One of the most important decisions you’ll have to make when starting a new business is whether a limited liability company (LLC) or sole proprietorship is a better fit for your company. According to U.S. Census data, there are over 23 million sole proprietorships and around the same number of LLCs in operation. Both come equipped with a unique set of advantages and disadvantages. Therefore, your choice will depend on the goals you have set for your business.
In this guide, you’ll learn everything you need to know about the two different business structures.
What is a Sole Proprietorship
A sole proprietorship is an unincorporated business that is run by a single owner. If you start conducting business, but decide not to form an official business entity (like an LLC or corporation), your business will be considered a sole proprietorship by default.
Sole proprietorships are popular amongst business owners because of their simplicity. However, because there is no protective barrier between you and your business, your personal assets and business assets are at risk of being commingled. This means you can be held personally liable for any debts and obligations belonging to your business.
Running your business as a sole proprietorship can be a risky strategy, but it does come with a couple of advantages.
Advantages of a Sole Proprietorship
One of the biggest benefits of a sole proprietorship is how easy it is to initiate and maintain. When you begin conducting business, your company will automatically be considered a sole proprietorship. If you are a freelance writer, for example, you are a sole proprietor. You don’t have to file any paperwork in order to get started, which also means you won’t have to pay any extra fees.
A sole proprietorship offers a few other notable advantages. These include:
- No formal requirements to register with a state
- Giving the owner (you) complete control of the business, as well as 100% of the profits – though this also holds you accountable for 100% of the losses
- The dissolution process is simple – aside from alerting your customers of the impending closure (which is not a requirement, but is something you should do regardless), you must cancel any licenses, registrations, and bank accounts you may have associated with the business
Though these benefits may sound desirable, it’s important to note that this business structure has one major downside (and you may discover that it’s a dealbreaker for you).
Disadvantages of a Sole Proprietorship
The biggest disadvantage of a sole proprietorship (and the #1 reason most business owners choose the LLC route instead) is that you will be personally liable for any debts or obligations of your business.
What does that mean? Well, in the event that your business is sued or defaults on a debt, creditors and lawsuit claimants can seize personal property and funds from your personal accounts. Think about that brand new sports car you spent years saving up for, or your dream home that you’ve devoted endless time and effort into renovating. These things can be taken from you in an instant if your business falls victim to a lawsuit or cannot pay its bills.
Other cons of a sole proprietorship include:
- Less privacy and credibility – unless you register your business as a DBA (doing business as) name, you will need to list your personal name on business documents and communications
- No tax benefits – you’ll have to pay the full amount of taxes on all of your business profits
- Minimal growth potential – in order to maintain a successful sole proprietorship, you’ll have to continue to run a low-risk business (which tends to correlate with low profits)
Despite its downsides, there are a few situations in which a sole proprietorship may prove to be beneficial.
When to Use a Sole Proprietorship
Operating as a sole proprietorship means you assume all of your business’s risks and debts, which can be scary. However, if you're someone who is new to entrepreneurship, a sole proprietorship might be a good way to test the waters and get a feel for how successful your venture will be.
Types of businesses in which a sole proprietorship might work include:
- Businesses that are low-risk and low-profit – some examples include tutoring, freelancing, or reselling products such as antiques or apparel
- Businesses that have a small customer base – these include hobbies or passion projects like photography, blogging, or starting a podcast
While certain business types work well as a sole proprietorship, most of the time, it’s better to form a limited liability company (LLC) so that you do have that added layer of protection.
What is an LLC
A limited liability company, or LLC, is a legal entity formed at the state level that separates you, the owner, from your business. The main purpose of forming an LLC is to protect your personal assets, but there are other other reasons to incorporate as well.
In order to form an LLC, you must file paperwork in the state in which you will be conducting business. You will have to pay filing fees (these vary by state), but in general, LLCs are cost-effective and easy to maintain.
There’s a reason why LLCs are so popular – they come packaged with a long list of benefits, most of which can greatly benefit you as a business owner.
Advantages of an LLC
True to its name, a limited liability company can offer you added protection in the event of a lawsuit or debt. If you are running a high-risk business that carries significant liability (for example: anything pharmaceutical or health-related), you’ll want to invest the extra time and money into creating a more formal business structure, like an LLC.
