Sole proprietorship vs LLC: Differences, pros and cons

Sole proprietorship vs. LLC: Overview

Determining what business structure is right for you is the most crucial step before starting a business. If you’re a first-time or seasoned business owner ready to start a new venture, weighing your options can be stressful. Two of the most common forms of business for individual and small business owners are sole proprietorships and limited liability companies (LLCs).

A sole proprietorship and LLCs share some similarities and differences to consider before making a decision. Both business models can function as a single-owned business. However, a sole proprietorship can only have one owner. In contrast, an LLC provides the option to have multiple.

If a business owner wants to operate as an LLC without shared ownership, the LLC becomes a single-member limited liability company (SMLLC). This structure is often selected to maintain some of the liability protections and credibility of an LLC as a single owner.

Single or multi-member LLCs and sole proprietorships are both pass-through entities. This means all revenue or losses must be reported by “passing through” to the owner’s personal income tax return. As a result, the business owner can handle their personal and business-earned income the same. This means all business earnings will be taxed under the owner’s individual tax rate.

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What is a sole proprietorship?

A sole proprietorship is an unincorporated business belonging to a single owner. The sole business owner is personally responsible for all business assets and liabilities. A sole proprietorship is not a separate legal entity. This means there is no separation between the owner’s personal and business assets. It is recommended to obtain business insurance to provide coverage for unexpected financial liabilities.

Individuals who sell goods or provide services automatically function as sole proprietors by default unless the business owner chooses another business structure. For example, freelance writers, photographers and accountants are common sole proprietorship businesses. Low risks and simplicity make this business model an excellent choice for small start-up companies before generating high revenue and onboarding employees.

If the business expands, you can hire employees to assist in growing your business. However, as the name implies, there can only be one “sole” business owner. If you decide to share ownership by partnering with someone, your business is no longer a sole proprietorship. Instead, the business becomes a general partnership. This allows two or more owners to share business responsibilities, including financial and legal obligations.

Sole proprietors do not have to choose a business name because the business is not a separate entity from its owner. Therefore, the owner’s name is the business name unless the owner decides to rename the business. In this case, the owner must register a fictitious or “doing business as” (DBA) name within the state.

Pros:

• Simple setup.
• Low startup costs.
• Little to no paperwork.
• Does not need an employer identification number (EIN).

Cons:

• Cannot sell stock.
• Harder to obtain financing from banks and investors.
• No separation between personal and business assets.
• Less credibility.

What is an LLC?

An LLC is a single or multi-member unincorporated business that functions as a separate legal entity from its owners or “members.” However, the IRS does not separate business taxes from the members’ personal tax returns. As a result, LLCs are considered pass-through entities. This means all taxes on business assets are distributed based on each member’s share that is established in the LLC operating agreement.

LLCs provide flexible tax treatment, which means members can decide to be taxed as a corporation, S corporation or C corporation to avoid self-employment tax. This may or may not lower taxes due to the risk of acquiring double taxation, depending on which option you choose. Unlike most business structures, an LLC provides the combined benefits of a sole proprietorship and corporation.

As an LLC, members also benefit from liability protection. This means the company is responsible for all financial liabilities, providing a corporate veil that protects members’ personal assets. To maintain the corporate veil, it is recommended to open a business bank account to keep personal and business finances separate.

To identify your company as a separate legal entity, you must choose a distinguishable business name. Additionally, as an LLC, it is mandatory to include “limited liability company” or abbreviations such as “LLC” at the end of the business name.

Better protection, tax flexibility and multi-ownership make this business model an excellent option for small and medium-sized businesses that want to minimize financial risk.

Pros:

• Tax treatment flexibility.
• Can have multiple owners.
• Enhanced credibility.
• Easier to obtain financing from banks and investors.

Cons:

• Cannot issue stock.
• More paperwork.
• Cannot operate internationally.
• Annual filing fees.

Sole proprietorship vs. LLC: Formation costs

There are no start-up costs to establish a sole proprietorship. However, there are several low-cost options to consider. If the owner decides not to operate under their name and wants to register the business under a fictitious name, there will be a name search and registration fee.

Additionally, sole proprietors may decide to obtain a domain name to launch a company website, get business insurance and, if necessary, apply for business licenses or permits.

