In case nobody has told you this yet, congratulations on your new business! You deserve some credit for taking the leap. But now the work begins, and if you're like other new business owners, you might be wondering — should you form an LLC or sole proprietorship?
The short answer will point you in the direction of forming an LLC due to the vast benefits that it offers, but it helps to take a closer look at LLC vs. sole proprietorship to determine the right move for your business.
Learn more about the differences between sole proprietorship and LLC formation and why they matter for your business.
What's the Difference Between Sole Proprietorship and LLC?
So…let's get to it. What's the difference between an LLC and a sole proprietorship?
Limited Liability Company (LLC). An LLC is a type of business structure that, akin to its name, removes any liability that the business encounters from the owner or owners of the company. Each state regulates LLCs a bit differently, but there are many similarities that span from coast to coast.
Sole Proprietorship. A sole proprietorship refers to an unincorporated business. You may have a registered trade name, but that's about it. As with an LLC, income is taxed as personal, and there aren't any state-level government regulations, but you also don't have any protection if you encounter legal liabilities.
The type of business you operate can help determine which you should choose. For example, if you perform construction handyman services, a sole proprietorship will suffice in most cases. If your business provides consulting services, however, it may be more beneficial to protect yourself by removing liability with an LLC.
The Most Important Distinction — Creating a Legal Business Entity
Perhaps the biggest and most important difference between LLC vs. sole proprietorship is that when you form an LLC, you are creating a legal business entity (limited liability company) that has a separate legal identity from your personal identity. Essentially, your business can stand on its own legs and be legally recognized apart from you.
This might sound like a minor distinction, but it matters. Setting up a legal business entity for your business makes your business “official.” Instead of just doing business as an individual person and having your customers pay you directly, setting up an LLC gives you the ability to do business as a business.
This route will always make your business seem more viable and creates a level of trust with your customers. Forming an LLC shows that you're adhering to state regulations and that purpose and policy are respected. In other words, forming an LLC vs. sole proprietorship will convey to your customers that you don't take shortcuts.
Making sure you have a business that exists as its own separate legal entity can help you in numerous ways. Here are the benefits of forming an LLC.
Benefits of an LLC
Separates Your Business and Personal Finances
It isn't fun to think about worst-case scenarios, but it's important to consider how your business — if operated as a sole proprietorship — would be affected if something were to go wrong financially. If you invest, take out a loan or secure a second mortgage to fund equipment, hire employees or rent office space, you could encounter substantial losses if your business performs poorly or becomes entangled in a lawsuit.
That's why one of the first things to do after forming an LLC is to get an Employer ID Number (EIN) and set up a business bank account for your business. This is an important step in creating a separate identity for your business because it gives you a place to keep your business income, a way to get paid in the name of your business and a way to start building business credit.
Having a business bank account and an EIN makes it easier to separate your business and personal finances. When you have an LLC, and when you clearly separate your business and personal finances, you can expect a higher level of protection for your personal assets in case of a lawsuit. Doing business with an LLC can give you a “corporate shield” over your personal assets, protecting your personal finances from some of the worst-case scenarios of being in business. This is a big factor to consider when choosing between forming an LLC or sole proprietorship.
If you are doing business as a sole proprietorship, without any of the legal protections or separate business finances that go with having an LLC, you might be vulnerable to losing your personal assets and life savings in case of a lawsuit. Doing business as a sole proprietorship leaves you unprotected in a way that forming an LLC does not.
Saves Time and Money on Your Taxes
Doing business as either a sole proprietor or an LLC means you pay tax on all of your business income when you pay your personal tax return — the business income simply passes through to your personal tax return. However, a sole proprietor without any separate financial accounts could be wasting too much time juggling business and personal paperwork at tax time. You might be missing out on business-related tax deductions due to your combined personal and business bank statements.
When you have an LLC with a separate business bank account, business credit card, business line of credit or other financial tools for your business, you will have an easier time managing your business finances and keeping track of tax-deductible business expenses to maximize your tax deductions.
Forming an LLC can also help you minimize your tax burden compared to a sole proprietorship. That’s because LLC owners have the option of choosing to have their LLC file taxes as an S Corporation, which has different tax treatment for business income and can potentially reduce the amount of money that you have to pay in self-employment taxes.
Use this free S Corporation tax calculator for more details. Depending on how much you earn, how much you pay yourself in salary and other details, you might be able to save thousands of dollars per year in taxes by forming an LLC and filing taxes as an S Corporation.
