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Key Differences Between a Sole Proprietorship and an LLC

When you start a business, choosing a business entity is one of the first decisions you'll make, and it's also one of the most important decisions. Understanding the benefits and drawbacks of each one is necessary for making an informed decision. 

While we've already discussed the tax benefits and drawbacks of an LLC, our small business accounting firm wanted to provide a deep dive into the difference between a sole proprietorship and an LLC, as well as some info on filing as an S corporation, to help you determine which one would have the greater benefit for your small business. 

What Is a Sole Proprietorship

Understanding the difference between sole proprietor and LLC first requires us to delve into the definition of a sole proprietorship and the taxes one may incur. So, let's start by addressing what constitutes a sole proprietorship. Most people start their business as a sole proprietorship simply because there is nothing you need to do to establish this business entity. If you begin running your business and don't form an LLC or incorporate, you default to a sole proprietor. So, let's now discuss the tax structure of a sole proprietorship.

A sole proprietor, a female shop owner, proudly discusses the difference between sole proprietor and LLC

Sole Proprietorships Taxes

A sole proprietorship is a "pass-through" entity meaning your business earnings and losses pass through to your personal tax return. Instead of filing tax returns as a business, you report the revenue and losses on your personal tax returns. Profits are added to your total household income and losses are included in your deduction.

While you do have to pay self-employment taxes, including a 12.4 percent tax for Social Security and a 2.9 percent tax for Medicare, you may be eligible for a 20 percent income tax deduction as a self-employed business owner on your 1040 return.

Sole Proprietorships and Liability

With a sole proprietorship, there is no liability protection in place for the owner. This means that if you have business debts you can't pay, you have unlimited liability, meaning your personal assets are subject to legal claims in addition to your business assets.

Who Should File as a Sole Proprietor

Sole proprietorships are typically best for those who work in low-liability fields, are self-employed with few or no employees, and are looking for a flexible option with limited paperwork. 

For instance, a freelance writer, photographer, or tutor is likely to benefit from filing as a sole proprietorship. 

What Is an LLC

An LLC, or Limited Liability Company, is a flexible and widely used business structure in the United States. It provides a legal entity through which business owners, often referred to as members, can conduct their operations while enjoying limited liability protection. Before we dive into the difference between sole proprietor and LLC, let's now address what constitutes an LLC.

A man defines an LLC in order to discuss the difference between sole proprietor and LLC.

This means that, in the event of financial or legal issues, the member's personal assets are typically shielded from business debts and liabilities. LLCs offer a simple and adaptable structure for various types of businesses, from small startups to larger enterprises, and they provide a convenient balance between the ease of management found in partnerships or sole proprietorships and the liability protection associated with larger corporations.

LLCs are typically governed by an operating agreement, which outlines the company's management structure and the rights and responsibilities of its members.

LLC Taxes

Taxes for LLCs, or Limited Liability Companies, are unique in that they offer flexibility in how they can be taxed. By default, an LLC is considered a "pass-through" entity for tax purposes. This means that the company's profits and losses are not taxed at the business level but instead "pass-through" to the individual members. Each member reports their share of the profits or losses on their personal tax returns. 

This taxation structure simplifies the process and avoids double taxation, which is a key advantage of the LLC structure. However, LLCs can also elect to be taxed as a corporation, which might be advantageous in certain situations, depending on the business's financial goals and structure. 

LLC and Liability

LLCs, or Limited Liability Companies, offer a significant level of liability protection for their owners—one of the primary advantages of this business structure. 

The key benefit of an LLC is that it separates the personal assets of its members from the company's debts and liabilities. In the event of legal claims or financial difficulties, the personal assets of members are typically shielded, and their liability is limited to the amount of their investment in the company. 

This limited liability is one of the main reasons why LLCs are a popular choice for small business owners, as it provides a buffer that helps protect their personal finances from the risks associated with the business. However, it's essential to note that there are certain circumstances, such as commingling personal and business finances or engaging in illegal activities, where the protection of limited liability can be pierced.

Who Should File as an LLC

While they may be a bit more complex and expensive to set up, incorporating an LLC has several benefits that make it worth it for businesses. They protect owner's personal assets, making them a great choice for businesses operating in a medium- or high-risk industry.  

They are also often recommended for those with several employees, or those with more than one owner. If you anticipate making significant profits from your business, an LLC can also give you more peace of mind when it comes to avoiding the mistake of being doubly taxed. 

Startups, e-commerce business owners, restaurateurs, and even those in real estate are just some examples of the types of businesses that should opt to file as an LLC instead of a sole proprietorship. 

What is an S Corporation 

There is another commonly used business type: the S corporation. An S Corporation, often abbreviated as S Corp, is a tax designation that allows businesses to pass their corporate income, losses, deductions, and credits through to their shareholders for tax purposes. This structure allows S Corps to avoid double taxation, similar to the way that LLCs do, as income is not taxed at the corporate level. Instead, it's reported on the individual tax returns of the shareholders. 

One key difference between an S Corporation and an LLC lies in the management and ownership structure. S Corps have stricter ownership requirements, with limitations on the number and type of shareholders, whereas LLCs offer more flexibility in ownership, allowing for a wider range of individuals and entities to participate.

A team meets to discuss key difference between sole proprietor and llc

Additionally, an S Corp requires certain formalities, such as holding regular shareholder meetings and maintaining detailed corporate records, which are not as stringent for LLCs. 

S Corp Benefits

Finally, let's outline the S Corp benefits before unveiling the difference between sole proprietor and LLC. S Corporations, or S Corps, offer several benefits for businesses. One of the primary advantages is the avoidance of double taxation. An S Corp passes their income through to shareholders' individual tax returns, which means the company itself is not subject to federal income tax. 

An S Corps provides limited liability protection, similar to that of an LLC, safeguarding personal assets from the company's debts and legal liabilities. An S Corp also allows for flexibility in structuring compensation, potentially reducing self-employment taxes for owner-employees. They may also appear more credible to potential investors and partners, as they follow more formal corporate governance and reporting requirements. Now that we've outlined all of the key features of an LLC, S Corp, and Sole Proprietorship, let's discuss the difference between sole proprietor and LLC.

Difference Between Sole Proprietor and LLC

So when starting your business, should you opt for a sole proprietorship or an LLC? Or, is an S Corp better for you? As with many questions you must ask yourself before starting a business, there isn't a blanket correct answer to this question. But, we will discuss the difference between sole proprietor and LLC so you can make an informed decision about what business venture is right for you.

While there is significantly more paperwork and regulation with an LLC, you may find the tax benefits and liability protections are beneficial, plus you can raise capital more easily through investors. If you're unsure, it's important to speak with an experienced accountant, as well as your attorney, who can discuss your unique needs and help you get set up. In sum, the difference between sole proprietor and LLC is largely related to how taxes are incurred and calculated. Another difference between sole proprietor and LLC is the paperwork needed to start an LLC and the liabilities you can incur. To that end, it's essential to consider how much risk you are willing to take on before starting either business venture.

Difference Between a Sole Proprietor and LLC: Schedule a Consultation with Our Small Business CPA Firm in Raleigh

If you're struggling to choose and set up a business entity and aren't sure which option is right, or you need assistance in setting up your business entity, we can help. Additionally, if you want more information regarding the difference between sole proprietor and LLC, please reach out to our Raleigh CPA firm today. Our firm can meet with you to discuss key differences between a sole proprietor and an LLC. Schedule a consultation today with an experienced small business accountant in Raleigh today by calling  919-420-0092 or filling out the form below to get started.

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