LLC vs Sole Proprietor: How To Choose What's Best for You
In this article:
Key differences between a Sole Proprietorship and LLC
Major factors to consider when choosing between them
How Noumena can help support you as either an SP or LLC
You have big plans for your business, but you also cherish your independence. There's something truly invigorating about carving your path. As you continue this journey, however, you will need to make an important choice: do you want to remain a sole proprietor — or could you benefit from establishing an LLC?
This decision requires careful thought and attention. It could hold enormous implications for the future of your business, including everything like paperwork, taxes, and, most importantly, personal liability protections.
Before you proceed with your business plan, it's essential to understand how LLCs and sole proprietorships work — and why this decision could make or break your business.
Here's what you need to know about being an LLC vs. a sole proprietor.
Sole Proprietorship Vs. LLC: What's the Difference?
LLCs and sole proprietorships are among the most common business structures. Yet, if you're like many ambitious entrepreneurs, you have no idea how they differ. These simple definitions should help discern the difference between a sole proprietor and an LLC designation.
A common solution among part-time freelancers, the concept of the sole proprietorship is simple: it involves any unincorporated business exclusively operated by one party. This individual holds full legal responsibility rather than sharing this with partners, members, or managers.
Limited Liability Company (LLC)
A limited liability company (LLC) functions as a middle ground between a sole proprietorship (or general partnership) and a traditional corporation. Specific to the United States, this unique entity is meant to protect each business owner (known as members) from personal liability.
Unlike a corporation, an LLC is "organized" rather than "incorporated." This is reflected in the name of the typical founding document for an LLC: the articles of organization.
What To Consider Before Choosing Between Them
Sole proprietorships and LLCs hold a few key commonalities, such as:
A limited need for paperwork (as compared to S corps or C corps)
The opportunity for just one person to be in charge
What's more, LLCs can be taxed similarly to sole proprietorships.
However, neither of these entities is suited to all types of people or business ambitions. Changing from one entity to another can be complicated, so it's important to understand the pros and cons of each setup before you proceed.
As you build your business plan, you may struggle to choose between registering as a sole proprietor vs. an LLC. Some things to consider include:
Tax Implications and Tax Returns
LLCs provide the ultimate taxation flexibility. Income tax obligations depend on how many members the LLC in question has.
Single-member LLC and Sole Proprietor Taxes
A single-member LLC may be treated as a "disregarded entity" by the IRS. This means the LLC can skip filings such as separate income tax returns. This is replaced by completing Form 1040 — Schedule C — just as expected for a typical sole proprietor.
Multi-member LLC taxes
Greater tax differences emerge as LLCs move from single to multi-member status. At this point, the organization is usually regarded as a pass-through entity for tax purposes.
Instead of the LLC paying its taxes, each member is responsible for paying according to the business income and the individual's ownership share. Additional documentation — such as the U.S. Return of Partnership Income — may be required.
Corporate LLC Tax Status
Finally, LLCs can opt for corporate tax status. While these legal entities technically remain LLCs under this approach, tax classification shifts to that of an S corps or C corps.
LLCs that opt for the latter are subject to covering the federal corporate tax rate.
Meanwhile, those that stick with S corps taxation complete a process like the pass-through approach described above — but with important distinctions regarding salaries or distributions.
Future Business Partners or Owners
Do you intend to continue working alone indefinitely, or do you expect to take on a partner eventually? If you suspect you will ultimately share responsibilities and profits with somebody else, it probably behooves you to do the extra work upfront and create an LLC.
As discussed, multi-member LLCs are common — and they're equipped to add or remove members easily as needed. This process may vary according to the requirements outlined in the LLC's operating agreement, but typically, a new version of the said agreement must be approved when adding another member.
With a sole proprietorship, adding a member changes the classification of the business — not to mention how income taxes and essential responsibilities are handled. Once the company is no longer operated by one party, it becomes a general partnership. This has much in common with sole proprietorships but may bring additional risks.
Legal concerns often play a central role in the decision to form an LLC. Operating a sole proprietorship may be more convenient, but this approach provides minimal legal protection. In case of a lawsuit or unexpected debt concerns, sole proprietors may be alarmed to discover that their personal assets are at risk.
With an LLC, protection from personal liability is built into the very structure of the organization. The LLC acts as a separate legal entity, shielding otherwise vulnerable owners. Members receive a much-needed buffer, limiting individual owners' potential to sacrifice personal assets due to legal issues. LLC members must take extra steps to ensure that the organization's limited liability status remains intact — but this modicum of effort can provide valuable protection.
In a phenomenon known as "piercing the corporate veil," it's possible for personal liability to be re-established. This is rare, however, and far less likely if business and personal finances are kept separate and all compliance requirements are fulfilled.
Initial Filing Fees and Recurring Fees
LLCs will be subject to both initial filing and recurrent fees. Sole proprietors typically pay upfront filing fees, ranging by state. However, the cost is usually minimal.
Initial Filing Fees
Arguably the most significant downside to forming an LLC is the cost of getting started. This varies considerably from state to state, but LLC formation is nearly always accompanied by considerable filing fees. Typically, these accompany the submission of the LLC's articles of organization. This is one of the key eligibility requirements for forming an LLC in the first place.
The articles of organization designate a principal address and a registered agent (a person or business capable of receiving service of process) for the LLC. The articles of organization may be known by different names, such as certificate of formation or certificate of organization. They often cost approximately $100 to file, but beware: in some states, this may be accompanied by additional fees such as the "Initial List of Managers or Members."
Unfortunately, these expenses don't end after your LLC is up and running. Be prepared to continue paying for years to come. Any changes to the articles of organization could result in fees ranging from $50 to over $150. Even if you don't need to change the registered agent or other early designations, you'll likely be required to pay annually to keep your LLC status current.
While these fees may seem prohibitively expensive, you must weigh them against the potential cost of not launching an LLC. As we've discussed, this could leave your personal assets vulnerable in the event of a lawsuit. Moreover, the legitimacy conferred by this business structure may make it easier to secure desirable business loans or investments.
Whether You're Growing an LLC or a Solopreneurship, Noumena Has Financing Options
Are you ready to take your business to the next level? Once you determine whether you're better suited to running a sole proprietorship or an LLC, it's time for your business to flourish.
At Noumena, we're eager to lend a helping hand. We offer flexible financing solutions specifically tailored to meet the unique needs of the modern solopreneur or LLC.
Contact us today to learn more about our services — or download our app to join the Noumena community.