LLC vs Sole Proprietorship – What are the Differences, Advantages & Disadvantages!

Learn all about LLCs and Sole Proprietorships and why one might be better than the other!
Denise E
Denise E
Senior Financial Editor & Contributor
Last Updated: April 15, 2021
Date Published: March 29, 2021

Deciding whether to incorporate or not is a big decision that you need to make as a business owner.

Today we are going to discuss two main business entity types: LLCs (limited liability companies) vs Sole Proprietorships.

We are going to dive into each one and talk about their advantages, disadvantages and differences so that you can make an informed decision when forming your company.

Let’s get started!

LLC vs Sole Proprietorship – What are the Differences, Advantages & Disadvantages!

LLC California Cost

LLC (Limited Liability Company)

An LLC is a popular and safe option for most small business owners.

It provides a flexible business structure and is fairly simple to set up.

Why business owners choose an LLC:

  • Business owners are not liable for the company’s debts and can choose their own management structure.
  • They qualify for pass-through taxation – meaning that profits are only taxed once.

Each business structure has its own advantages and features but for the majority of small businesses, an LLC is going to be the best choice.

LLC’s are simple, flexible and protect your personal assets.

An LLC (limited liability corporation) is a business structure designed to protect business owners from being personally liable for the company’s debts or other liabilities.

Furthermore, LLC’s can be owned by more than one person known as LLC “members”.

If the business doesn’t do as well as planned or you have a rough year, you as the business owner are personally protected under an LLC.

For example, if your LLC declares bankruptcy or is sued, your personal assets such as your vehicle, personal bank accounts, and house are safe.

Single-member LLC’s are pass-through entities which means that profits and losses from the LLC are “passed through” to you and taxed as personal income.

This benefits you because you are not required to pay both corporate and personal taxes on your earnings.

Multi-member LLC’s are taxed as partnerships and are also pass-through entities.

This means each owner pays personal income taxes on their portion of the profit.

Benefits of an LLC

  • No member limit- The owners or members of an LLC are free to choose whether the owners or designated managers run the business and how many member they want.
  • Personal asset protection – as mentioned above, your personal assets are protected should your LLC go bankrupt or be sued.
  • Pass-through taxation benefits – Limited liability companies are taxed differently from other corporations. An LLC allows pass-through taxation, which is when the business income or losses pass through the business and are instead recorded on the owner’s personal tax return. As a result, the profits are taxed at the owner’s personal tax rate. A single-member LLC is typically taxed as a sole proprietorship. Any profits, losses, or deductions, which are business expenses that reduce taxable-income, are all reported on the owner’s personal tax return. An LLC with multiple owners would be taxed as a partnership, meaning each owner would report profit and losses on their personal tax return.
  • Simple to set up and maintain – no annual meetings, formal officers, or complicated records.
  • Flexible – LLC’s have very little restrictions regarding the company’s structure. You decide if you want your business to be a single member LLC, multi-member LLC, and so on.
  • LLC’s are a widely recognized business structure and bring credibility to your organization.
  • Access to financing – Once your LLC is formed, you can start to build a credit history which opens the door to business loans and financing to grow your business.
  • Flexible profit sharing – LLC’s can choose how they want to do their profit sharing, they are not required to be equally distributed among members.

Cons of an LLC

  • Somewhat expensive formation and maintenance – More costly to establish than a sole proprietorship or partnership and LLC’s must file an annual report, and the fee can cost hundreds of dollars
  • Potential Funding challenges – One of the disadvantages of an LLC is when ownership needs an injection of cash or money. If the LLC had gotten turned down for a bank loan, it could be difficult for the owner to attract money from outside investors. A corporation might be able to raise cash from venture capitalist firms, which provide money to businesses in exchange for a share of the profits. Venture capitalists usually only fund corporations and not privately-owned LLCs.
  • Limited Liability can have limits – In a court proceeding, a judge can rule that your LLC structure doesn’t protect your personal assets. The action is called “piercing the corporate veil,” and you can be at risk for it if, for example, you don’t clearly separate business transactions from personal, or if you’ve been shown to have run the business fraudulently in ways that resulted in losses for others.
  • Self-Employment Tax – By default, the IRS considers LLCs the same as partnerships for tax purposes, unless members opt to be taxed as a corporation. If your LLC is taxed as a partnership, the government considers members who work for the business to be self-employed. This means those members are personally responsible for paying Social Security and Medicare taxes, which are collectively known as self-employment tax and based on the business’s total net earnings.
  • Member turnover – In many states, if a member leaves the company, goes bankrupt or dies, the LLC must be dissolved and the remaining members are responsible for all remaining legal and financial obligations necessary to terminate the business. These members can still do business, of course; they’ll just have to start a whole new LLC from scratch.

LLC Key Takeaways

  • For LLC’s, business operations are much simpler, and the requirements are minimal.
  • An LLC is a type of business entity that’s owned by its members. The entity is separate from the members.
  • Simple to set up and maintain – no annual meetings, formal officers, or complicated records.
  • Limited liability companies are taxed differently from other corporations. An LLC allows pass-through taxation, which is when the business income or losses pass through the business and are instead recorded on the owner’s personal tax return. An LLC with multiple owners would be taxed as a partnership, meaning each owner would report profit and losses on their personal tax return.
  • Easy to setup and maintain and cheaper than other business types
  • LLC’s have very little restrictions regarding the company’s structure. You decide if you want your business to be a single member LLC, multi-member LLC, and so on.

