A sole proprietorship is an ideal entity structure for self-employed and small businesses with a limited customer base. It is a cheaper and simple legal entity structure.
A limited liability company is useful for business owners looking for legal protection against business liabilities.
Let us discuss some key differences between an LLC and a sole proprietorship.
What is a Sole Proprietorship?
A sole proprietorship or a sole trader is a business entity structure with only one legal owner. It is registered and operated by a single person.
It is the same entity structure used by self-employed persons. It can have a business, trade, or an individual’s name as its legal registered name.
Most small business owners and self-employed persons choose this entity structure for its simplicity and lower costs.
A sole proprietorship can be transformed into a limited liability company (LLC), corporation, or limited liability partnership (LLP) as well.
A business owner with no partner and employees is by default the sole proprietor of a business. Hence, it is a popular choice for most small businesses and self-employed persons.
Characteristics of a Sole Proprietorship
A sole proprietor assumes the unlimited liability of the business. It means the business owner will be held liable for any unpaid debts and taxes for the business as well.
Also, a sole proprietorship comes with a pass-through tax structure. So, the business does not pay corporate taxes and the owner has to pay taxes on the income received from the business as an individual.
Registering a sole proprietorship is simple and requires fewer documents. You do not need complex business forms and documents like an article of association for this entity structure.
The main characteristic of this entity structure is the same legal entity concept. It means the business and the owner are legally considered the same entity.
Advantages of a Sole Proprietorship
A sole proprietorship is a preferred entity structure for most small businesses for several advantages it offers.
- It comes with a simple and faster process to register as a sole proprietorship. A single member can register a business within a few days by completing simple documentation and registration requirements.
- A sole proprietorship comes with a pass-through taxation benefit. It means the owners pay income taxes at a lower personal income tax rate rather than a higher corporate rate.
- In most states, the registration and licensing fees for a sole proprietorship are lower as compared to other entity structures. Also, the ongoing running and licensing renewal costs are lower.
- A sole proprietorship does not require obtaining an employer identification number from the IRS unless for hiring or other purposes.
Disadvantages of a Sole Proprietorship
As with any other entity structure, a sole proprietorship comes with some disadvantages as well.
- It does not offer legal protection to owners for business compliance and regulatory matters.
- A business owner assumes unlimited business liabilities for this structure.
- Lenders do not offer flexible lending terms to sole proprietors as a business entity.
- Owners may need to pledge personal assets to access debt financing.
- External investors like venture capitalists and angel investors do not prefer sole proprietorships for investments.
- A sole proprietorship may need to transform into other entity structures as it expands for compliance and regulatory requirements.
What is a Limited Liability Company (LLC)?
A limited liability company or LLC is a business entity type that comes with a separate legal structure for the owners and businesses.
Owners of an LLC are called members. It comes with a pass-through taxation choice for owners as well. However, an LLC can choose to pay corporate taxes at the entity level as well.
As the name suggests, an LLC offers protection to owners. Business owners do not assume the unlimited liability of business debt or taxes.
An LLC structure can be used by anyone including an individual, partners, self-employed, corporations, and even other LLCs.
Characteristics of a Limited Liability Company
The main characteristic of a limited liability company is the separate legal entity concept. Its owners are not held liable for business debts.
On the other hand, members of an LLC can choose between corporate and personal taxes. Thus, it combines the benefits of a sole proprietorship and a corporation.
The registration process of an LLC is simple and quick too. It does not require complex business documents and agreements. Although LLC members must provide an article of organization and an article of operations.
An LLC structure is more suitable for growing small businesses. It offers a formal business structure to business that appeals to lenders and investors.
Also, an LLC offers the flexibility of running a business as an owner or appointing managers.
A single-member LLC may not require obtaining an EIN from the IRS. However, if it is a multi-member, it must obtain an EIN from the IRS.
Advantages of a Limited Liability Company
A limited liability company offers several advantages to its owners.
- Business owners are protected from unlimited liability claims with an LLC structure. It means lenders cannot go after the personal assets of business owners.
- There are no restrictions on the minimum or a maximum number of members for an LLC. A sole proprietor comes with a single member and a corporation must get approved for a maximum number of shareholders.
- There are no regulatory requirements for appointing directors and running a board of directors.
- An LLC can choose between corporate taxes and pass-through tax benefits. Each member can pay taxes on an individual basis with lower tax rates.
- An LLC offers instant credibility to small businesses as compared to a sole proprietor. It announces the formal formation of the business.
Disadvantages of a Limited Liability Company
Some major disadvantages of a limited liability company include the following points:
- An LLC structure comes with higher costs than a sole proprietorship. These costs include registration, licensing, and renewal charges.
- It requires following stricter compliance guidelines and more paperwork.
- Changing the ownership stakes is difficult. All members must agree to any additions or deletions from the ownership stakes.
- It attracts fewer external investors and the business can only look to commercial banks for external debt financing.
Sole Proprietorship Vs LLC – Key Differences
Let us now summarize some key differences between a sole proprietorship and an LLC entity structure.
Formation Process and Costs
Business registration, formation, and licensing requirements are far easier for a sole proprietorship than an LLC.
In practice, most self-employed persons do not apply for a formal business license either. On the other hand, you must register and complete the formation process for an LLC.
Also, the costs of business registration and license renewals are significantly higher for an LLC.
Management and Decision-Making
A limited liability company requires an article of organization in most states. Even for an informal process, an LLC will require the segregation of management roles.
It can be a complex and challenging task to decide which members can run business operations and their level of activities for an LLC.
Contrarily, a sole proprietorship comes with a simple management process. The decision-making also remains with a single person with no ambiguity.
Taxes
An LLC can elect to pay corporate taxes at the entity level or pass-on taxes to all members. A sole proprietorship only comes with a pass-through taxation system where the owner pays all business taxes.
However, both entity structures must pay state and federal taxes for various business activities. For instance, paying payroll taxes, state sales taxes, and business taxes are common obligations for all types of business entities.
Legal Protection for Owners
A key difference between these two entity structures is the level of legal protection for owners.
LLC owners are legally protected from business liabilities and debts. It means if the business goes bankrupt, lenders cannot seize the personal assets of business owners.
On the other hand, a sole proprietor is fully responsible for repaying all business debts and taxes. Creditors can file a lien and seize the personal assets of the business owner.
Compliance Requirements
A sole proprietor only needs to get a license or business permit to establish a legal entity. It does not require complex paperwork and compliance requirements from state and federal regulators either.
A sole proprietor must comply with the local, state, and federal taxes though.
An LLC requires must file an annual report on top of the initial registration documents. Then, there are several additional steps that an LLC must take for further legal protection that are usually not required for a sole proprietorship.
