When you’re starting your business, there are lots of decisions to be made. One of those is what business entity you’ll use for your business. It’s probably not the most exciting choice you’ll get to make, but it could be one of the most important. A sole proprietorship is the most common business type, followed by the LLC. So, when starting out, most people are thinking about Sole Proprietor vs. LLC. This article explains and compares these two business entities.
What is a sole proprietor?
Being a sole proprietor means you’re doing business, but you have not set up a formal business entity. It is the default business structure for single-owner businesses. This type of business is not separate from the individual at all and no action is required to be a sole proprietor. It’s very easy to set up and it’s the most common business structure. You can only be a sole proprietor if you are the only owner of the business. (The default for more than one owner is partnership.) You can read more about operating as a sole proprietor in this article.
What is an LLC?
LLC stands for limited liability company. Owners of an LLC are called members and an LLC can have one, or many, members. LLCs with one owner are called single-member LLCs and when there is more than one owner, they’re called multi-member LLCs. They are based on state law and formed at the state level.
To operate as a sole proprietor, there is nothing required other than to start doing business. As soon as you start a business, you become a sole proprietor. There’s nothing you have to file with the state to start your business (except various licenses or permits that may be required based on your state and/or the type of business you have).
As a sole proprietor, your business name is your name. If you want to call your business something else, you must file for an assumed name (doing business as, DBA) with your state.
You don’t’ have to file anything to start your business, but you may need licenses and/or permits depending on they type of business you have. If you’re not sure, you can contact your Secretary of State’s office and they will usually direct you to the right place. I’ve found them to be very helpful!
You do not need a separate business tax ID number. You can use your social security number. But, sole proprietors can file for a separate tax ID number if they want. This is called an Employer Identification Number (EIN). You can file online here. Some people want to have an EIN so they don’t’ have to share their social security number with the different entities they work with. If you have employees, you are required to have an EIN.
To start an LLC, you file formation documents with your state. These are usually called Articles of Organization. This requires a filing fee, which varies from state to state. A few states require you to publish “notice” that you are forming the LLC. These states are: Arizona, Nebraska, and New York. It’s fairly easy to form an LLC and is something a lot of people can do on their own. If you want more information on starting an LLC yourself, check out this post.
Single-member LLCs can use their social security number to do business, but I think all LLCs should have a separate tax ID number. It shows you intend for the business to be separate from yourself and protects your social security number.
Operating as a sole proprietor offers you no liability protection. This means if your business gets sued, your personal assets may be at risk. You may be able to get business insurance to offset some of this liability.
One of the biggest reasons people start LLCs is for the liability protection. When you form an LLC, you are creating an entity separate from yourself (or other owners). You do have to maintain this liability protection by actually treating your business as separate from yourself. One of things you need is an Operating Agreement. You can read more about that here.
Having liability protection means your personal assets are (generally) protected from any lawsuits, debts, or other liabilities. This is important because you never know what could go wrong in your business and cause you to lose everything. (Side-note: some states have homestead exemptions for judgments or debts, so you won’t necessarily lose your house.)
Management, formalities, recordkeeping
Sole proprietors are obviously managed by the single owner. There aren’t any formalities required of a sole proprietor. If you have a DBA (doing business as), licenses and/or permits you will have to maintain those. But, you don’t have to hold meetings or keep minutes. There aren’t formal requirements for the records sole proprietors have to have to keep the business, other than income & expenses for tax purposes.
LLCs can either be managed by their members or managers. Member-managed means its managed by the members. Manager-managed means the members elect managers to run the business. These managers can be members or not.
Most states require LLCs to renew annually and pay a fee. The due dates vary through the year depending on the state, so you should look up when your state’s is due. An annual report is usually a simple document noting any changes in the business.
LLCs should keep records of the business activities. It’s also a good idea to hold at least an annual meeting and take minutes. If you’re a single-member LLC, use this as an opportunity to get away to the coffee shop and have a meeting (even if it’s just with yourself!).
Sole proprietorships and LLCs are generally taxed the same way. But, LLCs can opt to be taxed as a corporation. Otherwise, both are taxed at the personal level. So, any income you make from your business goes on your personal tax return on a Schedule C. Business expenses are also reported on your personal return. It’s important to keep track of all your expenses. We all have to pay taxes, but you don’t want to pay more than you have to.
You will probably also be responsible for a Self-Employment tax. This covers Social Security and Medicare taxes. You can read more about that here. You may have to file these quarterly.
If you want to know more about business tax for your sole proprietorship or single-member LLC, check out the IRS’s Self-Employed Individuals Tax Center.
It’s hard to get investors as a sole proprietor. Unless you’re getting family or friends involved, it’s going to be almost impossible to get anyone to invest in your business. You may be able to get a personal loan to finance your business.
If you need investors to get going, you may want to think about getting an LLC or other business structure (C-Corp or S-Corp).
It is possible to get investors with an LLC, but since LLCs are closely owned by their members a lot of people don’t like to invest in LLCs either. If a member dies or decided they just don’t want to have the business anymore, then the business dissolves and investors don’t make any money or get their investment back.
If you really need investors and aren’t able to get them as an LLC, you may want to think about converting your business to an S-Corp or C-Corp.
Choosing the right business entity is an important part of starting your business off on the right foot. Ask yourself:
- How much you want to manage as far as business formalities (filings, records, etc.)?
- How much liability protection you need for the type of business you have and what personal assets you need to protect?
- Whether you need investors?
- Whether you make enough money to get a tax benefit from being taxed as an S-Corp?
- Whether you want to pay the initial, and ongoing, filing fees for an LLC?
Some businesses can operate indefinitely as a sole proprietorship. Other than the startup & annual expenses, I haven’t seen a company that wouldn’t benefit from forming an LLC. Even if that benefit is just peace of mind.
Everything on this site is intended as legal information only. Nothing in this article, or in any emails you may receive from me, shall be considered legal advice. I am an attorney, but I’m not your attorney, and nothing on this site or in this article shall be deemed to create an attorney-client relationship. The law is highly dependent on specific facts and situations, and there is no substitute for legal advice from an attorney licensed to practice in your state who is familiar with the facts and circumstances of your particular situation.