When an entrepreneur is ready to start a business, he or she must decide what kind of business to set up. The type of business selected can impact everything from day-to-day operations to tax treatment. The decision is an important one, and often, one of the first big choices faced by new business owners.
There are a handful of different types of businesses to choose from, including a limited liability company and a sole proprietorship. To weigh the differences between an LLC vs. Sole Proprietorship, this guide will explore both options.
What is an LLC?
A limited liability company or LLC is a type of business entity that’s registered with the state, offers entrepreneurs limited liability protection, and relies on pass-through taxation. If you’re a little confused by that definition, don’t worry. Let’s sort the definition out.
To start, this type of business entity is registered with the state. To complete this incorporation, an owner must file LLC formation documents online, which are most commonly called Articles or Organization.
Setting up an LLC with the state provides limited liability protection, as the name suggests. That means that an owner’s business and personal assets are separate. If the company is sued or falls into financial ruin, the owner’s personal home, car, and bank accounts are protected and aren’t used to bail out the company.
Wondering what pass-through taxation means? An LLC isn’t taxed. Instead, the owner pays taxes on business income on his or her own personal tax return, which is called pass-through taxes.
What is a sole proprietorship?
A sole proprietorship is an unincorporated business entity that makes no distinction between the business and the owner. The owner is entitled to profits from the company and pays taxes on them.
What does unincorporated mean? It means the business isn’t registered with the state (with the exception of necessary permits or licenses). In other words, there is no paperwork to file with the state or yearly reports to submit. The entity is formed simply by an owner’s business activity.
A sole proprietor pays taxes on profits earned via his or her personal income tax, much like the owner of an LLC.
Unlike an LLC, however, a sole proprietorship doesn’t offer any personal liability. As mentioned, the business and the owner are one and the same, so personal and business assets aren’t separated. Simply put, the owner’s personal assets are at risk if the company accrues debt or is sued.
Benefits of an LLC
Small business owners that elect to set up an LLC enjoy the following benefits:
One of the biggest perks to an LLC is its liability protection. If a business has financial trouble or is sued, the owner’s personal assets are safeguarded. This kind of financial and legal protection is not offered with a sole proprietorship.
Setting up an LLC can provide a business owner with more credibility than a sole proprietorship. It often provides a sense of security to customers or vendors knowing that the company is an established business with the state.
Ownership and management flexibility
An LLC can take on many forms when it comes to ownership and management. An LLC can have as many owners, which are known as members, as it wants. If the LLC is owned by a single person, it is said to operate as a single-member LLC. Members can also manage the business.
Benefits of a sole proprietorship
Small business owners that elect a sole proprietorship as a business structure list these benefits:
No state registration
A sole proprietorship may need certain state licenses or permits to operate, but there is no paperwork that must be delivered to the secretary of state’s office to launch a business. Annual reports aren’t required either. An LLC, however, must file both LLC formation paperwork and annual reports with the state.
Easy tax reporting
The tax rates for a sole proprietorship are the lowest of all business entities. Plus, the owner and the business are the same, which means tax filing is an easy process. Many sole proprietors do their own taxes. An LLC is different. The company and owner are separate, which, for tax purposes, does add forms like a Schedule C to a person’s tax return.
No cost to start
There is no cost to start a sole proprietorship. In comparison, LLC owners are required to pay a filing fee when the business is registered with the state, which can range between $50-$500. Many states collect a filing fee every year as part of an annual report as well.
How to form an LLC
For entrepreneurs interested in forming an LLC, here’s how to set it up:
1. Pick a business name
The first item on the to-do list is to pick a name for the company. Before you settle on one, it’s best to check its availability. Most states won’t allow two businesses to operate with the same name. As a result, new business owners must see if the company name they want is already in use. Go to the secretary of state’s website and conduct a business name search to check name availability.
The name must also have “LLC” or “Limited Liability Company” in it.
2. Pick a registered agent
Every company must pick a registered agent, which is a person or company who serves as a point of contact. The registered agent might receive tax documents, notices from the state, or legal paperwork on behalf of the company. In most states, the LLC owner can serve as the company’s registered agent, or the owner can elect another employee or hire a registered agent service to fill the role.
3. File Articles of Organization
To officially set up an LLC, LLC formation documents, which are usually called Articles of Organization, must be filed with the state. The document is short and asks for the company name and address, the registered agent’s name and address, the date the company started, a list of managing members, and a brief description of the company.
These documents can usually be found and filed online through the secretary of state website. Expect to pay a filing fee as well.
These three steps are all that’s required to set up an LLC with the state. However, your LLC should also consider the following:
- Creating an operating agreement: An operating agreement explains how the company will run, which can solve arguments in the future.
- Obtaining an EIN before opening to customers: An EIN is an employer identification number that’s issued by the IRS and required for most business transactions like paying taxing or hiring employees.
How to form a sole proprietorship
Forming a sole proprietorship is easy. This business entity doesn’t file any formal documents with the state, so set up is simply these steps:
1. Pick a business name
Entrepreneurs who want to conduct business under a name that’s different than their own can file a DBA (Doing Business As) registration with the county or state. Registration varies by state, so entrepreneurs must research the process in their location.
Before registering, you can conduct a business name search (usually) found on the secretary of state’s website to make sure the name is available.
Remember, a DBA is not a separate legal entity. It just gives a business the opportunity to operate under a different name than that of the owner.
If you simply want to conduct business under your personal name, you don’t need to set up a DBA.
2. See if business licenses or permits are needed
A sole proprietorship must still obtain proper licenses and permits. To see what your business needs, check with local and state officials.
Those two steps are all that’s necessary to get a sole proprietorship up and running, but you might also consider the following:
- Setting up business bank accounts
- Registering with county and state tax authorities
- Obtaining an employer identification number, or EIN, from the IRS
FAQs About LLCs and Sole Proprietorship
To further aid startups, here’s a look at frequently asked questions that surround both LLCs and sole proprietorships:
Is a business owner automatically a sole proprietor?
Yes. A person’s business activities automatically signal tax entities that a person is running a business. A DBA can be set up if the owner wants to choose a business name, but it’s not required.
How do you prove a sole proprietorship?
A copy of the owner’s income tax return, especially the Schedule C, will show evidence of a business. If the owner sets up a DBA, that can also offer proof.
Can a sole proprietor hire employees?
Yes. To do so, the sole proprietor needs to apply for an EIN, which is issued online by the IRS.
Does a sole proprietor need separate bank accounts for the business?
It’s not necessary to have separate bank accounts. However, transactions that are related to the business should be properly labeled.
How is an LLC owner paid?
The LLC owner doesn’t get a salary, instead, he or she takes money from the company profits as needed. It’s called an owner’s draw.
Is LLC income taxed twice?
No. LLC income is not taxed twice. The LLC does not pay a business tax. A corporation, which is yet another kind of business entity, is subject to double taxation. An LLC is not.
Is setting up an LLC difficult?
No. There are certain documents that must be filed with the state, but the process is fairly simple. Instructions on how and what to file can usually be found on the secretary of state’s website.