What are the differences between a sole proprietorship and an LLC?

Wasittha says, “Hello, Laura! I’m a big fan, and thank you so much for providing good financial information. I’m starting a local cottage business creating freeze-dried foods that I can operate in my kitchen. My startup capital is less than $5,000, and I plan to work alone. What’s the difference between having an LLC and a sole proprietorship, and which is better for protecting my finances?”

Thanks for your question, Wasittha! The business entity you choose is an important consideration that many small business owners, freelancers, and contractors need help with. I’ll explain the differences between having a sole proprietorship and an LLC and which option may be best for you as you launch and grow your venture.

Choosing a business entity

When you work for yourself, there’s a lot to do. You might need to create products, find clients, bill customers, search for outsourcing, or do a zillion other things. But one of the first tasks you should do is choose a business entity. Your entity determines your business structure according to the laws in your state.

Plus, you need to know your business entity and name before getting a business bank account, buying business insurance, and paying taxes.

Types of business entities

There are several primary business entity types and sub-entity structures to choose from. You typically register your business entity by filing documents and paying an annual fee to a state agency, such as the Secretary of State.

However, choosing a business entity can also be a passive decision, where you do nothing. If you don’t register your business with the state, you’ll automatically be a sole proprietor, which I’ll explain more about in a moment.

Since doing nothing is always easier than doing something, many small businesses start as sole proprietors by default. That’s not a bad thing. But it’s wise to make an informed decision by considering all your options.

Your business entity choice comes with significant financial and legal considerations, so it’s not something to take lightly. Each business entity has different pros and cons, including the complexity of formation and annual requirements. It affects the tax you must pay, what happens in a lawsuit, yearly paperwork, and the amount of personal exposure to risk.

Some business entities are considered separate from their owners for tax purposes and must file business tax returns. Others allow income to “pass-through” to the owner and get reported on your individual tax return.

So, there isn’t one best entity for a business, and it’s not a binding decision. As your business needs change, you can always change your entity. However, the most common entities for solopreneurs and small businesses are a sole proprietorship and LLC, so we’ll review their main pros and cons.

If you already have a business or you’re thinking about becoming self-employed, don’t miss legitimate ways to reduce expenses, cut taxes, and save more. Money Girl reviews seven ways that having a small business saves you money in the following episode. Listen below:

What is a sole proprietorship?

A sole proprietorship is the simplest business entity. It’s made up of one person or is co-owned by a married couple. As I mentioned, you don’t have to comply with specialized government requirements or submit any paperwork to be a sole proprietor. That allows you to focus entirely on launching your venture and creating revenue.

If you earn income on the side as a freelancer or contractor, you may have a sole proprietorship and not even realize it. The simplicity of a sole proprietorship can make it a good starting point for solopreneurs, especially if your industry or trade has few legal risks.

Pros of being a sole proprietor

Here are the main pros of being a sole proprietor:

It’s convenient to start because you don’t have to take any formal action.
It’s free because you aren’t required to register with your state.
It gives you privacy because your business isn’t entered into public records.
It’s simple to maintain because there’s no annual paperwork (such as meeting minutes) to complete.
It’s easy to convert into another business entity, if you wish.
It simplifies taxes because you include the business profit or loss on your personal tax return using Form 1040, U.S. Individual Tax Returnopens PDF file , and Schedule C, Profit or Loss from Businessopens PDF file .

Cons of being a sole proprietor

While the simplicity of a sole proprietorship sounds great, it comes with disadvantages to consider. A primary downside is that it exposes your personal finances to an unlimited amount of risk. For instance, if a customer, client, or other party sues your business, your personal assets–such as your savings, vehicles, and home–could be at risk.

Here are the main cons of being a sole proprietor:

It makes you personally liable for the business’s activities and debts because there’s no distinction or legal separation between you and the business.
It can be challenging to build credit for your business or obtain financing if needed.
It may not have the same prestige as an incorporated business.

While many small businesses and solopreneurs start as sole proprietorships, they may change to another entity as they grow.

When I began working as a freelance writer and podcaster on the side of my day job many years ago, I wasn’t sure where it would go, so I maintained sole proprietor status for years. When I began working with large firms as a PR spokesperson and consultant, I decided to become a limited liability company or LLC.

What is an LLC?

An LLC is a business entity that exists separately from its owners, called members. An LLC and its members have liability protection from legal claims against the business. You can have unlimited members or a single-member LLC, making it a good option for solopreneurs.

LLCs are typically set up with an operating agreement that defines the company’s membership, management, and income distribution. But it can be a simple document and doesn’t require a formal annual meeting or minutes, as with a corporation, so record keeping is easier.

You must register an LLC with the state and file a report with a fee every year. I live in Florida, with a one-time formation fee of $100 and an annual LLC fee of $138.75.

Interestingly, you can choose how you want to be taxed with an LLC. You can pay tax as a corporation or as a “disregarded entity,” which allows you to include pass-through income on your personal tax return. That means your business doesn’t pay taxes on its profits–instead you include them on your individual tax return.

Pros of having a limited liability company (LLC)

Here are the main pros of having an LLC:

It’s recognized as a separate legal entity from the member(s), giving you unlimited liability for claims against the business and its debts.
It gives you liability protection for claims against any other members.
It has flexible organizational rules, requiring no formal officers or annual meetings.
If you elect to be a disregarded entity, filing taxes is easy because you include any profits or losses from the business on your personal tax return.

Cons of having a limited liability company (LLC)

The main con for having an LLC as a solo or small business owner is the administration and registration cost, which varies depending on where you do business.

Also, separating your business and personal finances is important to simplify reporting and doing taxes as an LLC. While you’re not obligated to keep your personal finances separate as a sole proprietor, I highly recommend it for staying organized. If you don’t know which expenses were personal or business, you might forget to claim qualified expenses as business deductions and overpay taxes.

With an LLC, you should have a business bank account and sign documents and contracts on behalf of the business, not as an individual.

Recordkeeping is crucial when you’re self-employed. These eight rules will help you to stay compliant with the IRS and better understand your business now and in the future. Listen in the player below:

Should you have a sole proprietorship or LLC?

The answer to whether you should be a sole proprietor or have an LLC depends on factors like your type of business, potential risk of getting into a lawsuit, expected income, and business goals.

If you do contractual work as a consultant or freelancer with no employees, being a sole proprietor with business insurance may keep you safe and give you peace of mind. But it’s wise to create an LLC from the start if your business exposes you to certain risks, such as becoming a real estate agent or working in health care or food service.

So, what are the differences between a sole proprietorship and an LLC in Wasittha’s case, or – more so – which one is best? Since Wasittha said the business would create food products, creating an LLC would offer personal liability in the event of a lawsuit. I also recommend having business insurance based on the potential risks.

Since the needs of every business owner are different and the tax law varies by state, consider consulting a business attorney or a tax professional to discuss the issues that should affect your business entity, tax, and insurance decisions.

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