Learn more about LLC’s and how to form them here.

Sole Proprietorship

Sole proprietorships are perhaps the most different and unique compared to corporations, limited liability companies (LLCs), partnerships, etc.

The biggest difference is that a sole proprietorship is not a separate legal entity.

The business owner and the sole proprietorship are essentially the same, thus making the owner responsible for any and all liabilities incurred by the business entity.

A sole proprietorship is an unincorporated business with only one owner who pays personal income tax on profits earned.

Why business owners choose a Sole Proprietorship:

  • The main benefit of a sole proprietorship is the pass-through tax advantage
  • Ease of creation, and the low fees of creation and maintenance.

The biggest disadvantage of a sole proprietorship is that the owner has unlimited liability.

Many entrepreneurs begin as a sole proprietorship because of how simple they are to setup and because filing taxes is pretty straightforward.

However, most sole proprietorships eventually end up getting restructured to an LLC as the company expands and grows.

Pros of Sole Proprietorship

  • Easy and inexpensive to form – A sole proprietorship is the simplest and least expensive business structure to establish. Costs are minimal, with legal costs limited to obtaining the necessary licenses or permits.
  • There is a lack of government involvement, making them popular with small business owners and contractors.
  • All profits/losses are passed through to the owner’s personal tax return and you are only responsible for paying personal federal, state, local and Federal Insurance Contributions Act (FICA) taxes. You are not required to pay any specific business taxes or unemployment taxes.
  • Complete control – Because you are the sole owner of the business, you have complete control over all decisions. You aren’t required to consult with anyone else when you need to make decisions or want to make changes.
  • Easy tax preparation – Your business is not taxed separately, so it’s easy to fulfill the tax reporting requirements for a sole proprietorship. The tax rates are also the lowest of the business structures.
  • You can still enjoy just about all of the same tax benefits of being self-employed, from turning some of your personal expenses into business expenses (business use of your home or car, for example), utilizing self-employed retirement plans like Simplified Employee Pension Individual Retirement Accounts for higher deductions, writing off regular business expenses such as marketing costs, writing off business travel costs, writing off costs to entertain clients and more.

Cons of Sole Proprietorship

  • Unlimited personal liability – Because there is no legal separation between you and your business, you can be held personally liable for the debts and obligations of the business. This risk extends to any liabilities incurred as a result of employee actions.
  • Funding challenges – Sole proprietors often face challenges when trying to raise money. You cannot sell stock in the business, which limits investor opportunity. Many financial institutions will characterize loans as “personal loans” rather than “business loans.” Banks are also hesitant to lend to a sole proprietorship because of a perceived additional risk when it comes to repayment if the business fails.
  • More on the line – The flip side of complete control is the burden and pressure it can impose. You alone are ultimately responsible for the successes and failures of your business. Hardships and failures not only affect your business, but your personal life since there is no legal separation between the two.

Sole Proprietorship Key Takeaways:

  • Simple to set up and maintain – no annual meetings, formal officers, or complicated records.
  • As the sole owner of the business, you have complete control over all decisions. You aren’t required to consult with anyone else when you need to make decisions or want to make changes.
  • Easy tax preparation – Your business is not taxed separately, so it’s easy to fulfill the tax reporting requirements for a sole proprietorship. The tax rates are also the lowest of the business structures.
  • Unlimited personal liability – Because there is no legal separation between you and your business, you can be held personally liable for the debts and obligations of the business. This risk extends to any liabilities incurred as a result of employee actions.
  • Most sole proprietorships end up being restructured to an LLC or other business type.

Conclusion

While there is definitely a place for Sole Proprietorships and many small business owners choose this structure, as mentioned before, most of them end up restructuring to an LLC.

An LLC provides the liability protection that a sole proprietorship does not and you still get the pass-through taxation benefits.

Although LLCs are a little more expensive to set up initially, they are still pretty straight forward (you can use a formation service to set up your LLC), and they give you the peace of mind that your personal assets are protected should your business hit a rough patch.

As you can see there are pros and cons to both types of business entities, so it all boils down to which option is the best fit for your business.

If you know that an LLC is the right option for your business, checkout our step-by-step guide to setting up your LLC.

Sole proprietorships are super simple to set up and can be done with your local state or with a formation service.

If you still aren’t sure which business type is right for you, we highly recommend speaking to a tax professional to determine which formation type is appropriate for your business.

Other articles you may be interested in:

Business Startup Checklist – A list of things needed to start a business

General Partnership vs LLC

LLC vs S Corporation

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  1. IRS.gov "Starting a Business" Page 1. April 7, 2021

  2. IRS.gov "Limited Liability Company (LLC)" Page 1 . April 7, 2021

  3. SBA.gov "10 Steps to Starting Your Business" Page 1. April 7, 2021

  4. IRS.gov "Sole Proprietorship" Page 1 . April 7, 2021