A single-member limited liability company (LLC) and a sole proprietorship are two of the most commonly created types of small businesses:
- A single-member LLC is a disregarded entity that is organized under state law by filing Articles of Organization with only one owner. LLCs protect owners from personal liability for the debts and obligations of the business.
- A sole proprietorship is a business structure in which a single individual owns and operates the business. The owner has complete control and decision-making power over the business and is personally responsible for all debts, liabilities, and legal obligations. No formal creation process is required—start conducting business, and you have a sole proprietorship.
Knowing which type of business to start takes careful consideration as a business owner.
Advantages of a Single Member LLC vs a Sole Proprietorship | Advantages of a Sole Proprietorship vs a Single-member LLC |
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Tax Treatment of Single-member LLC vs Sole Proprietorship
By default, a single-member LLC, which is a disregarded entity, is taxed exactly the same as a sole proprietorship. Both owners of single-member LLCs and sole proprietorships report their business’s income and expenses on Schedule C of their personal income tax returns and don’t have to worry about preparing a separate business tax return.
The two structures also share these similarities:
- Net profits are subject to income tax in the year they are earned and cannot be deferred by retaining profits.
- Losses are shown on personal returns so they can offset income from other sources, such as Form W-2 wages, interest, dividends, and capital gains.
- Owners pay all income taxes.
While this is so, single-member LLCs can make an election to be treated as an S-corp instead of a sole proprietorship. Unfortunately, you don’t have this advantage if you run a sole proprietorship.
Below, we’ll consider the tax treatment of an LLC with an S-election versus a sole proprietorship and single-member LLC without an S-election.
Single-member LLC With an S-Election | Sole Proprietorship & Single-member LLC Without An S-Election |
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If you seek help on completing a form, see our guide on how to fill out Form 1120S or how to fill out Schedule C.
Liability Protection of Single-member LLC vs Sole Proprietorship
While the IRS may treat single-member LLCs and sole proprietorships the same, they have very different liability protections.
Owners of single-member LLCs enjoy limited liability protection. That means that the owner’s personal assets are separate from the debts and liabilities of the business. If the business incurs losses or faces a lawsuit, the owner is not personally liable for the financial obligations. Meanwhile, outside of business insurance, an owner of a sole proprietorship does not have any protection against the debts and legal obligations of the business.
Operations of Single-member LLC vs Sole Proprietorship
There are a few differences between operating a single-member LLC vs a sole proprietorship. With a sole proprietorship, there is no difference between you and your business, so you won’t need to file any formal legal documents, open a business checking account, or get a business credit card.
Meanwhile, with an LLC, while the laws vary by state, you’ll have to adhere to quite a few more guidelines. Most states require that you include LLC as part of your company’s name. This puts the public on notice that you have registered business and have liability protection.
Most businesses include LLC or limited liability company in their name. While this is so, some states may restrict the words you can use in your company name to avoid confusion and misleading the public.
You’ll also want to avoid commingling your business and personal finances in an LLC. That means you’ll have to open a business checking account and obtain a business credit card or line of credit if you need it. If you are found to have commingled funds and or assets, if you are ever brought into court, the court can pierce the limited liability veil and you can become personally liable for any debts and obligations of your business.
For tips, see our guide on how to separate business and personal finances. It includes why it’s crucial and when to do so. The following articles may also be of interest to you:
Why Form an LLC vs a Sole Proprietorship
Many microbusinesses start as sole proprietorships and then convert to LLCs as they grow. Here’s a list of scenarios for when to convert your sole proprietorship to an LLC:
- You hire employees or purchase equipment and need to shield yourself from liability
- You want to raise capital by admitting a new owner
- You want to be perceived as more professional by banks and other creditors
- You can justify paying yourself a salary that is less than the net income of the company
- You want to be able to transfer ownership of the company to your heirs
Of course, if you anticipate being in any of the scenarios above within the first year or two of your new business, it probably makes sense to form an LLC from the beginning.
How To Form a Single-member LLC vs Sole Proprietorship
Frequently Asked Questions (FAQs)
Yes. You’ll simply need to file the articles of organization, get an EIN, open a business checking account, and transfer your assets into the new LLC.
No. Any equity investment would automatically convert the sole proprietorship to a general partnership and expose the investor to unlimited liability as a general partner. They can’t loan a sole proprietorship money since the sole proprietorship is not a legal entity separate from its owner. However, an investor can loan the owner (such as the sole proprietor) money.
Usually, if you want to close down an LLC, you need to let your creditors, vendors, and customers know. Then, you’ll have to pay off any remaining bills and distribute whatever is left to the owners. Finally, you’ll file the articles of dissolution with your state. If your LLC is treated as a sole proprietorship or partnership, generally there is no tax gain or loss on the dissolution. However, if your LLC is treated as a C-corp or S-corp, there is a taxable gain or loss.
Bottom Line
While sole proprietorships and LLCs have some similarities, there are also some slight differences, so when you start a business, it’s essential to choose the most suitable entity for you. Many small business owners start as sole proprietors and then convert to LLCs as they grow.