Starting an LLC requires a formal arrangement, considering it is a separate legal entity from its members. Therefore, the LLC must be:

• Registered within a state.
• Obtain a registered agent.
• Reserve a business name.
• Obtain applicable business licenses and permits.
• A published notice of a newly established LLC (applicable in some states).

Once you’ve started your business, there is an annual LLC fee to maintain registration. If you decide to operate the LLC outside its originating state, there is a foreign LLC registration fee. Keep in mind, LLCs cannot operate outside of the United States. This means business could only take place in another state.

Between mandatory and optional costs and the state in which it is registered, LLC filing fees can range between $40 to $500. To learn more about these required and circumstance-based LLC startup costs, read our LLC formation costs guide.

Sole proprietorship vs. LLC: Taxes

Sole proprietors must pay self-employment taxes if the business’s overall profit surpasses its annual expenses. This information is reported on Schedule C with Form 1040 of your personal income tax return. As of 2023, the self-employment tax rate is 15.3%. Currently, 12.4% goes towards Social Security tax, and 2.9% covers Medicare tax.

Additionally, you may have to pay federal and state taxes depending on the state. If you hire employees, you will also pay employment tax. Fortunately, you may qualify for tax deductions to subtract necessary business expenses from your taxable income.

By default, single-member LLCs are taxed the same as a sole proprietorship. However, multi-member LLCs will distribute taxes based on the percentage each member owns of the company. For example, a member owning 10% of the company will pay taxes on 10% of the business profit. Each member must file using Schedule K-1 (form 1065) to report their share of the company’s revenue and losses.

Alternatively, LLCs have the option to be taxed as a corporation. If the member or members of the LLC decide to be taxed as a C corporation, you will file taxes using form 1120, leading to a 21% federal corporate tax rate. If the LLC chooses to be taxed as an S corporation, the business will be taxed the same as a pass-through entity using form 1120-S.

Sole proprietorship vs. LLC: Personal liability protection

Sole proprietorships do not provide personal liability protection. Instead, sole proprietors are fully responsible for all business liabilities, including financial obligations and debt. However, there is an option to get business insurance to protect your personal assets from your business.

The type of coverage and costs for small business insurance depend on the level of risks, generated revenue, number of employees, location and history of business claims. General liability, commercial property and worker compensation are the most common types of coverage for small businesses.

However, in return for the upfront costs to start an LLC and annual filing fees, members benefit from the limited liability protection. This protects LLC members’ personal assets from potential business lawsuits, debts and losses by keeping the business as a separate entity from the members.

Sole proprietorship vs. LLC: Management structure

Sole proprietorships are single-owned businesses that solely rely on the owner to make all significant business decisions. If necessary, sole proprietors can hire employees to alleviate some job responsibilities. However, the business owner is responsible for completing the required steps to start the business. Additionally, the owner is in control of structuring daily operations, business finances, inventory and managing employees.

In contrast, an LLC is often a multi-member business that uses a member-managed or manager-managed business structure. A member-managed LLC allows all members of the company to share responsibilities within the business. This does not mean responsibilities are evenly distributed between members. Instead, this structure empowers members to contribute to the business collectively.

A manager-managed LLC puts selected managers of the company in charge of making key decisions for the business. However, there is an option to establish a member voting system to keep all members involved in the decision-making process. Once members of an LLC decide on a management structure, this decision is documented in a contract called an operating agreement.

Which is best for your business?

Sole proprietorships and LLCs are great business structures for small and medium-sized businesses. If you plan on operating as a small, single-owned, low-risk business without the increased complexity of onboarding employees, then a sole proprietorship may be the best choice. Additionally, less paperwork, easy setup and low cost make this an excellent business model for start-ups before generating high revenue.

Small, low-risk businesses that function as sole proprietorships include freelance writing, tutor services and accounting businesses. In contrast, an LLC would be a better choice for a small to medium-sized, higher-risk and multi-member business that would benefit from liability protection to protect the business owner’s and members’ personal assets. Remember, as your business expands, you can change your business structure from a sole proprietorship to an LLC. Suppose your business is ready to grow from one to multiple members. In that case, it will significantly benefit from a formal business structure that functions as a separate legal entity from its members and has an operating agreement among its members.

	SOLE PROPRIETORSHIP	LLC
Formation costs	No required start-up fees	Fees range from $40 to $500
Taxes	Pass-through tax structure	Tax treatment flexibility
Management structure	Sole owner in control of business	Uses a member-management or manager-managed business structure

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