Starting a business involves choosing a befitting business structure. Solo entrepreneurs generally have two options: single-member LLC vs sole proprietorship. According to the latest IRS tax stats, 28.4 million people filed returns as sole proprietors, while 2.8 million filed as single-member LLCs in 2020.
The business structure you choose has various implications — financial, legal, and operational. Unless you’re experienced in legal and tax matters, you may be confused about which one to choose.
To help you make an informed decision, we’ll explore the characteristics, pros and cons, similarities, and key differences between a single-member LLC and a sole proprietorship.
Single-Member LLC
A single-member LLC is a type of limited liability company that is registered with a state and owned by one person.
Usually, the IRS treats LLCs as partnerships, corporations, or disregarded entities, depending on the number of members and their decisions.
Since a single-member LLC has only one member, it’s categorized as a disregarded entity for income tax filing. By default, the IRS taxes a single-owner LLC in the same way as a sole proprietorship.
However, this can change if the owner files Form 8832 and chooses to be regarded as a corporation.
Setting up this type of business entity involves filing paperwork to the Secretary of State through a registered agent.
Although the process seems complex, some organizations, as GovDocFiling explained in its LegalZoom review, can walk you through the process.
Pros
- Your personal assets, such as your home and savings, are protected from business debts and legal liabilities.
- The entity appears to be more professional, credible, and stable in the eyes of vendors and lenders, gaining you access to small business loans.
- The taxes are flexible – you can choose to be taxed as a corporation or a sole proprietor.
- Your business name is automatically protected since you don’t necessarily have to file for a DBA.
- The operating agreement makes provision for succession, so the business doesn’t have to end if the owner resigns.
Cons
- The formation process involves a lot of paperwork.
- It involves some administrative tasks, such as annual reporting and record keeping, which may be burdensome.
- You must file a Statement of Information to keep the business active.
- Some states charge annual tax and an LLC fee depending on the business’s total income.
Sole Proprietorship
A sole proprietorship is an unincorporated or unregistered business operated by one person. It’s the simplest form of organizing a business as no legal steps are required.
Also, the business assets and liabilities aren’t separate from their owners. Hence, you’ll be responsible for business debts and legal liabilities.
When it comes to tax filing for sole proprietors, the process is straightforward, since your profits and income are grouped as the same.
You may also have to fill out Schedule C (profit or loss report) and Schedule SE (self-employment net earnings) along with your individual income tax return (Form 1040).
Pros
- Setting up requires minimal formalities.
- You have complete control over the business and can make decisions without elections.
- It’s easy to maintain as the legal costs are minimal and there’s no annual state requirement for business continuity.
- The tax filing process isn’t complex.
Cons
- Your personal assets are at risk if the business faces financial difficulties or legal issues.
- Raising funds may be difficult since you don’t have stocks or shares to sell.
- The business structure is generally perceived as unstable, impacting its ability to attract clients, secure contracts, or get a loan.
- Someone else can’t take over the business if the owner becomes incapacitated or dies.
Single-Member LLC vs. Sole Proprietorship: Similarities
A single-member LLC and a sole proprietorship both share certain similarities. We’ve discussed some of them below.
- Single Ownership: Both business entities are owned by an individual. There’s no partner or co-owner.
- Business Obligations: States and local governments require both businesses to obtain a license and permit to operate.
- Fictitious Name: You can operate a sole proprietorship using your own name or a DBA (doing business as). Also, an LLC can register a DBA while retaining its entity name.
- Business Expenses: When calculating taxable income, your business expenses are deducted from gross income (e.g. business income, wages, salary), not itemized deductions (e.g. medical expenses, mortgage interests).
- Employer Identification Number (EIN): Both business entities don’t need to obtain an EIN unless the owner is hiring an employee. Until then, you’ll use your social security number (SSN) as your taxpayer identification number.
Single-Member LLC vs. Sole Proprietorship: Differences
The key differences between single-member LLC vs sole proprietorship are as follows:
- Taxation: A single-member LLC can file to become a corporation, which changes the way it pays tax. On the other hand, a sole proprietor can’t automatically convert to another business structure.
