At some point, entrepreneurs must choose whether to stay as sole proprietors or upgrade to another business structure. One of the most popular business structures includes LLCs, but don’t make the mistake of becoming an LLC before you understand what it is.
10 Differences Between an LLC and Sole Proprietorship
Before becoming an LLC, you’ll need to do your research. We’re here to help. Below is a quick overview of 10 vital differences you must understand before deciding what suits you.
Regarding LLCs, the business is a separate entity from the business owner, and they protect it from liability as the business owner is not personally liable for the company’s actions. However, the business owner is personally liable for all activities with a sole proprietorship.
2. Tax Implications
An LLC can be taxed as a separate business entity and allows for pass-through taxation for the members, meaning the profits and losses flow through to the individual tax returns. With sole proprietorships, the profits and losses are reported as personal income.
3. Legal Formalities
LLCs require a proper setup. You must file an Articles of Organization with the Secretary of State and complete other compliance requirements. With a sole proprietorship, no formalities or paperwork are required to get started; you just claim self-employment income.
4. Operating Agreement
With LLCs, it is required to have an Operating Agreement drafted up, which outlines the operations and rules of the business. With sole proprietorships, no formal agreement is required. Use an LLC Operating Agreement template at FormPros to streamline the process.
5. Maintenance Costs
LLCs typically require more money to set up and maintain than a sole proprietorship. When creating an LLC, filing, and fee costs, as well as the cost of a formal Operating Agreement, need to be considered. Sole proprietors have limited business expenses in comparison.
LLCs may not be as flexible as sole proprietorships due to the potential for double taxation. However, this is only an issue if the business operates in Canada or is structured as a C-corp. Nevertheless, Sole proprietors generally have more control over when income or deductions occur.
7. Growth and Sale
It’s much easier to attract additional investors and grow your business with an LLC than with a sole proprietorship. If you ever decide to sell your business, LLCs appeal to potential buyers better. Sole proprietors look less legitimate because they often don’t have an EIN.
8. Name Protection
The name of a sole proprietorship is at risk of being copied by other businesses. With LLCs, the name is adequately protected when filed with the Secretary of State. If sole proprietors want to protect their intellectual property rights and brand visuals, they must become LLCs.
Unless formally dissolved, a sole proprietorship generally continues until the owner’s death, or they sell the business. The life of an LLC is much longer as it can be passed down to heirs with little disruption. An LLC is perfect for people who want to invest in their family’s estate.
10. Retirement Funds
Owners of sole proprietorships can roll over profits into an individual retirement account before paying taxes, whereas LLC owners can’t. LLC owners can still pay into their retirement fund and get a tax break provided the money they use comes out of their personal taxable income.
Many significant differences exist when deciding between an LLC or a sole proprietorship. Do your research and consult with a qualified accountant before deciding, or you could need to prepare for the extra taxes or regulations.
What is the difference between a sole proprietorship and an LLC?
The main difference between a sole proprietorship and an LLC is that a sole proprietorship offers no separation of personal liability from business obligations. At the same time, an LLC provides limited liability protection to its owners. Additionally, taxes are handled differently in both types of businesses, with profits and losses flowing through to the individual tax returns for sole proprietorships but passing through to the members’ tax returns for LLCs. Furthermore, legal formalities such as filing Articles of Organization and creating an Operating Agreement are required when starting an LLC but not with a sole proprietorship.
Is it better to have a sole proprietorship or an LLC?
It depends on the individual’s needs and goals. Sole proprietorships provide flexibility, cost less to set up, and require fewer formalities. LLCs offer limited liability protection and may be advantageous regarding taxes. Ultimately, you must weigh the pros and cons of each business structure.
What are some advantages of a sole proprietorship?
The main advantages of a sole proprietorship include complete control over your business decisions, no need for paperwork or filing fees, fewer legal obligations, and direct access to profits. Additionally, setting up a sole proprietorship is often cheaper and easier than an LLC, as the IRS requires no tax filings. Lastly, sole proprietors can roll over profits into an individual retirement account before paying taxes.
Are there any disadvantages to a sole proprietorship?
Yes, there are some drawbacks to a sole proprietorship. Since the business owner is personally liable for all debts and obligations, their personal assets are at risk if the business fails. Name protection is not guaranteed, and the life of a sole proprietorship ends when the owner dies or sells the business. Finally, LLC owners can access more tax incentives than those in a sole proprietorship arrangement.