only has one owner. In that way, a single-member LLC is similar to a sole proprietorship. But unlike a sole proprietorship, a single-member LLC has all of the same advantages (and disadvantages) as a multi-member LLC, which we will detail below.
5 differences between a sole proprietorship vs. LLC
Now that we’ve defined a sole proprietorship and an LLC, what are the main differences separating them? What are their unique advantages? Which one is right for you? As you consider which type of entity is best suited for your business, compare and contrast the two types of business structures with five key categories in mind:
1. Sole proprietorship vs. LLC: Getting started
Sole proprietorship — Sole proprietorships are relatively easy to set up. In some states, such as Virginia and California, you don’t need to file any legal paperwork with the state government to have a sole proprietorship.1 All you need is to pick a name, obtain relevant business permits and licenses, and begin conducting business. If you want to hire employees, you’ll need an Employer Identification Number (EIN), but that’s it.
However, before you turn on your “Open for Business” sign, be sure to check your state’s specific business registration requirements.
LLC — As you may have guessed, there’s more paperwork involved with registering an LLC. You’ll need to form the company, register it with the state, and file an article of incorporation. If there’s more than one member in your LLC, you’ll need to obtain an EIN for tax purposes.
There will also be some costs involved when you form an LLC. For example, in Virginia, it costs $100 and in California, it costs $70 to register a new LLC.2,3 It may also take a few weeks to process your paperwork, depending on your state.
2. Sole proprietorship vs. LLC: Getting credits and loans
Sole proprietorship — If you need to raise money to start your sole proprietorship, you’ll need to look into traditional means, like taking out a loan or a line of credit from the bank. Also, with a sole proprietorship, you can’t sell a portion of ownership in the business because it would no longer be considered a sole proprietorship.
LLC — It’s generally easier to raise money with an LLC. If needed, the LLC can offer ownership interest as collateral for capital infusion, as LLCs are considered to be less of a risk. In addition, lenders can’t leverage debts and other financial obligations against owners, so if a loan does go unpaid, the owners’ personal bank accounts aren’t on the hook.
3. Sole proprietorship vs. LLC: Management and operations
Sole proprietorship — It’s simple to manage and operate. The sole proprietor is the person in charge and responsible for all decision-making. They can hire whomever they want to manage day-to-day operations, help with taxes or legal work, and liaise with vendors. It is their business to run entirely.
LLC — A little more complex, an LLC’s structure is usually outlined in its operating agreement, especially when more than one person is involved. Operating agreements detail the decision-making and profit-sharing processes that will govern the business.
An LLC’s members can manage it, or choose a manager. If there is more than one member, members may vote on legal, financial, and hiring matters, and the decision will be based on the percentage members own in the business.
4. Sole proprietorship vs. LLC: Filing taxes
Like all businesses, both LLCs and SPs need to pay payroll taxes if they have employees and collect state and local sales taxes if taxable services or goods are sold. Also, both SPs and LLCs pay social security and Medicare taxes to the IRS through their self-employment taxes.
When it comes to income tax, both sole proprietorships and LLCs are considered to be “pass-through entities” by default, meaning the business itself doesn’t pay income taxes. Instead, profits pass through to the business owner, who then pays income taxes accordingly. However, LLC owners have more flexibility regarding income taxation and can opt for a different approach, which we’ll explain below.
Sole proprietorship — With an SP, taxes are tied to the business’s net income, which means taxes are included on the sole proprietor’s individual tax return and at the appropriate tax bracket.
LLC — A few options are available for LLCs when it comes to how they want to be taxed. They can either default to taxation as a pass-through entity or elect to be taxed as an S-corporation or a C-corporation. An S-corporation is an entity that passes its corporate income, losses, deductions, and credits through to shareholders for federal tax purposes. If taxed as a C-corporation, the LLC will pay corporate income tax at the federal level.
The benefit of being taxed as an S or a C-corporation is that retained earnings in a corporation aren’t subject to income tax. And when a company is taxed as a corporation, dividends from the business are usually taxed at a lower rate than ordinary business income.
If your business is registered as an LLC, we recommend that you speak with a tax professional to determine the most appropriate method for filing your taxes.
5. Sole proprietorship vs. LLC: Personal liability
Sole proprietorship — With no legal separation between the business and the owner, the sole proprietor is exposed to all of the company’s liabilities, debts, and financial risks. This means that in the case of a liability claim or credit default, the courts or the creditors can seek remedies from the owner’s business and personal finances. As such, a sole proprietorship has a much bigger liability risk, which should be covered with the appropriate business insurance.
LLC — The owner’s assets are separate from the business’s assets, so an owner isn’t personally responsible for obligations, debts, or defaults. If a hardship befalls the company, it can’t be used against an owner personally — unless a personal guarantee against a business loan was provided. An LLC will still require business insurance, but the risk to personal financial liability is considerably less than with a sole proprietorship.
Shield your business
Whether you decide to designate your business as a sole proprietorship or LLC, it’s essential to safeguard your business with insurance.
You have options: General liability insurance covers claims of third-party bodily injury and property damage, and personal and advertising injury. Professional liability insurance covers claims that your professional services caused your client a financial loss. Many businesses need both types of coverage. And if your business is sued, both types of insurance will provide your legal defense.
Thimble makes it easy to get tailor-made insurance coverage by the job, month, or year. Choose how you pay, then upgrade when business really takes off. Click “Get a Quote” or download our app, answer a few questions about your business, and get covered in minutes.