LLC vs. Sole Proprietorship: Which Should You Choose?

If you’re gearing up to start a business, you’re probably wondering what type of entity you should register as: a sole proprietorship or a limited liability company (LLC). Both are common structures for small businesses but differ in some important ways.

Read on to learn more about the differences between LLCs and sole proprietorships.

A sole proprietorship is a type of business structure where there is no separation between the business and the individual who owns and operates it. As the name suggests, sole proprietorships are run by only one person. These types of businesses are generally unregistered, and common examples are freelance writers, consultants, and other service work performed by one person.

An LLC is a business structure that separates the assets and liabilities of the business from the assets and liabilities of the person who owns it. This means that an individual’s personal assets are protected if their business goes bankrupt and still owes debts, or if there’s a costly lawsuit against the company. That’s where the “limited liability” benefit comes in. With sole proprietorships, you don’t enjoy this protection — any financial liability owed by your company could quickly spill over into your personal finances.

Also unlike sole proprietorships, LLCs need to be registered with the state where you’re conducting business.

The owners of the LLC are called members. If you’re owning and operating the business by yourself, you’ll be a single-member LLC. If there is more than one owner, you’ll be a multi-member LLC.

Sole proprietorships don’t require any registration for setup if you’re simply operating under your legal name. If you plan to operate under a different name, though, you’ll have to file a DBA (Doing Business As).

Sole proprietorships also generally don’t require an Employer Identification Number (EIN) so you’ll just use your Social Security Number where required.

LLCs require registration. You’ll have to file Articles of Organization with the state where you’ll be operating, file an operating agreement (a document outlining who owns the company and other details) and apply for an EIN.

Business formation services like LegalZoom and Bizee can help you get filed and make sure your legal bases are covered. Sometimes, you’ll have to pay a small fee to use the service, as well as the filing fee for the state where you’re operating, but plans at LegalZoom and Bizee start at $0 plus the state fee.

With an LLC, you’ll also have to file an annual report with your state, which simply provides updated information on your company and the activities you perform.

As a sole proprietor, the money you earn from your business can go directly into your personal bank account since there is no legal separation between you and your business. If you set up a business bank account, you can just transfer money from the business account to your personal account as an “owner’s draw.”

If you have an LLC, you can also generally take an owner’s draw from your business bank account. However, if your LLC is structured as an S-Corporation, you’ll have to pay yourself a salary, which can be a bit more complicated. For example, you’ll have to determine a “reasonable” salary for your role (it’s usually recommended that you pay yourself what you would pay another employee to do your role) and report the income on a W-2.

Sole proprietors report their business income on their personal tax returns where they’ll be taxed at your personal income tax rate.

Unless otherwise noted, LLCs follow the same tax rules as sole proprietorships — you’ll report business income on your personal income tax return and be charged at the appropriate rate. Your taxes essentially “flow” through you as the individual, not the business, which is why LLCs are known as pass-through entities. Your business’s losses, profits, income and deductions all flow through you.

However, you can elect to have your LLC taxed as an S-Corp. One advantage of this approach is that you’ll only have to pay a FICA tax (Federal Insurance Contributions Act tax, which helps fund programs like Social Security and Medicare) on wages your business pays to owners and employees. All other earnings will be considered dividend income. This can help save your business some money in the long-run.

Another big advantage to having your LLC taxed as an S-Corp? You can receive a deduction you otherwise wouldn’t have with an LLC that’s taxed as a sole proprietorship. According to the Tax Cuts and Jobs Act, pass-through entities claim a 20% qualified business income deduction. However, the taxable income must be below a certain number in order to qualify for the deduction unless you pay employee wages. Because LLCs that are taxed as an S-Corp are incentivized to pay wages to employees, they can potentially claim this deduction if they meet all other requirements.

It’s generally recommended to opt for an LLC over a sole proprietorship because having an LLC allows you to protect your personal assets should you be sued or default on its debts.

However, if you’re thinking you just want to test the waters before you dive into the deep end and file an LLC, consider starting as a sole proprietor first. There are some businesses, like freelance writing, selling crafts, tutoring and content creation, that are simple to run as a sole proprietorship. But for businesses with higher liability risk, like running a bakery or legal consulting, an LLC might be a safer option for you.

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