One of the most important legal decisions small business owners face is whether to form a limited liability company (LLC) or operate as a sole proprietorship. Both structures have advantages and disadvantages to weigh. This in-depth guide compares LLCs and sole proprietorships across liability protection, taxes, costs, management flexibility and other key factors.
Table of Contents
Defining Sole Proprietorships
A sole proprietorship is the simplest and most common small business structure. It consists of an individual business owner operating under their own personal name or a trade name. The sole proprietor personally holds all assets and liabilities of the business. All profits and losses flow through to the owner’s personal tax return.
Pros of Sole Proprietorships
- Easy and inexpensive to form. Simply obtain required licenses and permits.
- Owner retains complete control over business operations and decisions.
- Tax advantages. Income and losses are taxed only once directly through the owner’s personal income tax.
- Minimal paperwork and maintenance requirements.
- Easy tax filing. Business income and expenses reported on Schedule C personal tax return.
Cons of Sole Proprietorships
- Unlimited personal liability. The owner’s personal assets are at risk for all business debts and lawsuits.
- Difficulty raising capital and attracting investors since no equity ownership.
- Lack of business entity continuity. The business ceases to exist upon the owner’s retirement, death or exit.
- Self-employment tax requirements. Owners pay 15.3% self-employment taxes on net business income.
What are LLCs?
A limited liability company (LLC) is a legal business structure that combines aspects of partnerships, corporations and sole proprietorships. LLC owners have “pass-through taxation” like partnerships and liability protection like corporations. LLCs require more formal maintenance but provide advantages over sole proprietorships.
Pros of LLCs
- Limited liability for owners. Personal assets protected from business lawsuits and debts.
- Increased credibility with customers, partners and lenders.
- Separate legal entity from owners enables more flexible finances and taxes.
- Ownership flexibility through membership units rather than shares.
- Perpetual existence. The LLC continues beyond exits of individual owners.
Cons of LLCs
- More expensive to establish with state filing fees.
- Stricter operational processes like holding member meetings and maintaining records.
- Requires separate tax filing for business income and distributions to owners.
- Self-employment taxes for owners based on ownership stake.
Comparing Liability Protection
|Unlimited personal liability
|Liability limited to owner investment
|Personal Asset Protection
|Full protection for personal assets
|Business Creditor Claims
|Can seize owner’s personal assets
|Usually limited to business assets only
With an LLC, the owner’s liability is limited to their investment in the company. Personal assets remain protected from business debts and lawsuits in most cases. For sole proprietors, their personal and business assets are one and the same when it comes to liability.
Tax Differences Between LLCs and Sole Proprietorships
LLCs and sole proprietorships also have important tax differences:
- LLCs are taxed once at the entity level, then income/distributions are taxed on owners’ returns. Sole proprietors report income directly.
- LLCs file a Form 1065 informational return plus individual returns for members. Sole proprietors simply use Schedule C with a personal 1040.
- Both structures require owners to pay self-employment taxes on net business income based on ownership percentage.
- LLCs allow greater flexibility in how income is allocated and taxed among members.
Analyzing Operational Costs
LLCs have higher initial setup costs with state formation fees. Sole proprietorships only require local licensing fees in most cases. However, LLCs may yield cost savings on insurance, health benefits and legal services that balance out upfront filing expenses.
Comparing Management and Ownership Flexibility
Sole proprietorships vest all management and decision authority with the individual owner. LLCs can appoint managers and formalize decision-making structures through operating agreements. LLCs also provide more options for equity ownership through membership units. These factors give LLCs more flexibility as companies grow.
Key Takeaways: Choosing the Right Structure
- LLCs reduce personal liability exposure but have more operating requirements.
- Sole proprietorships offer simplicity but expose all assets to risk.
- Both structures allow pass-through taxation but LLCs offer more flexibility.
Analyze your specific business goals, risks, tax situation ownership needs when deciding between an LLC vs sole proprietorship. Consult legal, tax and financial advisors to make an informed decision.