No matter how much cash you earned this year, being self-employed can be a complicated business. You’re responsible for everything, including the proper way to structure your company. If you call yourself a freelancer or independent contractor, you’re likely already a sole proprietorship. But you may be wondering if you should form a limited liability company (LLC)? And how do you know if you should be a sole proprietorship vs LLC?
Here are the ins and outs of each so you can understand the difference between a sole proprietorship and LLC and decide which is best for you.
LLC vs sole proprietor: The basics
What’s a sole proprietorship?
A sole proprietorship is a one-person business owned by an individual who also handles the operation of the business. For legal and tax purposes, you’re not a separate entity from your business. You are the business.
Assets owned by the business are also owned by you; the same is true for debts, income, and liabilities. You pay taxes on your business profits at the same time you file your personal taxes, and these profits are reported on your personal income tax return. By default, your business name will be your personal name, unless you use a trade name, which is also known as “doing business as” or a DBA.
If you own a sole proprietorship, you’ll call yourself a “sole proprietor.” Generally, you don’t have to file anything to start a sole proprietorship; it just happens automatically when you make your first business transaction. Some states, cities, or counties may require you to get a business license or permit, but these actions do not determine whether you have a sole proprietorship.
What’s an LLC?
Where a sole proprietorship has everything commingled between the person and the business, an LLC creates a legal wall of separation between the two. Legally, the LLC is a separate entity. What’s owned and owed by the LLC is owned and owed by the LLC, and not you.
This is an attractive option for anyone looking to protect their personal assets. An LLC can be owned by a single person (which is called a member), but it can have more than one owner as well.
Pros and cons of a sole proprietorship vs LLC
If you’re a list-maker, get out your pen! Comparing the pros and cons of each is the best way to see which fits your unique business situation.
Pros of an LLC
The words “limited liability” can be very appealing for those who don’t want to mix business and personal. Also, businesses that form an LLC may be considered more professional to investors and potential business partners. Setting up an LLC isn’t terribly difficult, either, compared to some other more complicated business structures.
Cons of an LLC
For those who don’t have extra cash to spend, forming an LLC could cause a budget pinch. That’s not to say that it doesn’t have its value, but a single-person business who isn’t making much profit could find it hard to justify the expense. Also, most states require that LLCs pay an annual or biennial fee to maintain their LLC status.
There’s also the matter of paperwork, which has to be filed to form the LLC, then maintained every year or two to keep it active. If you’re not a fan of administrative duties, it’s possible to outsource this task for a fee.
Pros of a sole proprietorship
It doesn’t get easier than a sole proprietorship. Anyone can set one up, simply by doing business. Tax filing can be done on your personal return, with earnings reported on your Schedule C.
Cons of a sole proprietorship
What it has in simplicity, it lacks in protection. Since you are your business, if your company ends up in a lawsuit or becomes deeply in debt, it’s on you to sort things out.
For those who need their business and personal finances separated, including owning assets or applying for loans, this isn’t the ideal scenario. It’s also limited to a single owner (or a partnership of spouses, in some states). If you want to bring on part-owners to your venture, be prepared to ditch sole proprietorship status.
LLC vs sole proprietorship tax differences
Choosing to be a sole proprietor vs LLC doesn’t directly have anything to do with taxes. Even if you form an LLC, you’ll continue to pay taxes as a sole proprietorship, where the profits pass through to the owners’ personal income. This is the default tax treatment for single-member LLCs.
If your LLC has multiple owners, you’ll each pay taxes based on a percentage of ownership. The separation of an LLC from the owner for liability purposes isn’t what determines your tax situation.
In tax terms, the biggest difference between a sole proprietor and LLC is that an LLC has what’s called tax flexibility. That means you can request to be taxed as an S Corp or C Corp.
There are differences between S Corps and C Corps, especially when it comes to taxes. You can consult with a tax advisor on what’s best for your situation or read our guide to S Corps vs C Corps.
The most important difference is that C Corps pay corporate income taxes in addition to requiring their owners to pay personal income tax on their salary and corporate distributions; this is called “double-taxation.” S Corp owners only pay personal income tax on their wages and the company profits that are passed through to their personal tax return.
The bottom line is there’s not a big difference between LLC vs sole proprietorship taxes, unless you elect to have your LLC taxed as a C Corp or S Corp.
Other frequently asked questions
Still not sure if you should choose an LLC or sole proprietorship? These are some of the additional questions people ask when trying to decide the best path forward.
I’m not sure how to change from sole proprietor to LLC. What do I need to do?
Since you’re a sole proprietor by default, making the change to LLC requires that you register your business with your state. Each state has a different department handling this, but your state’s small-business office or secretary of state website is a good place to start. Forming an LLC involves a few steps, which vary by location but often include:
- Getting an articles of incorporation (sometimes, called articles of organization) template in person or online
- Naming your business, including research that verifies no one else is using the same name in your state
- Filling out and submitting the articles of organization
- Filing any additional state-required paperwork
- Creating and maintaining your operating agreement
Other steps might include assigning a registered agent and certifying that you’ll keep your records updated in the future. There are also fees, which range from $100 to thousands. Getting final approval can take weeks or even months, so plan in advance for the process to take its course.
(Note: These steps assume that you are operating legally in your state, or plan to. If your business needs additional licensing, permits, or zoning approval, get those finished in advance of applying for your LLC. Some pieces of the puzzle may be happening at the same time, simply due to the nature of how the government works. Again, your state rep can help you know which order of events to follow, but ensuring your company is legally allowed to operate is essential, especially before you spend all of that money to organize.)
You can also enlist the help of a service that does this work for you, freeing up that research and filing time for more important business matters.
Can a sole proprietor have employees?
Yes! You can hire one employee or several. Remember that you’re responsible for paying employer payroll taxes, withholding employee payroll taxes, following local labor laws, and paying your workers according to updated worker classification rules. (Knowing if a worker is an independent contractor, like you, or an actual employee isn’t something you want to get wrong.)
LLCs can have employees, too, and will pay them according to the same rules.
Pro tip: Did you know that employing your own children may have special tax benefits exclusively for sole proprietors? The IRS allows you to hire your own children and write off their wages as a business expense, just like any other employee. You can also potentially set-up retirement plans for your children to help with your savings goals.
One additional perk is that you don’t have to pay Social Security or Medicare taxes, just as long as it’s the child of the owner sole proprietorship or the child of both partners for a partnership. The child must also be under 18. This benefit doesn’t apply to corporations or LLCs with corporate tax structures.
Can a sole proprietor be an LLC?
No. While you can operate your business in a very similar manner from one to the other, you can’t be both at the same time. Once a sole proprietor’s business forms an LLC, it’s legally separated from the owner, a truly different entity.
How about the other way around, is an LLC a sole proprietorship? Yes, but only for tax purposes and only if the LLC hasn’t elected to be taxed as an S Corp or C Corp. When it comes to liability protection, an LLC is not a sole proprietorship.
Still not sure who would win in the battle of LLC vs sole proprietorship? The final choice is something only you can make. In the end, those who choose an LLC are those who need liability protection or who want to have several owners or partners. Those who pick a sole proprietorship have basic business needs or limited budgets.
Whatever you choose, the most important step is to weigh the pros and cons of a sole proprietorship vs LLC and choose the one that meets the unique needs of your business.
Linsey Knerl is a Midwest-based author, public speaker, and member of the ASJA. She has a passion for helping small business owners do more with their resources via the latest tech and finance solutions.