Sole Proprietorship vs. LLC

ByI. Mitic
December 22, 2021

A sole proprietorship and a limited liability company (LLC) are the two most common options for starting a business nowadays. Of course, there’s a significant difference between a sole proprietor and LLC, and choosing which will serve your business operations better requires some knowledge about each organization.

Insight on the strengths and weaknesses of these business entities allows you to capitalize on the advantages and work through the snags.

What Is the Difference Between a Sole Proprietor and an LLC?

A sole proprietorship is an unincorporated business whose identity is attached to its owner; there’s no distinction between the proprietor and organization. Your personal and business responsibilities - assets, expenses, and liabilities - are one and the same.

For example, you would be paying your business levies under your personal tax returns. As the name suggests, the proprietor is solely responsible for fulfilling business obligations and paying any potential debt.

On the other hand, an LLC is a business entity with a legal identity different from its owner(s). The owners have no legal obligations to the organization and, most importantly, there’s a distinction between business and personal assets.

Owner Control in a Sole Proprietorship and LLC

A sole proprietorship’s owner has absolute control over the business. They decide how to utilize the company's resources, determine which business ideas to implement, and direct business operations.

They do not need to consult another entity for any business trajectory. If the owner dies, the organization - assets and liabilities - becomes part of the deceased’s estate and therefore subject to inheritance when there is a written will.

In contrast, when an LLC has multiple business owners, they share management responsibilities according to the stipulations in the operating agreement signed at the LLC’s creation. The leadership is collectively responsible for all operational decisions, although they can delegate the decision-making to subordinates.

For single-member LLCs, the business owner has total control over the company, although they can hire experts to run it on their behalf. The main difference between the two business types here is that the assets of a single-owner LLC are separate from the owner’s private assets, unlike in a sole proprietorship.

LLC vs. Sole Proprietorship - Liability Protection

A sole proprietor has total personal liability for their organization. The owner can use private funds to offset business loans and expenses. Even when you sell the business, you are still responsible for the debt incurred during your tenure as the business owner.

In case of death, the deceased’s estate is used to settle all business deficits before its remainder is handed over to successors.

Additionally, in a proprietorship, the owner is liable for business legal issues. For example, when their company is in debt, the proprietor must first file for personal bankruptcy after liquidating business assets.

Only then can they request a discharge from the remaining business debt. This is where LLCs have the upper hand in the LLC vs. sole proprietorship battle:

LLC owners have limited liability protection because the organization is a separate legal entity. Both single-member and partner organizations get their personal assets shielded from liabilities relating to the company. However, in certain conditions, multiple LCC owners shoulder the company’s liabilities:

  • An owner participates in fraudulent activities or other unlawful business ventures.
  • An owner participates in legal ventures that infringe on the distinction between personal and business transactions. For instance, when they co-sign or secure a business loan.
  • An owner absconds their fiduciary duty for personal gain.

Compliance Differences Between a Proprietorship and LLC

A sole proprietorship is the simplest form of organization. Formalities are few, because the owner and business are the same entity. Some people are already proprietors without knowing: For example, a graphic designer or writer runs a profitable proprietorship.

Legalizing a sole-proprietor business is not an intricate process. The only legal requirements you’d have to fulfill are acquiring permits and licenses for your line of business and registering your business name (if you have one). The exact requirements vary by location, but they’re never too extensive.

This ease of compliance is one of the greatest pro-proprietorship arguments in the single-member LLC vs. sole proprietorship debate.

After all, limited liability protection comes with a list of compliance requirements, which is why many potential business owners turn to LLC formation services for help. The process is less convoluted for single-member LLCs than multiple-member LLCs, but compliance responsibilities still include special levies not included in the sole proprietor tax list. LLCs also renew their permits and licenses annually, so the legal cost of having all the required documents is higher compared to a proprietorship.

LLCs are also encouraged to keep careful records, such as reports, minutes, and recordings from meetings. Most of this information is evidence for business operations should the company ever come under review. They can absolve the organization and its owners if they are ever implicated in illegal activities.

LLCs also need to have articles of organization to legalize operations at the state level. They must draft operating agreements that set ownership control boundaries and stipulate business processes. Furthermore, they must keep records of names and addresses of the executives, directors, managers, and subordinate staff.