Ability to Bring on Investors or Business Partners
If you’re doing business as a sole proprietorship, by definition, your business cannot really grow; you’re in business for yourself and mostly “by yourself.” Forming an LLC gives you the legal ability to expand your business by bringing on a business partner or bringing on investors who can buy a share of ownership in your business.
If you have already been doing business on an informal basis with other business partners while being a sole proprietor, forming an LLC is an even better idea: It gives you a formal business entity with a flexible management structure. You can run your LLC as a single-member LLC or set it up as multi-member LLC. And you can change your LLC’s structure and Operating Agreement over time as your business evolves.
Pros of Sole Proprietorship
Setting up a sole proprietorship is as easy as putting up an "Open for Business" sign — for the most part. While this type of business entity requires much less paperwork than setting up an LLC, you may have to get a few permits or licenses depending on the type of business you're running.
Still, the process is much simpler than opening up an LLC, meaning you can spend less time filling out forms and more time creating a killer business plan.
Fewer Taxes and Fees
As mentioned above, setting up a sole proprietorship is generally a more straightforward process than setting up an LLC. This holds true when it comes to taxes and fees as well.
With a sole proprietorship, you don't have to get an EIN (though you can if you want to). Instead, you can use your SSN for all financial transactions. In addition, sole prop taxes use a pass-through taxation flow, meaning your business income flows into your personal income when it comes time to file.
Fees for sole props are fewer as well. With an LLC, you have to pay to register with your state, in addition to other annual fees. But if you choose to form an sole prop, you won't have to pay these reoccurring fees.
Can Use Your Personal Banking Account
When you choose to form a sole proprietorship over an LLC, you don't have to worry about setting up a business bank account. This means fewer headaches for you as you can easily track all your earnings and expenditures in the same account as your personal finances.
However, you don't have to use your personal account if you don't want to. You always have the option to create a business account to help keep things organized.
Can You Change Your Business from a Sole Proprietorship to an LLC?
Yes! If you're planning to operate (or are currently operating) your business as a sole proprietorship, you can absolutely convert your sole proprietorship into an LLC to take advantage of liability protection and other benefits. If you choose to do this, keep in mind that you may have contracts with existing clients, providers or suppliers that will need to be amended so that they list your LLC instead of your own name.
The biggest reason why business owners choose LLC vs. sole proprietorship is to add a layer of protection over their operations, so it's important to ensure that all of the pieces are in the right order and all paperwork checks out.
As a sole proprietor grows and starts taking on larger and more complex contracts, it becomes even more essential to understand the difference between sole proprietorship and LLC so that the best, safest and most profitable decision can be made.
LLC vs. Sole Proprietorship: How to Choose the Right One?
At the end of the day, you are the only one who can make the decision for your business based on how comfortable you are with liability, how you wish to see your business grow and whether or not you plan to expand into other areas that could be deemed as risky without the protection an LLC provides.
That said, here are a few things to consider:
Can your business withstand shaky economic times? Inflation, market crashes, recessions and interest rate hikes can be detrimental whether you have an LLC or sole proprietorship, but an LLC offers protection if things start to slide downward. Even if your business fails completely, you can walk away virtually unharmed.
Will you engage in complex activities? If you plan to purchase property, invest heavily in equipment or tools, and especially if you need to purchase bulk raw materials to carry out your business activities, you'll want to form an LLC. In the event that poor conditions arise, you won't be left holding the bag, so to speak.
Do you plan to expand? If your dream is to open up shop in other markets, other states or even other countries, you'll need to form an LLC or other business type to ensure that you are protected as you navigate various regulations, tax requirements, bylaws and other restrictions.
The bottom line is that doing business as a sole proprietorship can be too risky during uncertain economic times. By forming an LLC, you can benefit from various legal protections and financial advantages. Forming an LLC makes your business “official,” real and legitimate in the eyes of the law. It lets your business participate in the financial system with a separate business bank account and business credit. Doing business as an LLC helps protect your personal assets from the worst-case scenarios while opening up additional opportunities for your business to grow.
If you’ve decided that forming an LLC is the best option for your new business, you can incorporate today with Incfile. Our online business formation packages start at $0 + state fees, and it includes digital access to all your incorporation documents plus a year of free Registered Agent service. You’ll be supported by an experienced team that over 800,000 other business owners trust.
Chad is a freelance writer and former project manager focused on presenting information on SaaS, technology and business formation.