Are you about to launch a business? Then you’re probably thinking about how to structure it.
Sole proprietorships and limited liability companies (LLCs) are two of the most popular options. A sole proprietorship can have only one owner, while an LLC can have a single owner or multiple owners. But there are a ton of other differences too.
We’ll cover all the important differences in this article—like how they’re taxed and which one is better—and do a quick overview of each of them. Let’s get started so you can figure out which structure is right for you.
Sole Proprietorship vs. LLC 101
A sole proprietorship is for businesses that have a single owner. In a sole proprietorship, there’s no separation between the business and its owner. In contrast, an LLC can have one or multiple owners. And you create a separate legal entity for your business when you register your LLC.
Why is that important? Having a separate entity means that if you’re sued for damages, the business gets sued, not you as the owner. An LLC gives you—and your assets—a lot more protection.
Now that we answered your burning question, let’s take a closer look at each structure. We’ll discuss some other differences between the two you’ll want to consider once you know a bit more about them.
Sole Proprietorship Explained
A sole proprietorship is an unincorporated business run by a single person. It also can’t formally be registered as a business. For instance, the IRS considers any self-employed person a sole proprietor. So if you operate a food truck or run a startup from your garage, you can still qualify as a sole proprietor.
If you run a sole proprietor business, the IRS treats you and your business as one. Why does it matter, you say? Well, running a business as a sole proprietor has many implications:
- You have to report the income from your business through your personal tax return.
- There’s no distinction between your personal and business assets.
- You’ll be personally liable for a loss or damage caused by your business. That means if someone sues you for any reason, the money comes out of your personal bank account.
This may sound like a lot, but it’s actually the most popular choice. More than 70% of American businesses are sole proprietorships. What makes people choose a sole proprietorship despite knowing they’re on the hook if something major happens? Well, it’s easy to set up. Let’s go over how to start and run a sole proprietorship.
How To Start a Sole Proprietorship
You don’t need any legal registration to start a sole proprietorship. If you’re a self-employed person, you automatically become a sole proprietor.
But if you want to use a business name, you’ll have to apply for a Doing Business As (DBA) certificate. And if you plan to hire employees, you'll need an employer identification number (EIN).
Besides that, you may need to complete some paperwork depending on your type of business and industry. These things may include:
- Industry-specific business licenses.
- Occupational licenses.
- Commercial zoning permit.
For example, if you plan to start a food truck, you’ll need to obtain a food handler’s license and health department permit.
How To Run a Sole Proprietorship Business
When you run the business as a sole proprietor, you’re on your own. You have complete authority to make decisions. You don’t wait for approvals from partners or a board of directors.
You don’t even need to open a different bank account for your business. However, keeping your personal and business finances apart is still a good practice and will make it easier to file your taxes.
Liability Protection
The sole proprietorship structure doesn’t provide personal liability protection. In other words, if someone sues your business, they are effectively suing you, and can go after your personal property. For protection, you may need to get essential insurance coverage, such as:
Who Should Opt for a Sole Proprietorship?
Sole proprietorship suits people who want to run a small, low-risk business. You may want to go for sole proprietorship if:
- You want to launch a business quickly.
- You’re testing a new business idea.
- Your primary customers are friends and family.
- You have no immediate expansion plans.
That said, you can always start your business as a sole proprietorship and then convert it to another structure, such as an LLC, as it grows.
What Is an LLC?
LLC stands for limited liability company. It is a business entity registered with the state and has single or multiple owners, known as members. An LLC and its owners are considered separate entities. Put simply, if you own an LLC, the company's assets and liabilities are legally separated from your personal assets. So, if a customer sues your business, your personal property is protected.
How To Open an LLC
When forming an LLC, you need to register your business with your state. While each state has slightly different requirements, here are the typical steps:
- Draft an LLC operating agreement—rules you and your partners agree upon.
- File articles of organization with the secretary of state.
- Open a bank account exclusively for the LLC.
- Get an EIN.
You’ll also need to submit a fee to register your LLC. States charge an LLC filing fee ranging from $40 to $500, with an average LLC filing fee of $132. On top of that, you might also need to hire a registered agent for your LLC.
