What’s the difference between a sole proprietor and an LLC?
Sole proprietorships and LLCs are two of the most common business structures in the US. Sole proprietor is the simplest structure to adopt, while an LLC provides more legal protections to their owners.
What is a sole proprietorship?
A sole proprietor is any single-owner business that hasn’t filed paperwork to become an LLC or corporation. As a result, there’s no legal separation between the business and its owner.
What is an LLC?
An owner who wants to make their business a separate legal entity can file paperwork to become an LLC (or a corporation). The business may have ongoing obligations to maintain its LLC status.
Sole proprietor vs. LLC: 4 key points
- Sole proprietors don’t have to perform any actions or pay any fees. They’re automatically considered a sole proprietor as soon as they start operating.
- LLCs have to file paperwork with their state and pay fees. The fees are often quite low but in some states may range up to $500. The overall costs will be higher as you may want to get help from a business attorney or a legal admin service like LegalZoom.
Paperwork and compliance
- Sole proprietors need to meet their tax obligations and obtain any permits or licenses required to do business in their town or industry, but that’s it.
- LLCs need to deal with taxes, licenses and permits, too. Plus they may pay annual fees and, in some states, they have to file an annual report.
- Sole proprietors have no legal separation from their business. Anything that happens to the business – such as a lawsuit or bankruptcy – happens to them personally.
- LLCs are considered separate from their owner. Lawsuits and bankruptcies happen to the business and not necessarily to the owner/s. That doesn’t mean LLC owners are untouchable. They may still be held personally responsible for debts or damages if they behaved negligently or signed a personal guarantee, for example.
- Sole proprietors report their business income or loss on their personal tax return. They will pay self-employment taxes, but they’re entitled to deduct half of those taxes to offset that cost.
- An LLC formed by one owner is taxed like a sole proprietor by default. If there are multiple owners, the business is then treated as a partnership, with each owner reporting their share of profits on their personal return.
- LLCs can ask to be taxed like an S corporation or a C corporation, without having to form a board of directors. A tax professional will be able to figure out when it’s worth adopting a corporate tax structure. There will be different rules to follow in those cases.
Sole proprietors and LLCs have the same obligations when it comes to sales taxes and employee payroll taxes.
When businesses typically set up as an LLC
Owners may choose to make their business an LLC for lots of reasons. Three of the most common are:
- Expanded ownership: LLCs are a good structure for multiple owners.
- Limited liability protection: LLCs can protect owners from personal financial losses in cases where the business gets into trouble.
- Tax options: LLCs have some control over how they’re taxed and can change from one tax treatment to another (although they can’t easily toggle back and forth).
LLC or sole proprietorship – which should you choose?
Lots of businesses start out as sole proprietors simply because it’s the fastest and easiest way to get going. But speed and ease may not always be the most important factors as your business grows in size and complexity.
It’s a good idea to check if your business structure is still fit for purpose from time to time. Give the sole proprietor-vs-LLC debate extra thought anytime you consider extra loans, capital investments, expansion, or hiring employees.
Get a professional to help you through the decision. An accountant, especially a CPA, can provide the analysis and advice you’ll need.
Frequently asked questions about sole proprietor vs. LLCs
People who want to know the difference between a sole proprietor and an LLC also ask these questions.
Can a sole proprietorship become an LLC?
A sole proprietor can create an LLC and move their business activities into that new structure. The business they do may stay largely the same but it is now a different entity. They’ll need to update contracts and move to new bank accounts. Depending on the state and industry they’re in, they may need new licenses, a new employer identification number (EIN) and new payroll too.
Can you convert an LLC into a sole proprietorship?
No. If you want to run your business as a sole proprietorship you’ll need to close the LLC and then start from scratch, much like a sole proprietor becoming an LLC.
Can a single-owner business be an LLC?
Yes, you can form a single-member LLC. The process is the same as for forming a multi-member LLC.
Xero does not provide accounting, tax, business or legal advice. This guide has been provided for information purposes only. You should consult your own professional advisors for advice directly relating to your business or before taking action in relation to any of the content provided.
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