5 Key Differences Between Sole Proprietorship and LLC

One of the critical parts of any start-up or small business is fixing the structure of the business entity, especially if you are a new entrepreneur. But your choice has an impact on your taxes and legal matters. Regardless of whether you’re forming an LLC or a sole proprietorship, it’s a good idea to appoint a third party as your company’s registered agent.

Business owners are often confused about which one to go for - a limited liability company (LLC) or a sole proprietorship. Before we look at the major differences, let's review what each one means.

An LLC is a form of a private limited company. It is neither a corporation nor a partnership firm. But it is easy to form, and the owners are known as members.

The highlight of an LLC is that it is separate from its members, who are not personally liable for business debts. It has elements of a sole proprietorship, partnership, and corporation and is characterized by the flexibility that it offers to its owners. 

A sole proprietorship is a business owned by a single person. It is one of the simplest structures to create. Plus, you are at liberty to enjoy all the profits of your business. But a sole proprietorship doesn’t provide any legal separation between the businesses and the owner, making you responsible for any liability.

A sole proprietorship is the easiest and cheapest way to start a business as there isn’t much paperwork - except for the business license or permit as per the state laws. By default, any person selling goods or services without a partner is considered a sole proprietor. But to start an LLC, you will have to form a document called the articles of the organization.

When you start an LLC, you should include "LLC" or "limited liability company" at the end of your LLC’s name. The business entity is created under state law and offers you name protection in your state.

But in an LLC and a sole proprietorship, if you are using a trade name, you have to apply for a DBA or 'doing business as' certificate.

The operational and management structure of a sole proprietorship is simple. The owner can take business decisions without consulting any third party. You don’t have to manage any partners or members. Instead, you call all the shots - as long as you make sure that the business is operating legally and making profits. You can also hire accounting and legal experts to help you with business management.

An LLC’s structure is a little more complex. Most LLCs have an operating agreement, and it’s better to form one if your LLC has multiple members. The operating agreement will mention each member’s ownership stake, voting rights, and profit share.

An LLC can be jointly run by the members, or they can appoint a manager to handle day-to-day operations. Members decide on company matters in proportion to their ownership stake, known as membership units. Profits, too, are shared following ownership percentages.

A sole proprietorship and a single-member LLC look almost similar in terms of tax treatment. Both are pass-through entities, as the business itself doesn’t pay income taxes. The owner reports business income attached with his or her tax return, and the income gets taxed at the owner’s tax rate.

LLCs with multiple members, too, are pass-through entities, with each owner paying taxes for their share of the income from the business.

But there's a difference here - an LLC can save money by opting for corporate tax status. However, a sole proprietor doesn’t have the choice to file tax as a corporation.

In a sole proprietorship, the owner is responsible for the debts incurred by the business. If the company goes bankrupt, the sole proprietor must file for bankruptcy, and their personal and business debts will be under review. Also, in a lawsuit, a sole proprietor doesn’t have the immunity to safeguard their personal assets.

But since an LLC is legally disconnected from the owner, they aren’t personally liable for debts. Someone who sues an LLC can’t personally sue the owners, and members don’t have to pay business creditors from their pockets.

Many business owners start out as sole proprietors due to the minimal paperwork and low cost to kick-start their business. Taxes, too, are simple, as there is no need to file a separate business tax return. But as your business starts growing, a sole proprietorship structure may not fulfill your needs, especially with regard to taxation and legal aspects.

LLCs offer tax flexibility and allows owners to elect corporate tax status to save more money. Also, LLC owners are not personally liable for business debts, thus getting more protection from a business lawsuit.

For these reasons, an LLC is considered the best fit when you plan a start-up. So, on the off chance that your idea or business fails, your personal assets will not be touched.