Do you want to launch a new business venture on your own? There are two common business structures that could be options for your new commercial entity ― the limited liability company (LLC) and the sole proprietorship.
There are many similarities between the LLC and the sole proprietorship, but there are also quite a few major differences that could make one or the other a better choice for your company.
Depending on the priorities and goals you have for your business, there could be good reasons to use either of these structures. However, for the most part, we strongly prefer one of these business entities over the other.
This article takes a deep dive into the details of both the limited liability company and the sole proprietorship, and by the time you’re done reading, we think you’ll have a good idea of which one you should use for your business.
What Is an LLC?
The limited liability company is a business owned and operated by one or more people, who are often referred to as “members” of the LLC. The limited liability company is a hybrid business structure that combines the casual flexibility of sole proprietorships and general partnerships with the limited liability protection of a corporation.
The main reason for the LLC’s popularity is because it provides personal asset protection, which means that creditors can only pursue your business assets in a lawsuit against your company, while your car, house, and personal bank accounts remain protected. This is called an LLC corporate veil.
In addition, when compared to a corporation, many entrepreneurs save a considerable amount of money on taxes thanks to the LLC’s “pass-through” taxation, which has the LLC owners claim business profits or losses on their personal returns, and there is no corporate-level taxation.
What Is a Sole Proprietorship?
Along with the general partnership, the sole proprietorship is one of the most no-frills American business entities, and there are very few rules and regulations regarding their formation or maintenance. If you want to create a new sole proprietorship, all you need is to start working.
You’ll often see people speak of the general partnership and the sole proprietorship in the same breath, and for good reason ― these business types are not considered by the government to be distinct legal entities from their owners. Rather, the general partnership and the sole proprietorship are treated legally as extensions of their owners’ personalities. In other words, your sole proprietorship is not a legally separate entity from you as a person.
The sole proprietorship is so casual in its structure that it doesn’t even need a business name. In fact, many sole proprietorships operate under the individual names of their owners. For example, if your name is Sally Smith and you own a sole proprietorship, you can simply refer to your business as “Sally Smith.”
Similarities of the Sole Proprietorship and the LLC
One significant similarity between the sole proprietorship and the limited liability company is their taxation structures. The sole proprietorship and the LLC are both “pass-through” entities for taxation purposes, so there is no tax paid on the business level, and there’s no corporate tax return to worry about either.
Instead, the company’s profits and losses pass through the business entity to its owners, and those individuals then claim that money on their own personal taxes. We will note that LLCs can actually choose to be taxed like a C corp or S corp instead of the default partnership-style taxation, although these options are not frequently used.
Also, because owning a sole proprietorship or an LLC is considered to be a form of self-employment, you will need to pay self-employment taxes on any income earned through your business. Self-employment tax encompasses both the employer and employee portions of Medicare and Social Security, which comes to a total of 15.3%. This amount is in addition to your income tax responsibilities.
Another aspect of these business entities that overlaps is income distribution. Both the LLC and the sole proprietorship allow owners to split up the profits and losses however they want to. You can distribute your company’s net income equally, or you can create an uneven split that reflects each owner’s investments into the business.
Sole proprietorships and limited liability companies also both give their owners options for how they’d like to manage the business. The informal nature of the sole proprietorship means that you can manage it basically any way you want to, while an LLC gives its owners the choice of managing the company themselves, or designating a specified manager to handle the daily operations.
What Advantages Does the Sole Proprietorship Have Over the LLC?
The sole proprietorship has a handful of noteworthy advantages when compared to the limited liability company, starting with the fact that the sole proprietorship has no formation process.
Unlike LLCs, there is no document filing required to form a sole proprietorship with your state government. In addition, you don’t have to pay a formation fee, which an LLC is required to do, regardless of which state it’s formed in. All you need to do to get a sole proprietorship off the ground is simply start working.
Along those same lines, a sole proprietorship is not required to complete any ongoing maintenance tasks either. Whereas an LLC typically needs to file annual reports with their state ― and also often has to complete other compliance tasks like paying franchise tax ― sole proprietorships don’t have to worry about any of these things.
Additionally, you don’t need to designate a registered agent for a sole proprietorship. LLCs are required to have a registered agent to receive important document deliveries from the state and forward them to the company, which can often cost well over $100 per year.
However, because of the informal nature of the sole proprietorship, a registered agent is not required.
What Advantages Does the LLC Have Over the Sole Proprietorship?
The biggest advantage for the limited liability company is the fact that it gives its owners limited liability protection.
Thanks to this personal asset protection, which protects your car, house, personal bank accounts, and other personal assets in case of a lawsuit against your business, a successful suit against your LLC won’t entirely cripple your personal finances. The sole proprietorship has no such protection, and a lawsuit could be catastrophic for both your company and your personal life, because your creditors can pursue your business and personal assets.
The LLC also has exclusive rights to a unique business name, which the sole proprietorship does not. While a sole proprietorship can acquire a doing business as (DBA) name, this does not give you exclusive rights to your chosen name.
In fact, if another entrepreneur decides that they like your company’s DBA name, they can register a formal business entity with that name, which can then actually prevent you from using it anymore.
Also, a sole proprietorship can only be operated by one person by themselves, and cannot expand its ownership to include other people. This is in contrast to the limited liability company, which can be operated as either a single-member LLC or a multi-member LLC.
Which Business Entity Should You Choose?
We obviously can’t give you a one-size-fits-all answer for a question like this, as everyone’s business needs vary depending on a number of factors. However, we find that the limited liability company’s advantages far outweigh its disadvantages in comparison to the sole proprietorship.
The main advantages of the sole proprietorship revolve around the lack of a formation process, ongoing maintenance requirements, and the associated fees. However, the LLC’s personal asset protection is far more valuable than saving this small amount of money with the sole proprietorship.
If your sole proprietorship is sued, the funds you saved by avoiding the LLC’s formalities will seem like a pittance compared to the impact of a successful lawsuit.
Furthermore, the formalities of the LLC can often have a positive effect on customers, because it is seen as a more professional business entity. We’re also big fans of the way you can secure a truly unique business name with a limited liability company, which isn’t an option for sole proprietorships.
Conclusion
It may seem like a battle of personal preferences between the casual nature of the sole proprietorship and the more formal aspects of the limited liability company, but we think it’s a bit more clear-cut than that.
While there are some things to like about the sole proprietorship, the negative aspect of not having personal asset protection is a massive disadvantage that is just too much to overcome.
Plus, forming an LLC is extremely easy to do with online services like Zen Business and LegalZoom.
Whether you end up choosing the LLC or the sole proprietorship as your business structure, we appreciate you taking the time to learn about the American business landscape with us!