Starting a new business comes with many decisions, and one of the first questions to tackle is what legal structure your business will take. For most entrepreneurs, the choice boils down to sole proprietorship vs. LLC. But how do you decide which one is right for you?
Sole proprietorship and LLC are the two most common legal frameworks for small businesses, each offering different benefits and protections. However, many business owners struggle to understand the key differences between them, which can lead to unforeseen consequences later.
In this guide, we’ll walk you through everything you need to know about sole proprietorship vs. LLC, breaking down their characteristics and helping you make the best choice for your business. Let’s begin!
What is a Sole Proprietorship?
A sole proprietorship is the simplest and most common business structure for small, low-risk businesses. It is owned and run by one person, which means there’s no legal distinction between the proprietor (owner) and the business itself.
This means the owner is fully responsible for all of the following:
Profits
Losses
Debts
Legal issues
If we compare head-to-head sole proprietorship vs. LLC vs. C corp, the first and obvious distinction is that setting up a sole proprietorship is the easiest option.
To understand how to start a sole proprietorship, simply choose a business name (either your own name or a different one) and, if necessary, register for a “Doing Business As” (DBA). After that, you may need to obtain any required licenses or permits based on your industry or location.
From a tax perspective, a sole proprietorship is simple. All the business income is reported on the owner’s personal tax return, which means you avoid the hassle of filing separate taxes for the business. However, as the owner, you’re also responsible for self-employment taxes, which include Social Security and Medicare.
What is an LLC?
An LLC, or Limited Liability Company, is a type of business structure that, in the first place, is often used because it protects the personal assets of its owners. This means that the owner’s personal assets, such as their homes, cars, or personal savings, are completely safe if the business incurs debts or faces legal action.
LLCs also enjoy tax flexibility, allowing owners to choose how they want to be taxed—either as a sole proprietorship, partnership, or even a corporation, depending on what’s most beneficial.
The formation process for an LLC is relatively simple and typically involves filing basic documents with the state, such as articles of organization. Another important element is the operating agreement—a document that outlines how the LLC will function, including details on ownership, management, and profit-sharing among the members.
There are different types of LLCs, depending on the number of owners. A single-member LLC is owned by just one person, making it a good option for freelancers or small business owners. In contrast, a multi-member LLC involves two or more owners.
Sole Proprietorship vs. LLC: What’s the Difference?
Now that we've introduced the concept and purpose of these two business structures, let's take a closer look at the distinct features of sole proprietorships and LLCs, such as liability, taxation, costs, and others.
Sole Proprietorship vs. LLC
#1. Liability Protection
The most significant difference between sole proprietorships and LLCs is liability protection. This difference refers to whether members' personal assets are at risk in the event of debts or legal issues.
In a sole proprietorship, there is no personal liability protection; the owner is personally responsible for the business obligations. In contrast, an LLC provides liability protection, meaning that members are not personally liable for the company's debts.
#2. Taxation
Unlike an LLC, a sole proprietorship is not recognized as a separate legal entity. Therefore, the business income is reported directly on the owner's personal tax return. In addition to income taxes, sole proprietors are required to pay self-employment taxes on their net earnings.
When considering sole proprietorships vs. LLC taxes, it's important to note that an LLC offers more flexibility, as it can be taxed either as a corporation or as a sole proprietorship. Generally, a single-member LLC is treated like a sole proprietorship for tax purposes unless it chooses to be taxed as a corporation.
#3. Management Structure
Regarding management structure, a sole proprietorship is entirely controlled by the owner, who makes all business decisions independently.
An LLC can also have a single member, similar to a sole proprietorship; this business structure allows for multiple members, which leads to a more complex management structure. Members can have different roles, and it's common to hire an external manager to oversee the business.
#4. Cost of Formation
When considering the costs associated with each structure, a sole proprietorship is generally cheaper to establish. It typically requires minimal paperwork—often just a business license—and can be dissolved easily by ceasing operations and notifying relevant authorities like the IRS.
In contrast, forming an LLC involves higher initial and ongoing costs. For example, when establishing an LLC, the entity is required to submit documents such as articles of organization and an operating agreement. Additionally, there are annual or biennial report fees and possibly franchise taxes, which can add to the overall expense of maintaining the business.
