Turn your sole proprietorship into an LLC to protect your assets and limit your liability
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If you’re thinking about starting your own business, you’ve likely figured out the products or services you plan to offer. Now you have another critical decision to make: What kind of business entity will it be?
In this article, we’ll compare two of the most popular business entities, sole proprietorships and limited liability companies (LLCs). If you’re ready to form your own LLC, our business formation service can help you.
A sole proprietorship means less paperwork and more simplicity, but an LLC provides liability protection, more legitimacy, and more tax options. Compare the two business entities below.
One or more people can own an LLC, and it’s a separate legal entity from the owners. LLC owners, who are called “members,” are usually not personally liable for the business’s debts. If the LLC is sued or goes into debt, the creditors can’t go after the members’ personal savings or belongings in most cases.
An LLC has more options in how it’s taxed and run. By default, it’s taxed like a sole proprietorship. That means only the owners pay federal income taxes on the profits from the business. The business itself isn’t taxed on them. It has more paperwork and formality than a sole proprietorship, but less than a corporation.
A sole proprietorship is basically the default type of business. It’s a business run by a single individual and hasn’t applied with the government to be another type of entity, such as an LLC or corporation. It’s the simplest form of business to set up because there’s no form to complete to become a sole proprietor. In fact, if you’re selling something right now, you could be a sole proprietor without knowing it.
From a legal and tax standpoint, the sole proprietorship and the owner are the same. If someone sues the sole proprietorship, they can go after the owner’s personal assets. When the business makes a profit or a loss, it’s reported on the owner’s personal tax return without there being a separate business tax return. Whatever debt or liability the business has is the same as the owner’s.
The main difference between an LLC and a sole proprietorship is that an LLC is a separate legal entity from its owner(s). That means the liabilities and debts of the business are usually separate from those of the owners. If the business has to file for bankruptcy, that doesn’t mean the individual LLC members do. If someone sues the business, they’re usually limited to going after the business’s assets rather than the members’ personal assets (such as savings, house, car, etc.)
Note that there’s no absolute protection for the owners of any business. LLC members can still be held accountable for things like fraud, negligence, personally guaranteed debts, and intentionally causing harm to the business or someone else.
As with sole proprietorships, LLC profits are, by default, only taxed at the individual owner’s level and not at the business level. This is called “pass-through” taxation. But LLCs also have the option of being taxed as a C corporation or an S corporation.
We’ll get into this more in the tax section, but, for some LLCs, being taxed as a corporation could save them more money.
A sole proprietorship, as the name suggests, can be owned by only one person. An LLC, like a partnership or corporation, can have many members/owners. Plus, if you’re the sole member of the LLC and want to add another member later, you can do so without changing the business entity.
Having “LLC” or a similar designator at the end of your business name can make your business appear more legit to your customers, banks, and others you want to do business with.
Also, when you form your LLC, you’ll be able to give it an official business name that’s registered with the state. As a sole proprietor, you’re legally restricted to using your own personal name unless you get a “doing business as” (DBA) name.
While LLCs were created partially to cut down on the red tape faced by corporations, the process of forming an LLC is still more involved than the process of forming a sole proprietorship (which is basically none).
Although the LLC formation process varies from state to state, you usually have to find a business name that’s available, appoint a registered agent, file Articles of Organization, and get an employer ID number (EIN) from the IRS. Writing an operating agreement is also a very good idea, even if most states don’t legally require it.
Every state requires you to pay a fee for forming an LLC, usually to the Secretary of State office. They range from about $50 to $500, depending on the state. Further, LLCs generally have more ongoing compliance requirements than sole proprietorships, though not as many as corporations.
For example, almost every state requires LLCs to file an annual or biennial report, along with a fee. A few states have other requirements for LLCs, such as publishing notices in local newspapers or filing initial reports (in addition to the normal Articles of Organization). If you want to dissolve the LLC, most states also require you to complete some paperwork and pay a fee.
If you have multiple members in your LLC, you’ll obviously have more challenges than you would if you were the sole owner. A lot of these can be handled with a well-written operating agreement, but it’s still not as easy as making all the decisions yourself with a sole proprietorship or single-member LLC.
If you have a multi-member LLC, the business will have to file an informational return called a Form 1065, U.S. Return of Partnership Income. This is for the IRS’s information and not an additional tax to pay. On Form 1065, you report the business’s income, gains, losses, deductions, and credits. Along with this form, you would also include a Schedule K-1 for each LLC member that shows their share of the business income and losses.
