What is The Difference Between a Sole Proprietor And LLC?
If you are a business owner, one of the most important decisions you will make is what organizational structure to use. There are several options, but two of the most common are sole proprietorship vs LLC. So, what’s the difference between them? Here’s a breakdown.
What Is Sole Proprietorship?
A sole proprietorship, also known as a sole trader or proprietorship, is a type of unincorporated business in which profits are taxed as personal income to the owner. Since it is not required of sole proprietors to establish a particular business or trade name, many of them use their names.
Due to the lack of oversight from higher authorities, a sole proprietorship is the simplest business structure to set up and dissolve. Freelancers, independent contractors, and consultants love these models so much. Most new businesses start as sole proprietorships, and most stay that way or turn into limited liability companies or corporations as they grow.
The following legal framework characterizes a sole proprietorship:
- Like its proprietor, it does not exist as a distinct legal entity.
- The proprietor’s legal responsibility is boundless.
- To sue or be sued in its owner’s name.
Advantages of Sole Proprietorship
Simplified business ownership: Forming a sole proprietorship, as opposed to a partnership or corporation, is typically straightforward and inexpensive. However, this will vary from country to country. Compared to other types of businesses, sole proprietorships have relatively few legal filing requirements. Therefore, business owners do not have to wait too long to get their permits and go to work. To further promote risk-taking entrepreneurs and spur economic growth, the government has kept start-up costs to a minimum.
Full management control: One of the advantages of being a sole proprietor is that you have complete control over how your business is managed and run without having to worry about complying with the stringent disclosure and reporting requirements imposed on limited liability companies and corporations by various jurisdictions. This level of discretion and control over your business is unattainable under alternative organizational forms.
Easier tax set-up: The tax obligations for a sole proprietorship are less complicated and demanding than those for other business structures. To begin with, sole proprietors are not required by the IRS to file for an employer identification number (EIN), unlike other business structures. As a sole proprietor, you have the option of using your Social Security number for all financial transactions, but enterprises that have employees can use an EIN to collect and pay them independently of the filer’s Social Security number. A sole proprietorship also offers advantages when it comes time to file taxes. The profits and losses of a sole proprietorship are passed through to the proprietor and taxed as such. You may take care of all that must be done for personal and corporate tax purposes on a single annual 1040 form.
Simplified banking: Simplified banking is a major benefit for a sole proprietorship. Only sole proprietorships do not need a separate business checking account to conduct daily operations. (In theory, you could manage an LLC without a separate company checking account, but doing so would render many of the tax benefits and liability limitations that come with LLC status largely moot.) You can use your money for commercial transactions if you run your business as a lone proprietor. You needn’t worry about opening a business checking account; however, you may want to do so if you want to keep your business and personal funds in different places. In the end, a personal checking account will suffice for banking purposes; keep meticulous records that differentiate between business and personal expenditures.
Disadvantages of Sole Proprietorship
Unlimited legal liability: Ownership of the company and the business itself are inseparable in the eyes of the law. The proprietor is personally liable for all debts and responsibilities, just as they are the sole beneficiary of any and all earnings. If the company cannot pay its debts, the creditors may attempt to seize personal assets.
Limited access to capital: When starting a business, many people use their own funds. The amount of money they can access and borrow from others through loan connections is constrained. To put it simply, banks prefer to do business with well-established firms because they generate more annual revenue and have a longer track record of paying their bills on time.
Backup and succession: In the event that the business owner is unable or unwilling to continue running it, the company will shut down. In the event of an owner’s temporary inability to perform their duties as a result of, say, illness, they may be able to temporarily replace themselves with a trusted employee or member of their immediate family. Since sole proprietorships lack their own legal personality, it is difficult to transfer intangible assets from one owner to another.
What Is LLC?
Limited liability companies (LLCs) are corporate entities that shield their owners from personal liability for business debts and obligations. Limited liability companies (LLCs) enjoy the limited liability status of corporations while also enjoying the flexibility and flow-through taxation of partnerships and sole proprietorships.
Advantages of LLC
Limited liability: The company’s limited liability status is the primary perk. The corporation is a separate legal entity. In this way, the business’s owners and members are shielded from paying for the company’s debts or missteps out of their own pockets.
Pass-Through Taxation: By default, an LLC is a pass-through entity, which means its profits are distributed to its members rather than the firm itself. However, the gains are taxed according to each member’s federal income tax return. Since you won’t have to file as a separate corporation, this simplifies tax time. Losses sustained by a business can be written off on the owners’ personal tax returns, thereby reducing their overall tax obligations.
Management flexibility: An LLC can be run by its members, who can then make decisions on the business’s behalf. Business owners can also hire professional managers who may or may not be part of the company’s ownership structure. If members ever need to bring in someone with greater business management experience, this will help them do so. When starting a business, an LLC is the most convenient option. There is no need for the formalities associated with a corporation, such as appointing directors or holding annual shareholder meetings.
