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 |
|---|---|
|
|
- Tax Treatment of Single-member LLC vs Sole Proprietorship
- Liability Protection of Single-member LLC vs Sole Proprietorship
- Operations of Single-member LLC vs Sole Proprietorship
- Why Form an LLC vs a Sole Proprietorship
- How To Form a Single-member LLC vs Sole Proprietorship
- Frequently Asked Questions (FAQs)
- Bottom Line
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 |
|---|---|
|
|
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.
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:
- How to open a sole proprietorship bank account
- Top sole proprietorship business credit cards
- Leading business checking accounts for LLCs
- Best LLC credit cards
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
Step 1) Choose a business name: Choose a name for your LLC and check if it’s available in your state. You can do this through the Secretary of State’s office.
Step 2) File articles of organization: This document contains basic information about your LLC, such as its name, address, and purpose. You will also need to pay a filing fee, which varies from state to state.
Step 3) Obtain an employer identification number (EIN): This is a unique identification number that will be used for tax purposes and banking. For guidance, see our article on how to get an EIN.
Step 4) Create an operating agreement: Depending on your state, you may also need to create an operating agreement. If you need help, we have a template in our guide on how to create an operating agreement.
Step 5) Obtain business insurance (optional): Although an LLC already offers some limited liability protection, you may also want to get LLC insurance to protect your business against any unexpected hazard, such as a slip and fall. If you need assistance finding insurance for your business, check out our list of the leading business insurance companies for LLCs.
Step 1) Choose a name for your business or use your name: You can use your personal name, or you can choose a business name. When you choose a business name, you may need to register it as a doing-business-as (DBA) name with your state or county government.
Step 2) Register with your state if required: Some states require sole proprietors to register before beginning operations.
Step 3) Obtain business insurance (optional): To shield yourself against any future liability or legal obligation, obtaining business insurance is advisable. If you need help finding insurance for your business, see our top-recommended small business insurance companies.
Frequently Asked Questions (FAQs)
Can a sole proprietorship be converted into an LLC?
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.
Can investors invest in a sole proprietorship?
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.
How do I dissolve an LLC?
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.
