Single Member LLC vs. Sole Proprietorship

If you’re starting a business, you may be trying to decide whether to operate as a sole proprietorship or a limited liability company (LLC). While the two business structures have many similarities, they also have some key differences you should be aware of before you make your choice. 

What Is a Sole Proprietorship?

A sole proprietorship is the simplest type of business entity to have and operate. It is a business with one owner and is not incorporated.

It’s also the default business form for a solopreneur. If you operate a business by yourself and don’t form any official business entity with the state, your business is automatically considered a sole proprietorship. There is no paperwork to file. You and the business are the same in a sole proprietorship, which means you’re personally liable for the debts and obligations of the business.

In a sole proprietorship, the business name is your name, unless you register a DBA, or “doing business as.” Simply put, it’s a name that is registered for a company to do business under that is not its legal business name. For instance, a sole proprietorship run by Thomas Smith might file a DBA to operate as “Smith’s Shirts”. A DBA name is also sometimes called a fictitious name or a trade name.

What is a Single Member LLC?

An LLC is an increasingly popular business structure for startups, offering liability protection for ownership and greater flexibility than a corporation, particularly in terms of taxes. The LLC itself does not pay taxes. As a “pass-through” entity, income passes through the business to the owner or owners, who report it on their personal tax returns. An LLC is created by filing paperwork with your state, and nominal fees are involved. 

An LLC offers its owner or owners, who are called members, considerable flexibility in terms of management. You can choose your management and operational structure and decide how you want to be taxed. Your LLC can have a single member or multiple members, all of whom have personal liability protection, meaning your personal assets are not at risk if you cannot pay business debts or are involved in a lawsuit.

A single-member LLC has only one member.

Differences Between a Sole Proprietorship and a Single Member LLC

Legal Formation

To form a sole proprietorship, simply start doing business. However, depending on your location and type of business, you may need certain licenses and permits. Check with your state and municipality to find out what is required.

A sole proprietorship is the least expensive and easiest type of business entity to form. A sole proprietor does not have to file anything annually other than taxes and business license and permit renewals. There are no legal management requirements.

In an LLC, the formation requires more paperwork – you need to file articles of organization with your state. These forms vary by state but can generally be filed online. You’ll need to fill out the LLC name, the name and address of the registered agent, the name of the LLC owner, and in some states, the way the LLC will be managed. Fees are generally around $100.

A registered agent is the person or company that sends and receives official documents on behalf of your LLC. The registered agent can be you as the sole member, or you can choose a third party such as an attorney, or a company that offers registered agent services. Most states require that you have a registered agent. The agent must be a resident of the state where you do business or a corporation that is authorized to do business in your state.

An LLC may also need specific licenses and permits and may also choose to have a DBA.

Many states also require that LLCs file annual reports. Paperwork will also be required to dissolve the LLC, while with a sole proprietorship, you can just stop doing business.

Taxation

A sole proprietorship is also a pass-through entity, which means the business itself does not pay taxes. The sole proprietor reports the business income on their personal tax return and pays taxes at their personal income tax rate.

As previously mentioned, LLCs are also not taxable. In the case of a single-member LLC, you will be considered a disregarded entity by default and taxed as a sole proprietorship.

As a single-member LLC, however, you can choose to be taxed as a corporation. To do so, the LLC must file a document, referred to as an election, with the IRS. The LLC must then decide if it wishes to be taxed as an S corporation or a C corporation.

C-Corp status means profits are taxed at the current rate for corporations (21% as of early 2022), which is significantly lower than the typical individual taxpayer rate. But keep in mind, C-Corp shareholders, which includes members, must also pay taxes on their distributions (but not self-employment taxes). Thus, the C-Corp is subject to what is sometimes referred to as double taxation. 

As with sole proprietorship status, S-Corp taxation considers the LLC a pass-through entity, which means income passes through the company and into the hands of the owners. At this point, taxes are applied at the same rate as those of individual taxpayers.

S-Corps use Form 1120S to file their taxes, which is used to report the income, losses, and dividends of shareholders. S-Corp shareholders do not pay self-employment taxes, which is the primary advantage of S-Corp status compared to sole proprietorship or partnership. 

Generally, S-Corp tax status is beneficial if the company is profitable enough to pay the owners a salary and at least $10,000 in annual distributions so the owners can be taxed as employees and not pay self-employment taxes. It costs more to run an S-Corp than an LLC due to additional bookkeeping and payroll expenses. Thus, the tax benefits should be more than the additional costs for an S-Corp status to make financial sense. 

LLC owners may be eligible for the 20% pass-through deduction that was part of the Tax Cuts and Jobs Act, meaning that they can deduct up to 20% of the business income.

Both sole proprietorships and LLCs must pay payroll taxes if they have employees, collect state and local sales tax, and are responsible for paying self-employment taxes. Some areas do collect different taxes for LLCs, so you should check the laws of your state and municipality.

Management Structure

In a sole proprietorship, it’s simple – the owner is in control of all aspects of the business. The owner can hire employees, take on debt, and manage all operations.

An LLC with only one member is essentially the same. There is a difference, however. An LLC is a separate entity from you, the owner, and can enter into contracts, take on debt, purchase property, and more. As the LLC sole member, you will sign for such contracts as an authorized representative of the LLC. You will not be personally signing these contracts and therefore have no personal obligation or liability.

With a sole proprietorship, you and the business are the same, so when you sign contracts and other documents, you’re signing personally and therefore personally liable.

Liability

In a sole proprietorship, again, the owner is the business and is personally liable for all debts, and if the business goes bankrupt the owner must personally file for bankruptcy. If the business is sued, the sole proprietor is personally liable, and their personal assets are at risk.

An LLC is a separate entity from the owners and has its own obligations, therefore LLC members are not personally liable for the obligations of the business. If the business goes bankrupt, the owners can file for business bankruptcy, but their personal assets are not involved. However, if a member personally guarantees a business loan for the LLC, they are personally liable for that debt. The owners are also liable if they commit fraud or are negligent.

Making a Choice: Single Member LLC or Sole Proprietorship

Sole proprietorships are simple and inexpensive, so many small business owners choose to be sole proprietors. The biggest disadvantage for sole proprietors is personal liability. You may think that nothing will go wrong, but if it does, your personal assets, including your home, could be at risk.

A single-member LLC offers the advantages of personal liability protection and tax flexibility. Most people who choose an LLC do so because they want to protect their personal assets. An LLC is more expensive and requires more paperwork, but it’s a small price to pay for peace of mind.

Here’s a guide on how to change from a Sole Proprietorship to an LLC.

In Closing

A single-member LLC and a sole proprietorship are similar but have key differences, of which personal liability protection is arguably the most important. It’s a good idea to consult with an attorney to determine the best entity for you and your business.