#5. Regulatory requirement
The regulatory requirement also varies between these two structures. A sole proprietorship has minimal regulatory requirements, which makes it easier to manage as there are no extensive compliance obligations.
Conversely, an LLC faces more complex regulations, including required annual reports to maintain good standing with the state and potential franchise taxes depending on state regulations. More importantly, failure to comply with these requirements can lead to penalties or loss of liability protection.
#6. Credibility
Another critical difference is credibility. LLCs often project a more professional image, which can be beneficial for attracting investors and clients and securing loans.
On the other hand, sole proprietorships may find it harder to establish credibility, especially if they lack a consistent income history, which makes it more challenging to obtain financing.
Advantages & Disadvantages of Sole Proprietorships
As the simplest form of business structure, a sole proprietorship offers many advantages, such as simple setup, tax simplicity, and others. However, it also comes with some disadvantages.
Let's explore these aspects in detail.
4 Key Advantages of Sole Proprietorships
#1. Single Owner
This business structure is ideal for small businesses in their early stages, as it allows the owner to oversee the entire organization from the start. The owner is responsible for all operations and decision-making, which is crucial for developing effective business strategies.
As a sole owner, decision-making is streamlined since there are no partners or shareholders to consult, which allows for quick and decisive actions without delays from voting or discussions.
#2. Simple Setup
A significant advantage of a sole proprietorship is the ease of starting a business with minimal costs.
There is usually no need for formal registration or any complex procedures, except when operating under a different name than the owner's. In that case, registration involves filling out a form and paying a fee. Additionally, a specific license may be required depending on the business type.
The simplicity allows the business to begin operations quickly and with minimal hurdles.
#3. Tax Simplicity
Tax matters for sole proprietorships are straightforward, as there is no double taxation. The owner reports all income and losses on their personal tax return, alongside self-employment tax, without any need for additional forms or reporting.
#4. Minimal Regulatory Requirements
As the simplest business form, regulatory requirements are minimal, involve little paperwork, and basically no formal procedures.
The main requirements include DBA registration if operating under a different name, obtaining necessary licenses based on business activity, and filing taxes on income and losses.
3 Main Disadvantages of Sole Proprietorships
#1. Liability
The biggest drawback of this business structure is personal liability. The owner is personally responsible for the debts of the sole proprietorship.
So, if business debts cannot be settled with business assets, creditors can pursue the owner's personal property, such as savings, personal vehicles, or real estate, which poses significant risk.
#2. Credibility
Sole proprietorships are often perceived as less stable and reliable, mainly because they are associated with small businesses.
The absence of an operating agreement or other formal documentation can appear unprofessional, which makes the company less appealing to clients and partners.
#3. Limited Growth Potential
Due to lower credibility compared to LLCs, sole proprietorships may struggle to attract investors and secure loans from banks. They often rely on personal savings or small business loans to fund operations.
Also, the business's success heavily depends on the owner's skills, efforts, and availability, which can limit expansion and the ability to take on additional clients or projects.
When Should You Make a Sole Proprietorship?
You should make a sole proprietorship if you're the only owner and you plan to keep your business small and manageable without the need for partners or complex management structures. This business type is often a great fit for freelancers, consultants, or graphic designers.
But, as we said, keep in mind that, unlike an LLC or corporation, a sole proprietorship doesn’t offer personal liability protection.
Advantages & Disadvantages of LLC
Considering that a large number of businesses are registered as LLCs, it’s helpful to know the advantages and disadvantages of this type of legal entity.
So, let’s take a look.
4 Crucial Advantages of LLC
#1. Limited Liability Protection
As we said, one of the primary benefits of an LLC is that the owner's personal assets are protected from the business’s debts and legal obligations. If the business faces some obligation, such as paying debts, that will only affect business assets.
However, it’s important to note that this protection isn’t absolute—owners could still be liable if they personally guarantee debts or engage in illegal activities.
#2. Pass-Through Taxation
A pass-through taxation system, characteristic of an LLC, means that the business itself is not taxed as corporate is. Instead, profits and losses are passed through to the individual members, who report them on their personal tax returns, which helps avoid the issue of double taxation that corporations face.
For example, let’s say an LLC earns $150,000 in profit, and it has three owners who each own 33,33%. Instead of the LLC paying taxes, the $150,000 is split evenly among the three owners.
