Sole Proprietorship vs LLC: Which Business Structure Is Right For You

New business owners make countless decisions. Which kind of bank account should you open? Who do you need to hire? Is your neighbor’s unemployed son actually qualified to do your bookkeeping?

If these are the kinds of decisions that keep you up at night, you’re in good company. According to the U.S. Chamber of Commerce, there are 33.2 million small businesses in the country. In 2021 alone, there were a record-breaking 5.4 million applications for new businesses.

Those numbers mean millions and millions of people are losing sleep over the same huge decision you are — what should you choose as a business structure?

Not every decision is worth agonizing over. Whether you choose backpacks or keychains for your new office swag, your employees will wear them with pride.

But business structure matters, big-time. It affects your funding, tax responsibilities, and paperwork requirements. It also impacts your liability for any business losses. It can get overwhelming, but narrowing things down helps.

Sole proprietorship and limited liability companies (LLC) are two of entrepreneurs' most common forms of ownership. If you're not sure which is which, you're not alone. Many entrepreneurs don't fully understand the differences.

Never fear, that's why we're here.

All about sole proprietorships

If the term "sole proprietorship" has you daydreaming about a nice, safe cubicle and watered-down, lukewarm coffee from the office breakroom, don't worry. It’s an intimidating phrase but one of the simplest ways to do business imaginable.

That might be why more than 28 million business owners choose to file that way — at least, that’s the number from 2020, according to the most recent available Internal Revenue Service (IRS) data.

What is a sole proprietorship?

According to the IRS, a sole proprietor "owns an unincorporated business by himself or herself."

Incorporation is a process that establishes the organization as a separate legal and financial entity, but a sole proprietor doesn't incorporate their business. If you become a sole proprietor, you and your organization will be the same legal entity. Its income will be your income, and its debts will be your debts.

The pros and cons of sole proprietorships

Sole proprietorships are straightforward, but they have their limits. Here's what you need to consider.

Pros:

• Easier and cheaper to start: According to the Corporate Finance Institute, a sole proprietorship is the simplest and least expensive business structure to establish.

• Fewer tax responsibilities: Because a sole proprietor and their business are legally the same entity, you generally only pay taxes on business income once. However, that's not true for owners of incorporated businesses, who pay corporate and individual taxes on their income. 

• Less documentation: Every business has to keep detailed financial records, but it’s typically simpler for sole proprietors. Incorporated businesses have way more to track, including organizational setup, operations, and finances. Some documentation, such as the annual report, is an ongoing responsibility. If you’re the type that breaks into a cold sweat at the thought of long division — thanks, fourth grade — you might be happier as a sole proprietor. 

Cons:

• Unrestricted liability: The owner carries the organization's financial and legal responsibilities. There's no separation between a sole proprietor and their business. This means that, for good or ill, what happens to one happens to the other. For example, if you take out a loan or place an order with a vendor, you have to cover the costs if the company can't. A sole proprietor is also personally liable in case of a lawsuit. If someone sues you due to a contract dispute, injury on your property, or other incident, you and your business will be liable for the debt. 

• Financing limitations: While LLCs can take on additional members to share the financial load, sole proprietors can't. Neither structure can sell shares or stock, but this limitation is often more rigid on a sole proprietor. Sole proprietors have to fund their businesses independently. Plus, since they're liable for business debts, lenders may be more reluctant to approve their applications.

Which kinds of businesses choose sole proprietorship?

Sole proprietorships are the default structure for many independent business owners, including freelance creatives, home services providers, tradespeople, and tutors or teachers. It's the ideal structure for running things your way without the interference of shareholders.

How to register as a sole proprietor

Remember learning that a sole proprietorship is the easiest to establish? It's so easy, you don't have to fill out any special paperwork or sign any forms. Instead, you're automatically a sole proprietor by doing business and collecting income. 

That said, you may have to file for a business license. Check with your state and local governments for requirements.

Introducing LLCs

LLC is one of those acronyms that seem to lend an air of legitimacy to anything it's attached to. An LLC is a business structure that bridges the gap between a partnership and a corporation. While it may not be incorporated like a legal entity, it offers significant advantages in terms of legal protection compared to a sole proprietorship.

What is an LLC?

An LLC is an unincorporated business with one or more owners, who the law calls "members." In most cases, an LLC member can be any entity, including a person, corporation, or other type of business.

An LLC allows for multiple owners to share the responsibility. However, you'll face more regulations and documentation requirements than with a sole proprietorship.

The pros and cons of becoming an LLC

In many ways, a sole proprietorship offers the best of both worlds—but even convenience comes at a cost. Weigh these important positives and negatives before deciding to start an LLC.

