Before starting a new, solely owned business, it is important to understand the pros and cons of two popular business structures: the limited liability company (LLC) and the sole proprietorship.
To make the best decision, you should carefully consider your choice of business entity from multiple angles, including ownership and control of the business, asset protection, and tax implications.
As you begin evaluating, remember to -
- Understand the main advantages and disadvantages of each
- Evaluate the strengths and weaknesses of each as they pertain to your business needs
- Consider that what’s best for your business depends on your unique situation
What Is a Limited Liability Company (LLC) for a single owner?
One of the most common types of small businesses in the U.S. is a single-owner or single-member LLC. This is a business entity registered in the state of formation, which usually will be where the company does business.
The term single-member is used to recognize that the LLC has one owner, as opposed to an LLC in which there is more than one owner. A single-member LLC has all the same advantages—and disadvantages—of a multi-member limited liability company.
Each state has different requirements for forming an LLC.
Note that you can form your LLC in a different state than where you do business. Each state other than where you initially formed your LLC is a “foreign” state. You are required to foreign qualify in those states in order to do business there. This generally requires filing an application for authority with that state’s business entity filing office.
Advantages of a single-member LLC
There are many benefits to forming an LLC versus operating as a sole proprietorship. A single-member LLC is generally shielded from personal liability for debts associated with the business.
Note: Single-member LLCs must be careful to avoid commingling business and personal assets. This could lead to what is called piercing the corporate veil and the loss of your limited liability.
According to the IRS, a single-member limited liability company is a "disregarded entity", meaning there is no separation between the business and its owner. By default, the IRS taxes it the same as a sole proprietorship.
However, you do have the option to be taxed differently.
As with a sole proprietorship, the business’ income tax obligations automatically fall to the LLC owner. If you want to elect another tax route, single-member LLC owners can choose to be taxed as a C corporation or S corporation. This is something you can’t do if you elect to do business as a sole proprietorship.
Other benefits of forming a single-member LLC include the following:
- LLCs can be a good choice for medium- or higher-risk businesses and for owners with significant personal assets they want to protect. This is because owners are shielded from personal liability as recourse for the acts of the LLC. As such, creditors can’t pursue your personal assets, like a home or savings account, to pay the business debts.
- An LLC is a legal entity that is separate from the owner in the eyes of the law. This means your LLC is held accountable for its actions when entering into agreements or contracts, acquiring debts or otherwise taking on business obligations.
- Starting an LLC may help a new business establish credibility more so than if the business is operated as a sole proprietorship.
- LLCs typically do not pay taxes at the business entity level. Any business income or loss is passed-through to the owners and reported on personal income tax returns. Any tax due is paid at the individual level.
Ultimately, LLCs can have a limited life if you don’t prepare ahead of time. In many states, if an LLC has no members, for example, if the only member dies, the LLC will have to be dissolved. Statutes allow the single-member LLC to continue by providing for it in the operating agreement, for example, naming a representative to take over. The fact it can continue if the owner dies can be considered an advantage of an LLC over a sole proprietorship.
Disadvantages of a single-member LLC
While there are many good reasons to choose a single-member LLC for your business, there are disadvantages to be aware of as well. The first of these is cost. An LLC is subject to state formation fees, as well as ongoing fees such as annual report fees and franchise taxes.
Before you file the documents to form your LLC, you’ll need to select a registered agent located in the state. This person—which can be a corporate service company—receives legal papers on your behalf, which is specifically beneficial in the case of a lawsuit or legal issue. The registered agent’s name and address must be included in the formation document.
There are additional requirements for a single-member LLC, including, but not limited to the following:
- Your LLC’s name must include “LLC” or “Limited Liability Company” and other rules and regulations associated with naming your single-member LLC depending on your state. Your LLC’s name will also have to be different from the names of other domestic and foreign LLCs and other business entities that are on file with the business entity filing office.
- Depending on your state, you may need to also file with the county, in addition to publishing notice of your LLC formation in a local newspaper or an initial report filing.
- In most states, you will also be required to complete periodic filings, such as those for annual or biennial reports, and pay franchise taxes. These extra filings and costs vary from state to state, making it important that you’re aware of all potential requirements.
Finally, be aware that inadvertent administrative dissolution can happen easily if you’re not clear on the laws regarding your LLC duties. For example, if you thought that because you didn’t have to pay state income tax, you don’t have to pay franchise taxes either, and you fail to pay the franchise taxes, your LLC could be dissolved.
What is a sole proprietorship?
Sole proprietorships are the most basic form of business structure. If you don’t form a business entity, like an LLC or corporation, but start conducting business, you're automatically considered a sole proprietorship. This means your business is not an entity separate and apart from its owner and your business’s assets and liabilities are not separate from your personal assets and liabilities. This means you can be held personally liable for the debts and obligations of the business, which is one of the main differentiators from an LLC.