Each owner reports $50,000 on their personal tax return and pays taxes on it based on their own tax rates. In this way, a pass-through taxation system can lower taxes and help avoid double taxation.
#3. Flexibility in Management
LLC owners can choose to manage the company themselves or appoint managers to run everyday operations. This flexibility allows LLCs to operate without the formal structure that corporations require, such as a board of directors or corporate officers.
Owners can use operating agreements to customize their management obligations and profit distribution arrangements so that the entire internal organization of the company depends on their agreement.
#4. Minimum Compliance Requirements
Unlike corporations, LLCs are not required to follow rigid formalities like holding annual meetings, drafting bylaws, or keeping detailed minutes of meetings. This reduces the administrative burden and costs for LLC owners.
But this doesn’t mean that LLCs are free from all legal obligations and paperwork. Owners must always ensure they file an annual report and register any changes that occur within the company with the relevant authorities.
However, the number of these obligations is significantly lower than for corporations.
3 Notable Disadvantages of LLC
#1. Self-Employment Taxes
While LLCs avoid corporate taxes, their members are still subject to self-employment taxes, sometimes leading to a higher tax burden.
In an LLC, the IRS typically treats the members as self-employed, meaning they are responsible for paying both the employer and employee Social Security and Medicare taxes. This is in contrast to corporate stakeholders, who only pay taxes on the money they receive from dividends and wages.
However, LLC owners can choose to be taxed as an S corporation, which can reduce the self-employment tax burden. Without this option, new LLC owners may be surprised by the extra taxes they owe.
#2. Limited Lifespan
In many states, an LLC may automatically dissolve if a member leaves the company, retires, or dies unless the operating agreement specifies otherwise. This can make the business unstable, as its future could depend on the health or continued involvement of its members.
Without a clear succession plan in place, the departure of one member, for example, can force the dissolution of the LLC, requiring the remaining members to reorganize the business or start a new entity.
#3. Complexity in Formation
Although forming an LLC is less complicated than establishing a corporation, it is still more complex than setting up a sole proprietorship or general partnership. As we said, the formation process typically involves filing Articles of Organization with the state, drafting an operating agreement, and paying formation fees.
Additionally, some states require additional fees, such as franchise taxes or annual report fees, which must be paid to keep the LLC in good standing. These requirements, though lighter than those for corporations, still represent a barrier for some entrepreneurs looking for the simplest path to starting a business.
When Should You Make an LLC?
You should make an LLC if you’re starting a business and want a flexible and relatively simple structure. You should also keep your personal assets completely separate from the company’s obligations, especially if you choose a risky business to start.
A limited company is a framework that is formally easier to manage than a corporation and which gives everything on your table—from small and everyday to big and strategic decisions. Additionally, if you want to minimize the tax burden, an LLC is a great choice since you get to decide how the business will be taxed.
Finally, an LLC allows easy transition and expansion if the business grows, new markets and opportunities arise, and the need to operate as a corporation becomes necessary.
Final Thoughts
Sole proprietorship vs. LLC—both are suitable legal structures for starting a small business. Each comes with benefits that can give you a boost, but also potential downsides depending on your needs.
If you’re offering consulting services, web design, or other solo gigs, and you want to keep things simple without worrying about paperwork or strict formalities, a sole proprietorship could be the right choice. Just keep in mind that you’re personally liable for any business debts with your personal assets on the line.
On the other hand, if you’re looking to team up with others, pool resources, grow the business, attract investors, and protect your personal assets from business liabilities, then starting an LLC is the way to go.
Sole Proprietorship vs LLC FAQ
Yes, you can convert a sole proprietorship to an LLC anytime. Converting to an LLC typically involves filing the necessary paperwork with your state, obtaining an EIN, and updating any business licenses or permits.
LLCs offer flexible tax options. They are pass-through entities by default, which means that profits and losses are reported on the owner's personal tax return. Still, there is an option for being taxed as a corporation, which may offer different benefits.
Yes, most sole proprietorships require a business license to operate legally, depending on local laws and the type of business. So, be sure to check with your city or country for specific licensing requirements.
The biggest issue is personal liability. Owners are personally responsible for all debts and legal obligations, putting their personal assets at risk if the business faces lawsuits or financial problems.