Pros:

• Tax flexibility: As an LLC, you can choose how the IRS taxes you. Don’t get too excited; you still have to pay taxes, but you get to decide whether you or the company pay taxes on your profits. If you choose to be what tax pros call a “pass-through entity,” the business income becomes your income. You pay taxes on them, just like you would as a sole proprietor. 
  Your other option is to choose a corporate tax structure. In that case, you claim your share of profits and losses, and then the business pays taxes on the rest. Some LLCs choose this structure to keep more revenue in the company without owing the higher personal tax rate.

• Enhanced protection: An LLC's "limited liability" aspect safeguards members' personal assets. Creditors and courts can't go after those assets to cover company debts. For example, suppose you put $50,000 of your savings into your LLC. If someone sues the company for $1 million, the court can only go after whatever is left of your original investment. It can't take the $100,000 you've saved for your kid's college education. If you had a sole partnership, the situation could look quite different.

Cons: 

• Higher taxes and fees: Old mafia movies show us that protection comes at a cost. Unfortunately, that's true in real life too, and LLCs are no exception. Even if you choose the partnership tax setup, you and any other active members of an LLC must pay self-employment tax. That tax includes Social Security and Medicare contributions, which a traditional employee and their employer would share responsibility for. As of 2023, the self-employment tax is 15.3% of your earnings. It’s certainly preferable to a shake-down by the mob, but you still might not choose it if you’re just setting out.

• More "red tape": Unlike a sole proprietorship, which starts as soon as you get your first customer, an LLC requires you to file articles of organization. Your articles of organization tell the state everything it needs to know about your business, what it does, and who's involved. You'll also need to file annual reports detailing your business activity.

Types of businesses that choose LLC structures

LLCs are popular among multi-owner and higher-risk businesses. For example, certified public accountants (CPAs), financial advisory offices, and contractors may decide LLC offers better protection than a sole proprietorship.

How to register as an LLC

To become an LLC, you'll need to complete the following steps:

• Choose and register your business name.

• Select a registered agent who will receive your business's government and financial documents.

• File articles of organization, which tell the state everything it needs to know about your business, what it does, and who's involved.

• Draft an operating agreement to document how your business will make decisions.

• Get an Employer Identification Number

• Apply for any federal, state, or local licenses you need based on your industry.

Mistakes can be costly in business. Hiring a lawyer if you choose to apply as an LLC will help ensure your paperwork is spotless.

How to determine which structure is right for you

A sole proprietorship might be right for you if you enjoy running your business solo and intend to do so for the foreseeable future. You can typically incorporate it later if you choose. Because it offers this flexibility, sole proprietorship is a popular way to test new business ideas.

However, a sole proprietorship is often better for lower-risk businesses because liability issues are involved. For example, if you work in an industry such as healthcare or professional services, which are more prone to lawsuits, you may choose an LLC to protect your assets.

Finally, consider whether you'll want to look for investors soon. If you incorporate as an LLC, you'll have the option to sell shares in your company and potentially grow faster.

Sole Proprietorship vs. LLC: Common Questions

Should my business be an S corp or a C corp instead?

If you want your organization to be its own legal entity, you'll need to become a corporation. A corporation is an organization that operates separately from its owners.

C and S corps are the two primary types of for-profit corporations. A C corp pays corporate taxes as an independent entity, while an S corporation passes profits and losses to shareholders. 

S corporations and LLCs with corporation tax structures have much in common, but the structure and legal requirements differ.

How do I switch between a sole proprietorship and an LLC?

If you start as a sole proprietorship, you can become an LLC by completing the required LLC organization paperwork. 

Converting an LLC to a sole proprietorship is more complicated. First, expect to dissolve the LLC and distribute the assets among your members. Once you've dissolved the organization, you can start doing business as a sole proprietor.

What are the tax benefits of each business structure?

Both sole proprietorships and LLCs offer the option to bypass corporate taxes. This choice will save you money as your business grows, but you may pay more taxes on your profits. Choosing C-corporation taxation as an LLC lets you pay corporate taxes on that revenue.

Sole proprietors and LLC members pay self-employment taxes, except LLCs that choose to pay taxes as a corporation. In that case, the LLC pays the member's portion of Social Security and Medicare taxes.

Be ready: Get your finances organized

Wherever you land in the sole proprietorship vs. LLC debate, one thing's for sure—you'll need your finances in order. Found offers all-in-one business banking for self-employed individuals and small businesses, so you always know where you stand. Your account is created in your name using your Social Security number, so your choice of business structure won't affect your application.

Found is all-in-one banking built for your business. We believe in doing what you love—which probably isn't paperwork. Found’s auto-save tax feature lets you set money aside whenever you earn. It’s as easy as your old familiar W-2, but you’re in control. Plus, Found updates your tax estimate as your income changes, so you’ll know what to expect when you file. No more tax season surprises.

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The information on this website is not intended to provide, and should not be relied on, for tax advice.