Flexibility in Sharing Profits: Members of a limited liability company can divide the company’s earnings however they see fit. Contrast this with a general partnership, where all partners must share earnings equally. Instead, LLCs permit profit distribution according to the conditions of the operating agreement. For example, the agreement may provide that the member who puts in the most initial capital or sweat equity (the effort required to bring the business to fruition) will receive a larger cut of the earnings. In addition, a limited liability company can have an unlimited number of shareholders. Additionally, unlike a corporation, there is no need to keep a board of directors or set of officers in place.
Disadvantages of LLC
Cost: A limited liability company (LLC) has higher start-up and ongoing expenses than a sole proprietorship or general partnership. The state typically imposes a startup cost. Furthermore, annual reports and/or franchise tax costs are imposed by several states regularly. To find out more, contact your state’s Secretary of State.
Transfer of ownership: The transferability of LLC ownership is typically more restricted than that of corporate ownership. Unless there is a shareholder agreement prohibiting the sale of shares, shareholders in a business are free to sell their holdings to new investors. Adding new members to a limited liability company or changing the ownership percentages of current members typically requires unanimous consent from all members unless the members agree differently.
Members Must Immediately Recognize Profits: The profits of a C-corporation are not required to be paid out to shareholders in the form of a dividend immediately. This means that C-corporation stockholders are not usually subject to taxation on their portion of the company’s profits. The profits of an LLC are considered part of a member’s taxable income without any further action on the part of the member.
Fewer fringe benefits: Group insurance, medical reimbursement programs, medical insurance, and parking provided to employees by their LLC must be reported as income. Employees who possess more than 2% of an S-corporation face the same restrictions. However, C-corporation employees do not need to include fringe benefits in their taxable income because they are not considered wages.
LLC vs. sole proprietorship: Operations and management
The difference between sole proprietor and LLC lies in operations and management. Because there is only one individual responsible for making decisions and carrying them out, a sole proprietorship’s operational and management structure is straightforward. All choices concerning the company are ultimately up to the proprietor and are not subject to review by any outside parties. However, they may bring on staff, outside counsel, and other professionals to assist with running the company’s day-to-day operations. But it is the sole proprietor’s responsibility to ensure the company operates lawfully and profitably and to pay off any outstanding debts.
The management and operations of an LLC are more intricate and are usually spelled out in an operating agreement. Having an operating agreement is common practice for LLCs, especially with several members, despite only a few states mandating it. Members’ respective financial investments, voting rights, and profit distributions are all spelled out in the operating agreement. An LLC can be administered either by the members themselves or by management designated by them. The voting power of members of a limited liability corporation (LLC) is based on the number of membership units each member holds.
LLC vs. Sole proprietorship: Taxes
What is the difference between sole proprietor and LLC in terms of taxes? Given that they are “pass-through” entities, neither entity is responsible for paying income taxes. Income from a business is reported on a Schedule C linked to the individual taxpayer’s tax return and is subject to taxation at the individual’s marginal tax rate.
LLCs have more leeway in their tax structures than a single proprietorship. Owners of LLCs are the only ones who get a say in how their company is taxed. LLC members can choose to have their business taxed as a pass-through entity (the standard) or as an S-corporation or C-corporation (the other options). Filing as a corporation for tax purposes might be financially advantageous for LLCs. Dividends paid by a corporation are often taxed at a lower rate than the company’s regular commercial revenue.
Talking about the difference between LLC and sole proprietorship tax, a corporation is exempt from paying income tax on its retained earnings. On the other hand, members of an LLC must pay taxes on all business profits, whether given to members or kept by the company. A corporation can claim more tax breaks and credits.
LLC vs. sole proprietorship: Legal protection
Let’s analyze the difference between a sole proprietorship and an LLC in terms of legal protection. In a sole proprietorship, there is no formal distinction between the owner and the business. The business’s debts are ultimately the owner’s responsibility. In the event of business failure, a lone proprietor will be required to file for personal bankruptcy, which will encompass both business and personal debts. To add insult to injury, a sole proprietor’s personal assets are fair game in a lawsuit against the business.
Forming a limited liability company (LLC) is a good strategy for safeguarding private wealth. The proprietor of a limited liability company (LLC) is not personally responsible for the business’s debts. Business owners can avoid paying off business debts with their own money by filing for business bankruptcy in the event of business failure. In most cases, a plaintiff who files a lawsuit against an LLC will not be able to go after the LLC’s owners individually. In the case of fraud, negligence, or personally guaranteed debts, LLC owners can, of course, be held personally accountable. There is no form of corporate organization that can shield its owners from all possible business-related obligations.
What To Choose?
So, LLC or sole proprietorship? The standard response is “it depends,” as with so many similar inquiries. There are many aspects to consider when deciding on the ideal business structure for you; it’s advisable to talk to an attorney who specializes in corporate law before making any final decisions. The benefits and protections afforded by an LLC cannot be overstated, especially given the difficulties associated with securing financial backing for a corporation.