In addition to the separation of business and personal assets, you can expect a few other perks with an LLC:
- More credibility – something as small as adding ‘LLC’ to your company name can give your business a sense of legitimacy and help improve customer trust
- It’s easier to obtain financing – instead of being forced to apply for personal loans, you’ll be able to secure small business loans, which can help your business grow faster in the long run and keep that protection of finances in play
Sold on starting an LLC? Not so fast. Before you make your final decision, let’s take a look at the cons of forming this type of entity.
Disadvantages of an LLC
Though an LLC can offer your remote business asset protection and unlimited growth potential, there are a few downsides you should be aware of.
- Annual state filings are required – you’ll need to file paperwork each year in order to maintain your good standing status (the requirements differ between each state) and renew any state and local licenses
- More expensive to form and maintain – while LLCs are inexpensive to form, they are still costlier than a sole proprietorship
Many business owners find that the pros outweigh the cons when it comes to forming an LLC, but that is a choice that only you can make.
When to Form an LLC
As you’ve learned, an LLC can benefit your organization in many ways, especially if you are running a remote business that is high-risk or profitable. But, what if you aren’t 100% sure that it’s a good fit?
Here are some questions to ask yourself if you’re considering forming an LLC:
- To what extent do you, the owner, want to be shielded from liability?
- Will you need financing?
- Do you wish to create a new credit record for your business?
Still not sure a limited liability company is the right choice? If your company falls into any of the following categories, an LLC is well-suited for you:
- You have a large customer base – you’ve grown your following over the years and you now have hundreds, or even thousands, of loyal customers who place orders from you on the regular
- You want to protect your personal assets from legal liability – your assets (including your home, car, etc.) are important to you, and you want to do everything you can to make sure they are safe and secure
- Your business is profitable or high-risk – if there’s a good chance you may face a lawsuit at some point in the future, forming an LLC is a smart choice
An LLC can also shield you from liability for any actions taken by your employee(s), so if you plan to expand your remote business in the future, this might be another good reason to incorporate.
Similarities Between a Sole Proprietorship and LLC
Though a sole proprietorship and LLC are two different business structures, they do have a few things in common. These include:
- You’ll need to obtain an Employee Identification Number (EIN) – regardless of which entity you choose for your business, you’ll need an EIN to open a business bank account
- You’ll need to apply for any necessary licenses and permits – these will vary from state-to-state, so it’s best to check the rules for federal, state, and local permits and licenses
- They are both pass-through entities – this means that your business itself won’t have to pay income taxes
FAQs About Sole Proprietorships and LLCs
Below, you’ll find a few of the most frequently asked questions relating to sole proprietorships and LLCs.
Do You Need to Register With the State as a Sole Proprietor?
No, you do not need to register with the state you are doing business in. You will, however, need to register any necessary licenses and permits (these will be dependent on your location and industry).
When is a Sole Proprietorship Sufficient?
A sole proprietorship is often a good choice when your new company is just starting out. Businesses can, and often do, fail, so sometimes it’s better to test the waters before diving in.
What is the Best State to Form an LLC in?
This will depend on your business’s needs. With that being said, there are several states in which LLC formation is more popular than others (due to the benefits they offer small business owners). These include Wyoming, Delaware, and Nevada. These benefits are often for domestic LLCs, but depending on your industry you might seek professional advice on the best state.
How Do You Change Your Business Structure to a Single-Member LLC?
It depends. If you are currently operating as a sole proprietorship, meaning you haven’t registered with a state, you can go through the registration process for an LLC. In order to register your LLC, you will need to file your Articles of Organization with the state in which you want to do business and acquire a registered agent. Note all states have different requirements to form your LLC so be sure to check the Secretary of State website.
Sole Proprietorship vs. LLC: Which Should You Choose?
When it comes to the age-old question of which business structure is better, an LLC or a sole proprietorship, there is no right answer. While an LLC can protect your assets and make securing financing easier, you may be at a stage in your entrepreneurial journey where this is not a priority to you.
Lower risk businesses tend to function well as sole proprietorships. However, if you’re operating a company in a high-risk industry, have a large customer base, or are profitable, an LLC is probably a better option for you. Remember: you can convert your sole proprietorship to an LLC at any time.