- Liability Protection: Unlike a sole proprietorship, the state recognizes a single-member LLC as a separate legal entity from its owner. So, if the business fails to repay its debt or faces a lawsuit, the business owner won’t be liable. Even though it’s cheaper to start a sole proprietorship, you may lose everything you own if your business runs into debt.
- Regulations: A sole proprietor only requires licenses and permits to operate, but a single-member LLC requires more. This includes filing annual reports and paying several fees within a stipulated time frame. Failure to do so may result in a suspension of the LLC or heavy fines.
Factors to Consider When Choosing Between Single-Member LLC vs Sole Proprietorship
While both business structures have their benefits and drawbacks, choosing between single-member LLC vs sole proprietorship can be a daunting task. To ensure you make the right decision, we’ve outlined some factors to consider when choosing the most suitable business structure.
Protection from Liability
The most significant difference between both structures is the level of liability protection they offer. This implies that you should weigh the risks involved in your business or industry before forging ahead.
Assuming you plan to start a service-based business, such as a restaurant or retail store. A single-member LLC can protect your personal assets from product liability or customer injury claims. However, a freelance writer, whose business risk is relatively low, can choose sole proprietorship.
Start-Up and Operating Cost
Generally, a sole proprietorship requires minimal cost since there’s no formal registration. However, some states require you to have business permits, licenses, and a DBA. Also, if you plan to hire employees in the future, you’ll need to get an EIN.
On the other hand, forming a single-member LLC involves different costs for acquiring and operating the business. These include filing documents, paying a registration fee, continuous compliance, and annual fees. Hence the need to carefully consider your budget for establishing and maintaining the legal entity.
Business Credit and Credibility
The structure you choose impacts how potential investors, suppliers, and customers will perceive it. Some people may view a single-member LLC as more professional and established compared to a sole proprietorship. That’s because the latter is associated with small, informal businesses.
Let’s say you’re starting a construction or professional service firm (accounting, medical, or legal); an LLC may provide a more professional image for attracting clients and investors.
Business Growth and Exit Strategy
A sole proprietorship lacks the ability to expand and bring in partners. However, a single-member LLC can add more members and become a multi-member LLC or convert to a Corporation.
Additionally, a single-member LLC has a clear ownership as stated in the articles of organization, which makes it easy to sell or transfer the business in the future. A sole proprietorship ends as soon as the business owner dies or becomes incapacitated. Thus, you should consider your long term plans for the business and whether you plan to transfer ownership or pass it down to your children.
Below is a list of questions to guide you in choosing between a single-member LLC and a sole proprietorship. Consider forming a single-member LLC if you answer “yes” to any of the following questions:
- Do you have personal assets that you want to protect from lawsuits or potential business liabilities?
- Does your business or industry involve significant liability risk?
- Do you plan to get funding from lenders or investors?
- Do you anticipate significant growth, such as hiring employees, scaling operations, or potentially selling the company in the future?
- Is portraying a professional and credible image important for attracting and retaining customers?
- Are you comfortable with the costs and additional administrative fees associated with forming and maintaining an LLC?
- Do you anticipate significant profits and plan to explore tax-saving strategies?
Consider forming a sole proprietorship if you answer “yes” to any of the following:
- Your business activities involve minimal liability risks.
- You don’t anticipate significant growth or funding from investors.
- Simplicity and lower fees are your priorities.
- Presenting a professional business image isn’t important to your potential clients or type of business.
- You plan to operate the business independently without the need for partners or investors.
Single-Member LLC vs Sole Proprietorship: Which Should You Choose?
Before deciding on a business structure, it’s important to outline your business needs. If your business is low risk with minimal overhead or you’re just starting and require a simple structure, go for a sole proprietorship.
If you’re in the growth phase and need more credibility and access to funding, a single-member LLC is preferable.
In either case, you should consult an accountant or attorney who can evaluate your unique situation and provide expert guidance on choosing the best business structure.
Author Bio
Brett Shapiro is a co-owner of GovDocFiling. He had an entrepreneurial spirit since he was young. He started GovDocFiling, a simple resource center that takes care of the mundane, yet critical, formation documentation for any new business entity.
