When creating a legal business entity for your small business, you have several options. Two of the best for very small companies are sole proprietorships and LLCs.
In this article, we’ll look at the two company types and compare and contrast the pros and cons of each. We’ll help you decide which distinction is better for your company based on the size of your small business and what’s important to you. We’ll also provide guidance for freelancers thinking of forming a single-person business.
What Is a Sole Proprietor?
A sole proprietor is someone who works for themselves and wants to set up an official business entity. Forming a sole proprietorship is, in most states, the cheapest and easiest way to create a legal identity for a business.
To form a sole proprietorship, you need to choose a business name and then register that name with your state. Fees are as little as $5, though you will need to notarize the registration in many states.
Sole proprietors aren’t required to keep their business pay or expenses separate from their personal accounts. When they file taxes at the end of the year, they record business losses or profits with their personal tax returns. They also usually pay self-employment taxes but can file all that together with their personal tax returns.
Sole proprietorships file taxes quarterly. When you file taxes as a sole proprietorship, you use Schedule C.
What Is an LLC?
An LLC is a limited liability company — a legal entity whose owner is not personally liable for any debts or legal filings against the company. An LLC can just be one person, though it is different from a sole proprietor in that business income is kept separately from personal income.
Creating an LLC is usually a quick, easy, and relatively inexpensive process. Fill out an application, pick a business name, pay a filing fee, and you’ve done it. Fees vary by state: Some states charge as little as $40, and some charge as much as $500.
The Sole Proprietor vs. LLC Debate
Choosing between operating as an LLC or a sole proprietor is more than choosing a legal identity for the IRS. It’s about defining your business so it has the best chances of success.
Pros and Cons of a Sole Proprietorship
The pros of forming a sole proprietorship are numerous. The greatest one is how easy it is to form. There are no government procedures, and legal filings aren’t extensive.
If you want to operate the business under a different name than your legal name, you are required to file a “Doing Business As” (DBA) name with your state. A DBA can protect your personal assets during legal issues. This process can be done for as little as $5 plus a notary fee.
Taxes are also easy with a sole proprietorship. These businesses are granted “pass-through taxation,” so you can report your business income on your individual, federal tax return. No fancy forms are required.
Sole proprietorships do not require you to file annual reports or pay annual state fees, which simplifies record-keeping. (There is one major exception in California, which requires sole proprietors to pay a state franchise tax, which is a minimum of $800 per year for your business.)
The biggest con of a sole proprietorship is personal liability. With a business type like this, you and your business are viewed as a single legal identity. By that measure, your personal assets and your business assets are legally viewed as one and the same.
This opens up risk. If your sole proprietorship were to rack up major business debts or be sued, creditors could come after your personal assets, even if your business name (DBA) is different than your real name. (A DBA doesn’t offer you the legal shield that an LLC does.)
This exposed risk could also make it more difficult to secure funding — a bank may be reluctant to offer a business loan or a line of credit if they feel you are taking on an unacceptable level of risk — that could be the result of several things, but lack of legal protection could be one of those reasons. Also, sole proprietorships are harder to grow, as taking on partners or employees will cease the designation and force you to form a new business entity.
Pros and Cons of an LLC
The biggest benefit of an LLC is personal liability protection. LLC members separate their debts from personal assets. This means if a business runs up debt or is sued, creditors can’t come after personal assets.
With tax treatment, you have the option to form an LLC as an S-corporation, meaning you can access pass-through taxation. Even if you keep all bank accounts separate (as you should), you can keep the tax process simple, with business profits going to your individual income tax return.
LLC also gives you more flexibility in growing your business. You can bring in partners, hire employees, and take on equity investors without jeopardizing your business’ legal standing (like you would with a sole proprietorship).
The cons of an LLC mostly involve the process of forming and maintaining one. You’d most likely need some legal help to form an LLC, though there are plenty of helpful websites to guide you. Filing fees are more expensive, and you’ll need to fill out forms with your secretary of state. LLCs must also file annual reports and maintain accreditation through annual fees, though those reports and fees vary wildly by state.
Choosing What’s Right for Your Small Business
The choice between a sole proprietorship and LLC is a tough one for many small business owners. It really comes down to what is more important to you.
If you are the only employee in your small company and don’t foresee taking out any major lines of credit or racking up debt, a sole proprietorship may be all you need. It’s easy to form, can be done quickly, and allows you an easy way to get official recognition as a business. You can avoid annual reports, keep a simplified tax return, and avoid annual fees to the state.
An LLC is a smart choice for a small company with much anticipated growth. It’ll keep your business profits and debts separate from personal assets. (You can also form a partnership, another distinct legal identity for a business, which has different pros and cons from an LLC.) While the LLC formation process is a bit more onerous, online legal sites have made the process pain free, and LLCs in some states can be formed for as little as $40. Even if it’s several hundred dollars, that’s often a wise investment for the protection it offers.
The Right Choice for Freelancers
If you are a freelancer, you might be wondering about the right way to go. Should you work as yourself and pay a self-employment tax or register as a sole proprietorship? Maybe you should form a single-member LLC?
Again, the decision depends on your situation. Most freelancers will be content to not form any business type at all. They can work under their own name, file quarterly self-employment taxes, and not have to worry about forming a business. If you are doing contract work for clients, you’ll likely be fine with this simpler option.
If you decide to form a business, though, and start taking on bigger clients with broader scopes of work, it’s probably smart to create a business identity. If you can afford it, we recommend taking the time to form an LLC. Even if it begins as a single-member LLC, this will give you more protection, allow you to grow and expand your business, and sleep easy knowing your personal assets will be safe, no matter what happens in your business.
Sole Proprietor vs. LLC: Two Helpful Options for Your Business
If you decide your small business should have a distinct legal identity, both a sole proprietorship and an LLC are viable options. Both allow for easy tax filing and help you separate your business life from your personal life.
If your main goal is quickly forming a business, a sole proprietorship can allow you to do so simply by picking a name to do business under, and registering the DBA with your state. If you have grander ambitions for your business or want more protection, an LLC is probably the smarter way to go. You know your options and what you need to do: Now go start that business.