They must document their tax returns, bank reports, and financial records.

Differences in Taxation

When comparing the tax benefits of an LLC vs. a sole proprietorship, the proprietor takes the win. Tax preparation is simple for individual entrepreneurs: The levies on their net business earnings are filed as part of their personal tax return using their tax rate for federal tax purposes.

A single-member LLC gets similar levy requirements because the organization is a disregarded entity for tax purposes. 

However, both kinds of organizations also have to pay the self-employment tax, which covers Social Security and Medicare for each taxable income in the organization. As you can see, there isn’t much of a tax-related difference between an LLC and a sole proprietorship.

An LLC and an individual proprietor can file for tax deductions on their pass-through income of up to 20%, following the Tax Cuts and Jobs Act (valid until 2025).

For federal tax purposes, a multi-member LLC is considered a partnership. Partners equally divide the company's yields and losses for taxation and pay their share using a Schedule E (Form 1040) attached to their tax return. The profits are distributed between the LLC owners.

Although these LLC owners do not pay additional tax on their income, they also have to pay the self-employment tax. Also, they can choose to incorporate their business for tax purposes.

Differences in Profitability

A sole proprietor enjoys the profits from their organization alone. The same is true for single-member LLC owners, as no other person is legally entitled to the company’s income. On the other hand, multi-member LLC owners share their profits according to the distributive stipulations in the company’s operating agreement.

Raising Capital

Funding isn’t a significant factor in the sole proprietor vs. an LLC debate: Both kinds of company owners (provided it’s a single-member LLC) fund their companies through personal resources. However, they are eligible for business loans to raise capital as well. Getting a business loan from financial institutions for both owners requires a personal guarantee to secure the loan.

For a multi-member LLC, the burden of raising funds to start the business is shared among the owners. Capital allocation determines the share of payments each member is responsible for, as cost-sharing is an added advantage for multi-member LLCs.

Which Business Organization Takes the Lead?

If you want complete autonomy over your organization, then a sole proprietorship or a single-member LLC is the best choice. The two company types let you single-handedly manage business operations, set up policies, and determine resource flow. However, you also shoulder losses alone. The only benefit a single-member LLC has over a proprietorship is it gives the owner limited liability.

A multi-member LLC gives you control of a portion of the business. You do not have absolute power, but your voice is crucial. Furthermore, your profits might depend on your capital contribution, if the operating agreement stipulates as much.

Although you won’t be paying business income tax, you’ll still have to pay the self-employment tax, too. The significant benefits of a multi-member LLC are that you get limited liability and only pay for a portion of company losses.

FAQ

Which is better, an LLC or a sole proprietorship?

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The best business type depends on your business venture and the autonomy level you desire. An LLC shelters you from business liabilities but also limits your control. On the other hand, a sole proprietorship exposes you to all business risks but gives you absolute power.

Do LLCs pay fewer taxes than sole proprietorships?

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Sole proprietors pay fewer taxes because they file their business income under their personal tax returns. On the other hand, both the single-member LLC and multi-member LLC owners pay business income tax and self-employment tax. The most disadvantaged of the lot is the single-member LLC owner, because they do not share their taxes with anyone.

When should a sole proprietor become an LLC?

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There is no designated time for transitioning between a sole proprietorship and a single-member LLC. If you don’t want to pay the additional business taxes that come with owning an LLC, you don’t have to ever change your business type. On the other hand, if you wish to separate your personal and business assets, you might formulate your business as a single-member LLC right from the start.

Is a single-member LLC the same as a sole proprietorship?

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A single-member LLC is not the same as a sole proprietor. Regardless of ownership numbers, an LLC enjoys limited liability, but also pays more taxes. On the other hand, a sole proprietor handles business liabilities as if they were their own. An LLC is a separate legal entity from the owner, while a sole proprietor and their business are the same entity.

About author

For years, the clients I worked for were banks. That gave me an insider’s view of how banks and other institutions create financial products and services. Then I entered the world of journalism. Fortunly is the result of our fantastic team’s hard work. I use the knowledge I acquired as a bank copywriter to create valuable content that will help you make the best possible financial decisions.

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