Sole Proprietorship or LLC: Which is Right for You?
Whether a sole proprietorship or an LLC is the right choice for your business depends on whether you need limited liability protection.
If a business carries any risk or debt, it must be structured as an LLC in order to protect the business owner's personal assets with limited liability protection.
Sole Proprietorship Pros and Cons:
The only advantage of a sole proprietorship is that they take zero effort to set up. This advantage is quickly outweighed by the lack of any other benefits.
- No Personal Liability Protection. Your personal assets (car, house, bank account) are at risk in the event your business is sued or if it defaults on a debt.
- No Tax Benefits. Sole proprietors pay taxes on their profits and also pay full FICA taxes (Medicaid and Social Security taxes). When your business becomes profitable, taxes will be expensive.
- Limited Growth Potential. When a business becomes more profitable, risk increases. When risk and profit increase, so does the need for a legal formal business structure.
- Less Credibility and Branding Opportunities. A sole proprietor must invoice, receive payment, open a bank account, and market with their surname unless their state allows them to register and maintain a doing business as (DBA) name.
When to Use a Sole Proprietorship
Sole proprietorships are best for small businesses with the following traits:
- Very low-profit and low-risk.
- They have a small, familiar customer base — think family, friends, and neighbors.
- They are hobbies like photography, blogging, or video streaming.
LLC Pros and Cons:
Because the cost of forming an LLC is a small disadvantage compared to a sole proprietorship, and the advantage of personal liability protection is so great, we recommend that most small business owners form an LLC when starting their business. The only small businesses that shouldn't form an LLC are ones that need to attract investors-- these small businesses should form a corporation.
- Personal Liability Protection. LLCs provide personal liability protection. This means your personal assets (car, house, bank account) are protected in the event your business is sued or if it defaults on a debt.
- Tax Benefits. LLCs have options to customize their tax structure. This allows businesses to use the best tax strategy for their circumstances.
- Growth Potential. LLCs can grow in profit and risk because they provide personal liability protection and tax benefits.
- Credibility and Consumer Trust. LLCs generally earn more trust from both banks and consumers than do informal business structures like sole proprietorships. This can impact a business's ability to take out loans and can affect marketability.
When to Use an LLC
LLCs are recommended for businesses with the following traits:
- Customers that aren't family and friends
- It's a business that's meant to earn money
- It's a real business that you want to grow
Recommended: Northwest will form your LLC for $39 (plus state fees).
What Is a Sole Proprietorship?
A sole proprietorship is the most common business structure and the simplest to form. Sole proprietorships are unincorporated businesses. Legally speaking, in a sole proprietorship, there is no distinction between you and your company.
You become a sole proprietor simply by conducting business. If you’d like to operate a sole proprietorship using any name other than your given name, you’ll need to register for a "doing business as" (DBA) name. This will allow you to use an assumed name to enhance the credibility of your business and provide some privacy.
Sole Proprietorship Taxes
Tax season is simple with a sole proprietorship— just like an LLC. Sole proprietorships only have one tax option though, which can limit the ways a business owner can save on taxes.
What Is an LLC?
Another option for a one-person business is the single-member limited liability company (SMLLC). The main benefit of an LLC is personal asset protection, which means that creditors and courts can't pursue your personal money or possessions in a potential lawsuit or bankruptcy. This is possible because, unlike a sole proprietorship, an LLC is viewed as a separate entity from its owner.
Starting an LLC does require business owners to file articles of organization with their state to officially form their business.
For tax purposes, a single-member LLC is essentially the same as a sole proprietorship.
LLCs can also elect to be taxed as S corps or C corps, which can potentially save business owners thousands in taxes owed.
Ready to Start an LLC? Check out our Best LLC Services review.
How to Start an LLC
Step 1) Name Your LLC
First things first— you'll need the right business name in order to register your LLC with the state. Naming your new business goes well beyond creative branding.
In order to form an LLC successfully, you have to be sure no one else in your state is using your name and that it meets state guidelines.
If you need help coming up with a catchy name, try our business name generator. You can use this tool to generate both business names and domain names.
Step 2) Choose a Registered Agent
When you fill out your LLC registration forms, you will also need to list your registered agent in most states. A registered agent is sometimes called a resident agent, statutory agent, or agent for service of process.
A registered agent will be responsible for receiving important legal documents on behalf of your LLC. A registered agent’s most important job is to accept service of process (legal summons) in the event of a lawsuit.
Many entrepreneurs choose to hire a registered agent service to help with this part of their business. You can also appoint a friend, colleague, or yourself. In most states, your registered agent must meet these requirements:
- is 18 years or older
- has a physical address in the state where business is conducted
- is available (in person) during normal business hours
To learn more, read our What Is a Registered Agent article.
Step 3) File Your LLC With the State
This is the step we’ve all been waiting for— it’s time to officially form a limited liability company. You can do this on your own, with the help of a lawyer, or through a professional LLC filing service.
Most states offer online filing and fees for registering your LLC will vary from state to state.
To learn exactly how to complete this step for your LLC, just select your state.
Step 4) Create an LLC Operating Agreement
Creating an LLC operating agreement is the only way for you and your members to legally define your roles and lock down your LLC’s management and ownership structure. Having this document in place will also give you something to return to if there’s a dispute.
An operating agreement isn’t filed with the state— it’s stored in your company records. The operating agreement should outline:
- each member’s responsibilities.
- how new members will be admitted.
- how existing members may transfer or terminate their membership.
- how profits and dividends are to be distributed.
To learn more, read our What Is an Operating Agreement for an LLC guide.
Step 5) Get an EIN
An Employer Identification Number (EIN), or Federal Tax Identification Number (FTIN), is basically a social security number for your company. Your EIN allows the Internal Revenue Service (IRS) to keep track of your business’s tax reporting.
To learn more, read our What Is an EIN guide to learn more.
LLC or Sole Proprietor: Summary
In general, if your company engages in activities that generate any risk— an LLC may be the best choice for you.
While it can be a little more labor-intensive and costly to set up and maintain, the personal asset protection alone is often well worth the costs incurred. On the other hand, if your business is more of a hobby, a sole proprietorship can be an excellent way of doing business without taking on any extra regulatory or financial burden.
Need Help Forming an LLC? Check out our Best LLC Formation Services 2022 review to learn about the cost of using a professional service to form your LLC.