In addition to those informational reports, individual LLC members still report income from the business on their personal returns.
Although LLCs are usually pass-through tax entities on the federal level, several states have additional taxes for LLCs on the state level.
Some states charge LLCs a gross receipts tax, and several others charge an annual fee called a franchise tax. Sole proprietorships are usually exempt from these kinds of state taxes because they’re not formally registered with the state. For example, California has an $800 annual franchise tax for all LLCs, a hefty fee that a sole proprietorship wouldn’t have to pay.
As we said, there’s no formal process with the state to start a sole proprietorship. Still, if you want the business to go by a name other than your own personal legal name, you’ll need to apply for a DBA name. Note that different states use different names for this, such as “trade name” or “fictitious name.”
To operate legally, you’ll also need any required business licenses and/or permits. This is true regardless of the business entity type you have. Some states and localities require a general business license to operate any kind of business. You also need to think about professional licenses, signage permits, zoning, and a host of other possibilities. If you have employees, you’ll also need an employer ID number (EIN).
If you want to end your sole proprietorship, it’s as easy as starting it. You don’t need to file anything with the state, other than to cancel your DBA and other licenses/permits you may be using.
Unlike a multi-member LLC, you get to call all the shots for the business. You don’t need to consult anyone else. Of course, this is also true of a single-member LLC.
Unlike a multi-member LLC or partnership, you only have to deal with your own personal tax form. Just list the business’s revenue and expenses on Schedule C.
Because your business isn’t registered with the state, you don’t pay a filing fee to start it or renew it on a regular basis. Any fees paid to the state will likely be limited to DBA fees and licenses and permits and their renewals.
Again, because a sole proprietorship isn’t registered with the state, you’ll have less government paperwork to keep up with.
Legally, you and your sole proprietorship are considered the same entity. Someone who sues your business is also suing you. That means everything you own — your bank account, your home, your car, your priceless paintings of dogs playing poker, and all your other personal assets — are all up for grabs. If the business goes into debt, you are personally responsible for that debt.
You’ll find that clients, lenders, and others you deal with likely won’t take you as seriously without an “Inc.” or “LLC” after your business name. And, unless you get a DBA, you’re legally obligated to only represent yourself by your personal legal name. Many customers feel better about making a check out to “Smith Consulting, LLC” than just “John Smith.”
Investors are generally less likely to invest in a sole proprietorship over a more formal business entity like an LLC or corporation. Banks and other lenders are more likely to consider a loan to a sole proprietorship as a personal loan, which means the amount of the loan will likely be less.
The difference between forming a sole proprietorship and an LLC is pretty significant. A sole proprietorship doesn’t really have a formal formation process other than getting a DBA (if you want one) and getting licenses and permits (if your business needs them).
Forming an LLC typically requires five basic steps. To very briefly summarize, you’ll need to find a business name that’s unique in your state and follows your state’s naming laws, appoint a registered agent, file Articles of Organization with the Secretary of State office, create an operating agreement (not always legally required, but always a good idea), and get an EIN. We can help you create an LLC in just minutes using our LLC formation service.
How you manage your business is pretty straightforward if you’re a sole proprietorship or a single-member LLC. You’re the sole owner, so you get to make all the business decisions. If you have a staff, you also get to decide how to manage them, the policies to put in place, etc., so long as you stay within federal and state labor laws.
If you have an LLC with more than one member, though, things aren’t as clearcut. You’ll need to negotiate with the other members and decide who will manage the daily operations, who will make the decisions for the business, and put a plan in place for any future scenarios, such as a member leaving or inviting a new member to join.
The best way to handle this is with an operating agreement. With an operating agreement, you and the other members decide on all these issues and put them into a legally binding document. That eliminates any ambiguity later if any disputes come up.
While most states don’t legally require you to have an operating agreement or file one with the state, it’s still a legally binding agreement once it’s signed. A lawyer can help you draw one up, or you can do it yourself. If you’re not sure how to begin drafting such a document, we have an operating agreement template that can help you get started.
The difference in taxes between an LLC and a sole proprietorship will depend on where you live, how many members are in your LLC, and how you want your LLC to be taxed.
By default, LLCs have pass-through taxation like sole proprietorships. That means that the IRS only taxes the profits when they’re distributed to the individual business owner(s) without first taxing them at the business level. As we mentioned earlier, an LLC with multiple members will have to file a couple of extra informational forms, Form 1065 and a Schedule K-1 for each member.
