Sole Proprietorship Vs. LLC: Here’s What You Need To Know

If you’re opening up a new small business, setting up an online store or starting a freelance side gig, you might be trying to figure out whether an LLC or sole proprietorship is best for your needs. These two business models can make a significant difference in how you run your company from a legal, tax and management perspective. Here’s what you need to know about what sole proprietorships and LLCs do and how to choose the best option for your needs.

At a Glance: Sole Proprietorship Vs. LLC

Sole proprietorships and limited liability companies (LLC) are two of the most common business structures for individuals and small businesses. A sole proprietorship is the simplest and requires minimal paperwork. An LLC requires upfront paperwork and costs but could provide your business long-term benefits that make the investment worth it. Legal protection and potential tax advantages are two big factors to consider when choosing between a sole proprietorship and an LLC.

What Is a Sole Proprietorship?

A sole proprietorship is an unincorporated business that’s owned by the individual running it. A sole proprietorship is the default choice for anyone who runs a business but hasn’t set up another formal business structure like an LLC. As a sole proprietor, there’s no separation between your personal and business assets and expenses.

Individuals that do a lot of contractual work, such as freelancers, consultants and personal trainers often choose to file their taxes as sole proprietors. This is the easiest way to go if you’re just starting out or you’re not yet making enough profit to justify the costs of an LLC. However, even if you’ve been in business for decades, a sole proprietorship may still be the best option, depending on the type of business you run. It’s all going to depend on your income, business type and your personal management preferences.

What Is an LLC?

An LLC is a business where the owners are not personally liable for the company’s debts or liabilities. This creates a legal and financial separation between the LLC and the owner and means that a creditor could not legally go after your personal assets if you are unable to pay your debts. Additionally, the company’s bankruptcy is considered separate from the individual’s.

Limited liability is one of the main reasons people choose to open an LLC instead of remaining a sole proprietor. If your business has more than one person on the team, an LLC is likely the most straightforward way to structure your business. If your business is composed of just one owner, the IRS will treat your LLC as a sole proprietorship. While setting one up is more involved than a sole proprietorship or partnership, the benefits for many small businesses make it worth the time and costs.

It is also worth noting that, with an LLC, earnings are distributed among the owners, and LLC income is taxed as individual income rather than corporate income. An LLC is considered a pass-through entity, in which business income is treated as personal income to the owners. An LLC is also distinct from a Corporation, which is a different classification with its own unique taxing structure.

When Should You Open an LLC?

There are a few reasons to open up an LLC instead of operating as a sole proprietorship:

• You want to expand the company to more than one owner, which is easy with an LLC.
• You want to protect your personal assets from potential financial and legal liability.
• You want to take advantage of any applicable local, state or federal tax benefits that come with forming an LLC.

In summary, setting up an LLC could be a good solution if you want to separate your personal and business assets and liability. Because LLCs operate as an independent entity, the owner’s personal assets are protected from lawsuits the company may face.

People also consider opening up an LLC when they reach a certain income threshold in their business and the additional fees and paperwork make sense from a tax perspective. This varies by state and the type of business, so it’s a good idea to speak to your accountant and compare the taxes you’ll be paying with each business structure.

Running Your Business as a Sole Proprietorship Vs. LLC

There are a few distinctions in operating a business as a sole proprietorship vs. an LLC. As a sole proprietor, there’s no separation between you and your business. This could be the best arrangement for a consultant, freelancer or independent contractor. In these situations, you would claim your income on your personal tax return.

Sole proprietors are not obligated to separate their personal and business expenses. However, you can still keep your business and personal finances separate by opening up a different checking account for your business. This will make it easier when it comes time to file your taxes. You’d also be able to operate under your business name, called “Doing Business As.”

However, when a person wants to scale their business, determines the limited liability is necessary, or wants to expand the business team, it may be time to consider opening an LLC. Some people choose to open up an LLC because it gives their business a sense of legitimacy. You’d be operating your business as a company, receive payment from the company name, and your clients will see your LLC.

With an LLC, you’ll be able to establish business credit in a way that you couldn’t with a sole proprietorship. An LLC is considered a legal entity, which means you’ll be filing a separate tax return for your company and pay yourself a salary. When you’re deciding whether to open up an LLC, the fees associated with an extra tax return are additional expenses to consider.

Frequently Asked Questions (FAQs)