A registered agent receives legal and tax documents for your LLC. This person can be you, another member, or a hired professional. Hiring a registered agent for your company can be helpful since they are more familiar with what you need to report to the government.
Depending on the state, you may also need to register a name for your LLC, known as a DBA or trade name. Visit your state website to check out their specific requirements. If you are the business's sole owner, you’ll need to register as a single-member LLC.
Is a Single-Member LLC the Same as a Sole Proprietorship?
A single-member LLC and a sole proprietorship are similar in their operation, but they aren’t the same.
First, you’ll need to register your single-member LLC with the state (you don’t need to register your sole proprietorship). Second, even if you are a single member, you must keep your business and personal accounts separate. Also, you’ll need to file annual reports with the state.
Looks like a lot of work, right? You might wonder why people choose a single-member LLC over the simpler sole proprietorship. Let’s get into that right now.
Benefits of a Single-Member LLC vs. Sole Proprietorship
We’ve already said this a ton, but we’ll say it again since it’s so important: the main benefit of being a single-member LLC is that your personal assets are legally protected. If someone comes after your business, you won’t have to pay them from your personal bank account. What are the other benefits?
- Flexibility in taxation compared to sole proprietorships.
- Can add more owners to make a multi-member LLC.
- And, once again, your personal assets are protected.
How To Run Your LLC
Unlike a sole proprietorship, where it’s just you running things, an LLC is a little more complicated. First, your LLC’s daily activities should follow your operating agreement—the rules you and your partners agree on during the LLC formation.
Second, in a multi-member LLC, you need to consult every member before making a decision. The members can vote on the decision based on their share in the business. For example, if a member has a 25% stake in the company, they own a quarter of the votes. Put simply, it may take more time to make business decisions in an LLC.
Besides that, an LLC needs to keep a separate bank account for the business. For instance, if you registered your coffee startup as an LLC, the startup's cash should stay in your business account and shouldn't mix with your personal finances.
LLCs also need to do more extensive year-end accounting. If you have an LLC, you’ll need to:
- Go over your business account and check that the balance matches your income after deducting your expenses—also known as account reconciliation.
- File an annual report with the state that contains information such as your business address, names and addresses of members, state identification number, and list of authorized signatories.
- Pay annual LLC fees.
Who Should Opt for an LLC?
Opening and running an LLC might seem overwhelming at first. But in the long run, choosing an LLC might be beneficial if you:
- Operate a high-risk business (and therefore could possibly be sued).
- Have plans to expand your business.
- Want to pursue investors and business creditors.
- Have a high cash flow business and need flexible tax plans to minimize your taxes.
Before making your final decision, let’s discuss what we often hate the most: taxes.
Sole Proprietorship vs. LLC: Taxation
Sole proprietors file taxes as a part of their personal income tax returns. LLCs can also choose to do the same, but they have much more flexibility in choosing how they’re taxed.
How Is a Sole Proprietorship Taxed?
The IRS considers sole proprietorship businesses as “pass-through” entities. It means the income from the business is passed onto the owner’s personal tax return.
You’ll need to fill out a Schedule C to report profit or loss from your business along with your Form 1040.
What Taxes Does a Sole Proprietorship Pay?
Here is the list of taxes you pay as a sole proprietor:
- Taxes on your business income.
- Self-employment tax (SE tax) that goes toward Medicare and Social Security. The self-employment tax rate in 2022 is 15.3%, out of which 12.4% goes to Social Security and 2.9% to Medicare. This is essentially just the full tax rates for these things, which normally would be split equally with an employer if you were hired by someone.
If you have employees, you’ll also need to pay the employer portion of that tax. But you can show it as a business expense on your Schedule C. Are all these taxes making your head spin? Take figuring out payroll taxes off your plate by signing up for Hourly. The easy-to-use app submits all your state and federal payroll taxes for you, and lets you pay employees with just one click.
How Is an LLC Taxed?