Advantages of a sole proprietorship
Sole proprietorships are ideal for low-risk businesses and entrepreneurs who want to test their business idea before pursuing a formal entity formation option. As such, there are many advantages.
- There is no cost to establish a sole proprietorship, which makes it a popular option for entrepreneurs with little to no funding.
- The owner maintains 100% control and ownership of the business. A sole proprietorship can have only one owner, and that owner is entitled to the profits and control of the business.
- A sole proprietorship is easy to dissolve once the business closes. By definition, when you stop doing business you no longer have a sole proprietorship, but you do need to remember to cancel all licenses and registrations that are associated with the business. This includes canceling your d/b/a name if you registered a d/b/a name for your business.
- Filing tax forms is easy. Simply complete the IRS Schedule C.
Disadvantages of a sole proprietorship
It’s important to consider the disadvantages of a sole proprietorship. While the financial savings are appealing, there are drawbacks to this business structure.
- The most significant disadvantage of a sole proprietorship is your exposure to liability as the business owner. You are personally liable for any debts or obligations of your business, so if the business can’t cover its debts, creditors or lawsuit claimants can seize personal property and funds from your personal accounts.
- You may struggle to raise money because, with a sole proprietorship, you can’t sell stock. Banks are also often reluctant to lend to sole proprietorships, making it difficult to get a loan.
- If your business changes and you want to bring in another owner, you’ll need to register for an EIN (Employer Identification Number). By bringing in another owner you go from a sole proprietorship to a general partnership. You are no longer the sole owner, and thus, cannot be registered with your social security number. In addition, you’ll also need to report both earnings and losses with Form 1065 – US Return of Partnership Income, and file individual K-1s to cover each partner’s portion.
Comparing LLC and sole proprietorship: The similarities
A single-member LLC has its advantages, as does a sole proprietorship. There are many similarities between the options as well, from paperwork to tax requirements. Get all the facts before making your choice.
- Whether you’re a sole proprietor or the owner of a single-member LLC, you’re required to report your income and expenses on Schedule C of Form 1040. The net income will be taxable to you regardless of whether you withdraw cash from the business or not.
- Business expenses will be deductible against your gross income and not as itemized deductions. As such, it’s important that you maintain complete records of your income and expenses. This ensures that you can take the full amount of the deductions that you’re entitled to.
- Note that for both an LLC and a sole proprietorship, expenses can include automobile mileage for business travel, entertainment, meals while traveling for business, office equipment, and home office expenses. If paying for your own health insurance, you can also deduct 100 percent of the premiums as a business expense.
- If you hire any employees, whether you have a sole proprietorship or an LLC, you need to acquire a taxpayer identification number, in addition to withholding and paying payroll taxes. Without employees, your social security number is your taxpayer identification number.
- When it comes to business licenses and permits, both business structure options require you to keep up with those obligations. Note that state and local governments, like counties, cities or towns, usually impose these business requirements. But in some cases, the federal government does, too. You need to be aware of all business obligations, regardless of whether you choose an LLC or sole proprietorship.
- As a sole proprietor, you can choose to do business under your own name, or you can choose an “assumed business name”, also referred to as a DBA (Doing Business As), d/b/a or fictitious name. Similarly, with a single-member LLC, you can do business under the legal name of the LLC, which is the name on its formation document. Or, you can have the LLC register its own DBA.
Differences between LLC and sole proprietorship
There are important differences between LLCs and sole proprietorships. The most significant difference is whether you have limited liability for the business’ debts and obligations, as with an LLC, or whether the business’ liabilities and obligations fall to you personally in the event of a lawsuit or debt collection.
An LLC has distinct advantages in the areas of legal protection and liability. While there are filing fees for setting up an LLC, that cost can be well worth it when compared to the thousands of dollars you could be liable for as a sole proprietor.
On the other hand, it costs no money to start a sole proprietorship. You can also transition into an LLC or other formation option whenever you’re ready. This also means dissolving your business is as simple as stopping operations (and canceling any licenses and permits).
Finally, while sole proprietorships have very few regulatory requirements, LLCs are associated with a variety of fees and filings, both initially and ongoing. This can be difficult to manage on your own, which can lead to missing important filings and, in return, incurring penalties.
When deciding between a single-member LLC and a sole-proprietorship, focus on the needs of your business. As an entrepreneur testing the waters, a sole proprietorship may be an easy and cost-effective option, while a fast-growing business that needs funding would be better suited to an LLC. Consider your business objectives when reviewing your options, from financial to operational, to make the best choice for you and your business.