While the federal taxes paid should be the same for a sole proprietorship and an LLC being taxed as a pass-through entity, some states have additional taxes for LLCs. As we mentioned in the LLC section, some states levy a gross receipts tax or a franchise tax that applies to LLCs but usually not to sole proprietorships.
An LLC does have the potential to save its owners more in self-employment taxes than a sole proprietorship. We’ll explain.
As an LLC, you have the option to be taxed as a pass-through entity, a C corporation, or an S corporation. Sole proprietorships don’t have these choices. Larger LLCs can sometimes benefit from C corporation taxation (despite the double taxation), but more LLCs are interested in S corporation status.
Sole proprietors and members of a traditional LLC are considered self-employed, meaning that they pay self-employment taxes on all the profits they receive from the business. This is about 15.3%, which is more than the taxes they’d pay when working for someone else because their employer would pay part of them.
By electing S corp status, though, LLC members can become employees of the LLC and receive a salary. Once they do that, they only pay self-employment taxes on that salary and not the remaining profits. This can add up to thousands of dollars.
However, the IRS does expect S corporation owners to pay themselves at least a “reasonable” salary (as in, something on par with what others in their field are making) so that they’ll still pay something in self-employment taxes and contribute to Social Security and Medicare. But the portion of the profits they don’t use for their salary won’t be subject to self-employment taxes.
That will depend on many factors, such as the amount of personal liability you’re willing to take on, how you want to be taxed, and how much you can handle in terms of paperwork and fees.
A single-member LLC is one that has only one owner (member). An LLC, regardless of the number of members, provides liability protection that a sole proprietorship does not. But (as mentioned above) you’ll need to weigh many factors in deciding which would be best for you and your business.
According to the IRS, a sole proprietorship without employees that doesn’t file any excise or pension plan tax returns doesn’t need an EIN, although it can get one if the owner chooses. An LLC with more than one owner needs an EIN, as does an LLC with employees.
A single-member LLC being taxed as a “disregarded entity” (like a sole proprietorship) without employees that doesn’t have an excise tax liability can usually get by without an EIN. In that case, the LLC owner would use their Social Security number. However, it may be best to get an EIN, anyway, as using your Social Security number too frequently can expose you to identity theft. Plus, some banks require an EIN for opening a business bank account.
A sole proprietorship doesn’t have a formal formation process other than getting a DBA (if you want one), business licenses (if needed), or permits (if your business needs them).
An LLC is a separate legal entity from its owner(s). That means the liabilities and debts of the business are usually separate from those of the business owner, which will protect your personal assets if the business experiences any litigation.
Some of the benefits of an LLC include personal liability protection and tax flexibility. Entities are easy to set up, if you use a formation service provided by a company like ZenBusiness. Forming your business as an LLC can also provide added credibility.
Legally, you and your sole proprietorship are considered the same entity. Someone who sues your business is also suing you. That means everything you own – your bank account, home, car, etc. – can be impacted by litigation.
A sole proprietorship’s net business income is taxed at the business owner’s individual income tax rate. For tax purposes, a single-member LLC is a “disregarded entity” and is taxed at the same rate as a sole proprietorship.
We help budding entrepreneurs who want to form an LLC by taking care of the state filling process and walking them through the red tape. If you want to form your LLC as an S corporation, we can handle that for you, too, with our S corporation service. Once your business is established, we can help you stay in the state’s good graces with our Worry-Free Compliance service.
If you’d rather go the sole proprietorship route, we may be able to help you secure a DBA, depending on your state. Take a look at our other services to see how else we can help you launch your dream business today.
You choose the filing option and add-on services that fit your needs like expedited filing speed, Employer Identification Number (EIN), Registered Agent, and Worry-Free compliance.
Our team collects and files all the necessary paperwork with the State to form your business based on the plan and time-frame you select at checkout.
This process can take a few days or a few weeks depending on the filing speed you select and the State’s internal processes and formation backlog.
The documents include your business formation certificate and employer identification number (EIN) assuming you purchased that additional service.
Our registered agent and worry-free compliance services ensure your company is always in good standing with the state.
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Disclaimer: The content on this page is for informational purposes only, and does not constitute legal, tax, or accounting advice. If you have specific questions about any of these topics, seek the counsel of a licensed professional.