By default, the IRS considers single-member LLCs as sole proprietorships. That means you’ll file business income on your personal income tax return. You’ll also do this if you’re a multi-member LLC. Due to this, both single- and multi-member LLCs are considered pass-through entities.
Either way, you’ll have to pay the full 15.3% tax for Social Security and Medicare on your personal tax return (a.k.a. self-employment tax). Not too thrilled about that? As an LLC, you have other tax options too. Here are all the ways you can be taxed as an LLC:
- S corporation: Income from the business is still passed through to your personal tax return, but you have the option to pay yourself a W-2 salary. Your salary is only subject to half of the 15.3% tax for Social Security and Medicare. The other half is paid for by your business, but you can write it off as a business expense.
- C corporation: You pay the corporate tax rate of 21% on your business’s taxable income, which is revenue minus operating expenses. You can also pay yourself a salary, which is reported as W-2 income on your personal return. Like an S corp, your salary is taxed half of the 15.3% tax for Social Security and Medicare. The other half will be paid for by your business (and can be written off as an expense). If you take an owner’s draw or pay money to shareholders, the recipient must pay taxes on these payments.
- Partnership: Business income is split between the partners, and each person’s portion of the profit is reported on their personal tax return. Each individual will pay income tax based on their portion, along with the full 15.3% tax for Social Security and Medicare.
- LLC classification (default option): Business income is reported on your personal tax return and subject to your personal income tax rate. You will also pay the self-employment tax, which is 15.3% if your business brings in less than $147,000 per year. This is how sole proprietorships are taxed as well.
Some states also charge you additional taxes for operating an LLC. For example, California requires all LLCs to pay an annual tax of $800. Besides that, you pay an additional LLC fee if your income exceeds $250,000. The exact figure depends upon your income slab. So, based on what you earn, you may end up paying an annual LLC fee ranging from $900 to $11,790.
Which Business Structure Has Lower Taxes?
Both sole proprietorships and LLCs pay the same taxes if they choose to get taxed on their personal tax return. But LLCs have options to adjust their tax rates and pay less tax than a sole proprietorship.
Here are a few LLC structures that can help you save on taxes:
S Corporation
With a sole proprietorship, you have to pay 15.3% self-employment tax (for Social Security and Medicare) and your regular income tax. But with an S corporation, you can pay yourself a salary—you’re only taxed half that 15.3% tax on the salary you pay yourself. Your business pays the other half, and you can deduct that as a business expense when you file your business’s tax return.
In an S Corp, when you get distributed some of the profit, you won’t have to pay 15.3% self-employment tax on that either. Instead, you’ll just pay income tax on it. In contrast, all income and extra profits in a sole proprietorship are subject to that 15.3% self-employment tax. So it could really benefit you tax-wise to file as an S corp.
C Corporation
Filing your taxes as a C corp benefits you if you plan to keep your earnings in the business account for future growth.
If you choose to file your taxes as a C corporation, the tax rate is 21%. So if you keep all your business income within your business account, you’ll only need to pay 21% corporate taxes on those earnings instead of the 32-37% income tax you’d pay as a high-earning sole proprietor.
Besides that, similar to S corporations, you can pay yourself a salary and only pay the employee portion (7.65%) of the payroll taxes—which is half of the self-employment tax.
In other words, LLCs have huge tax benefits for small business owners compared to sole proprietors. But keep an eye out for other taxes and fees levied on LLCs before making your final decision.
Sole Proprietorship vs. LLCs: Which Is Better?
Since an LLC gives you more flexibility with taxes and protects your personal property, it’s a better choice if you have the resources to handle the extra fees and administration.
LLCs have a ton of benefits for entrepreneurs compared to sole proprietorships, like:
- Liability protection: Your personal assets are safe from lawsuits or damage claims involving the business.
- Tax benefits: LLCs can help you minimize your taxes.
- Growth potential: LLCs help you expand your business by adding more owners.
- Credibility: Registering a business as an LLC may help you build trust with your investors and customers.
Even if you are a single owner, registering your business as a single-member LLC will give you all the above benefits.
But not all businesses have to register as LLCs. If you want to quickly launch your small business at the minimum cost, go for a sole proprietorship.
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