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, there is no distinction between you and your company. You become a sole proprietor by simply conducting business.
If you’d like to operate a sole proprietorship using any name other than your given name, you’ll need to get 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 protections.
Tax season is also simple with a sole proprietorship. Because the business is not separate from you as a person, any business income or losses are claimed on your personal tax return. There’s no need to file a separate business return.
What Is a Single-Member LLC?
Another option for a one-person business is the single-member limited liability company (SMLLC). The main advantage of the LLC is personal asset protection, which means that creditors can't pursue your personal money or possessions in a potential lawsuit. This is possible because, unlike a sole proprietorship, the government views an LLC 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. Although, as a rule, your personal and business assets are kept separate, the IRS allows LLC owners to report business profits and losses on their personal tax return.
Which Structure Is Best for You?
Whether a sole proprietorship or an LLC is the right choice for your business depends on whether your business will earn a profit or carry any risk.
Only very low profit/low risk businesses should be sole proprietorships.
Sole Proprietorship Advantages and Disadvantages:
The only advantage of a sole proprietorship is that they are easy to form and maintain. As mentioned earlier, unlike an LLC, which requires business owners to form their company with the state and conform with state regulations and guidelines, there is essentially no setup or maintenance work required to form or maintain a sole proprietorship.
- 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.
LLC Advantages and Disadvantages:
Because the cost of forming an LLC is a minimal disadvantage compared to a sole proprietorship, and the advantage of personal liability protection is great, we recommend that most small business owners form an LLC when starting their business.
- 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 and 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 a Sole Proprietorship
Sole proprietorships offer advantages under some circumstances.
Sole proprietorships are best for small businesses with the following traits:
- They MUST be low-profit and low-risk.
- They have a smaller customer base — think family, friends, and neighbors.
- They might start as hobbies like photography, blogging, or video streaming.
When to Use an LLC
LLCs offer taxation benefits, increased credibility, and, most importantly, personal liability protection.
LLCs are recommended for businesses with the following traits:
- Larger customer base
- Potential for immediate, sustainable profit
- Increased risk of liability and/or loss
- Could benefit from unique tax options
Our free guide will walk you through the process of LLC formation. In just five easy steps, you can be on your way to owning an LLC.
Interested in hiring a professional LLC formation company to form your LLC? Check out our review of the best LLC services.
How to Start an LLC
Step 1) Name Your LLC
First things first— you need the right business name in order to register your LLC with the state. Naming your new business goes well beyond creative branding. You could have the most catchy name in Connecticut but if it isn’t unique and legal, you can’t use it.
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 LLC Operating Agreement 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.
In general, if your company engages in activities that generate any financial risk — especially those that can’t be mitigated by insurance coverage — an LLC may be the best choice for you.
While it can be 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 fairly simple and risk-free, a sole proprietorship can be an excellent way of doing business without taking on any extra regulatory or financial burdens.
Protect Your Personal Assets
Use our free step-by-step guide to form an LLC today