Choosing the right legal entity for your business is going to be one of the first few important decisions that you’ll take as an owner or an entrepreneur.
A sole proprietorship and a Limited Liability Company (LLC) have their own pros and cons. The major difference is that an LLC protects your personal assets and limits your liabilities, a sole proprietorship does not.
In this read, we will have a detailed look at the key differences between these two business entities.
A sole proprietorship is a type of legal entity with only a single owner, who is subjected to pay personal income tax through profits earned from the business. This is considered to be one of the easiest and quickest ways to get your business up and running with minimum formalities, government regulations or state requirements.
Consultants, contractors and other types of sole owner businesses opt for this legal entity as it benefits them in numerous ways.
Here are some benefits of a sole proprietorship:
- Less paperwork and other formalities required (apart from licenses or permits related to your industry).
- No annual state-level filings required.
- It is a pass-through entity, which means that profits or losses will be reported on the personal tax returns of the owner. There are no other business taxes to be paid.
- To improve your market credibility for funding or other purposes, you can create a DBA (Doing Business As) name for your business and register it with your relevant secretary of state along with an yearly fee.
There are some negative elements associated with a sole proprietorship:
- This type of legal entity does not give you liability protection which means your personal assets (car, home, bank account, etc.) could be at risk in case of a lawsuit against your business.
- Raising business capital is a big challenge for a sole proprietorship as most lending institutions consider your funding request as a personal loan, rather than a business loan.
- Sole proprietorship is never the first choice for any investor, further reducing external financing options.
- Not easy to build business credit.
Limited Liability Company (LLC)
According to EntitySearch, LLC is a legal business entity where owners (referred to as members) have personal asset and liability cover in the event of a lawsuit against the business.
One of the major highlights of an LLC is that it has the features of both a corporation and a partnership. An LLC is formed by submitting articles of organization with the relevant state’s secretary of state and appointing a registered agent, along with the state filing fee.
Here are some of the positive points of an LLC:
- LLC separates your business and personal assets and gives you limited liability protection in case of a lawsuit filed against your business. This means that creditors can not lay claims on your personal assets (car, home, bank account, etc.) for debt recovery.
- Owners have the flexibility to choose how they wish the LLC to be taxed – Sole proprietorship, an S-corp or a C-corp.
- Less administrative or paperwork requirements as compared to a partnership or a corporation
- Less formation costs as compared to other business types
And here are some of the cons of an LLC:
- LLC is required to pay annual state filing or other licensing fee.
- State-specific business or unemployment taxes will have to be paid in addition to personal, state or local taxes
- Since LLC is a separate legal entity, the hassle of maintaining records will be additional work
LLC Vs Sole Proprietorship – Main Differences
Let us now have a look at some of the key elements that separate an LLC and a sole proprietorship.
A sole proprietorship is far more convenient and less expensive to set up as compared to any other business entity, let alone an LLC.
Once you have obtained your business or industry-specific licenses and permits, your EIN and a couple of other requirements, you’re all set to commence your business activities right away.
Comparing these two business entities with other types such as a corporation or a partnership, they’re both less likely to raise business capital without much obstacles or difficulty.
Investors and lending institutions are usually skeptical about funding an LLC or a sole proprietorship. However, there are other ways to raise funds for your business such as crowdfunding, microloans through non-profit lending institutions, using your own income as an investment source, etc.
Sole proprietorship taxation is a lot simpler than an LLC. The current self-employment tax rate is 15.3% and sole proprietors are subject to pay this tax. Single-member LLCs are treated as sole proprietorship by default.
On the other hand, multi-member LLCs can either be taxed as a C-corp or an S-corp, depending on which specific business entity is chosen for tax purposes.
Moreover, LLCs itself are not taxed, instead the profits or losses will be reported on the owners’ personal income tax returns. Additionally, the process of completing the tax returns is costlier for an LLC as compared to a sole proprietorship.
The Liability Cover
One of the many reasons why business owners or entrepreneurs go for an LLC is the limited liability protection they get with this specific business entity.
Contrary to this, sole proprietorships are at a greater risk in the event of a lawsuit filed against the business. Even though it depends on a given scenario, creditors can still lay claims on your personal assets for debt recovery.
Our Final Word
The nature of your business, the industry you’re in, business taxation, formation costs, the element of foreign funding right away or in future, and your expansion plans – these are the factors that should determine which specific business entity you go for.
With a sole proprietorship, you can get a lot of flexibility and start your business with very low initial costs. On the other hand, LLCs offer personal asset protection and liability cover that can save you from a lot of trouble.