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Sole proprietorship vs. LLC: What’s the difference?

Sole proprietorship vs. LLC: What’s the difference?

One of the most crucial decisions new business owners will face is choosing the correct business structure for their venture. This choice can determine your tax strategy, funding opportunities, initial costs, and many other important factors that affect your business’s viability. From LLCs to C-Corps, public or privately traded, the options can feel endless – and overwhelming. 

To help you make an informed decision, we will be covering the major differences between sole proprietorships and Limited Liability Corporations (LLC). Both of these structures come with unique benefits and drawbacks. To make things as clear as possible, we will compare and contrast the tax implications, liability, and cost of each business type. 

Sole proprietorship: the basics

Arguably the simplest form of business entity, a sole proprietorship (sole prop.) is defined as a single individual who owns an unincorporated business by themselves. To use more technical language, there is no legal separation between the entity and the owner. In practice, this means that the business owner is personally responsible for the actions of their business. 

Additionally, a sole proprietorship is a status assigned to a business automatically. Let’s say you decide to sell a product online through your craft store. The moment you sell an item for a profit, you are considered a sole prop. The same reasoning applies to selling services as well. 

Limited Liability Corporation (LLC): the basics

In contrast, a limited liability corporation (LLC) is more complex. This business entity is owned by one or more persons and is separate from them. This means that the owners of the business are not personally responsible, the LLC is. 

An LLC also allows for a more complex business structure. Rather than only having one owner, an LLC can have multiple owners (also called members), managers, and shareholders/investors. This allows for more flexibility for funding and business operations. 

Key differences

Now that we have outlined the basics of each structure, we will examine the core differences for each in terms of tax implications, cost, liability, and structure. 

Tax implications 

As mentioned previously, because there is no distinction between a sole proprietorship and its owner, their taxes are filed the same way. This also means that your personal tax rate will be unaffected if you are a business owner or not. But, you are eligible to deduct certain expenses from your gross income to lower your tax bracket. 

For example, if you work out of your home as a data analyst, you will be able to deduct some of your home expenses (utility costs) from your income. It’s important to note that if your business makes more than $400 annually in profits, you will be required to file self-employed taxes as part of your Form 1040, Schedule C. 

On the other hand, because LLCs are an entity separate from their owner(s), their taxes are filed separately. They also allow for multiple filing options. Even if you own an LLC, you can elect to file your taxes as a sole proprietorship, a partnership, or a corporation. This allows for more strategic choices to realize significant tax benefits. 

Cost 

Given that sole props. are created with the sale of a good or service, there is no cost associated with setting one up. Unless you decide to register a name for your business, the lack of fees is a considerable plus. 

In contrast, setting up an LLC costs a few hundred dollars and comes with recurring annual payments. Firstbase start here is the simplest and most cost-effective way to create a new LLC.

Liability 

The most considerable difference between sole proprietorships and LLCs is the liability of their owners. 

Considering there is no legal difference between the owner of the sole proprietorship and the business itself, the owner carries unlimited liability. Practically speaking, this means that if your business is sued, you will be responsible for paying any claimants and fees out of your own pocket. This also means your personal assets could be seized to pay off said fees. 

LLCs are entities legally separate from their members. Suppose your business is sued or required to pay certain fees. In that case, only the business will be required to fulfill those fiduciary obligations, not you personally – unless you have signed a personal guarantee. 

Additionally, if you have employees working for you, your corporation can shield you from liability issues that come with employee mistakes. Let’s say you run a contracting business and one of your employees damaged a customer’s home. Because the damages are quite severe, the customer decides to sue. But, because the employee is hired by the LLC and not you, your assets are out of reach. 

What about C-Corps?

If you’re thinking about the right structure for your business, you may also have heard of C-Corps. C-Corps are different from both sole proprietorships and LLCs in a number of ways.

For example, while sole proprietorships and LLCs are taxed at the individual level, C-Corps are responsible for corporate tax (both state and federal). C-Corps can also issue stock, which often makes them more attractive to founders that are looking for investors.

While we don’t have time to cover the details of C-Corps in this article, you can read more about them in this article.

Wrapping up

To wrap up, sole proprietorships and LLCs come with several key differences. Before making any final decisions, you need to fully understand the pros and cons and how each option applies to your unique situation.

If you’re thinking neither of these structure types appeals to your situation, a C-Corp might be a business structure suitable for you. Hit the link below to start the incorporation process and create an LLC or C-Corp in one of eleven supported states.

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