LLC vs. Sole Proprietorship: Which Is Right for Your Business?

Despite being two of the most common small business structures, there are several key differences between an LLC and a sole proprietorship to consider before choosing which is best for you. We've outlined the five most important.

1. Management structure

Managing an LLC

In an LLC, the business can be owned by one or more members. Its members usually manage an LLC, but they can also appoint a manager to handle the day-to-day operations.

And, while it may be slightly more complex than managing a sole proprietorship, the multi-member, diversified nature of an LLC offers considerable upsides, especially as a business grows.

Simply put, more hands make for lighter work, and in situations where many or all of an LLC's members actively contribute to daily operations, the company often grows much more quickly than it would if it were entirely run by a single individual.

That said, this structure also requires more thought regarding profit distribution. Typically, the members of an LLC will form an operating agreement upon joining the company, which is a document that outlines expectations, obligations, and compensation (which may or may not correlate with each member's ownership percentage).

Managing a sole proprietorship

By definition, a sole proprietorship means that an individual has complete control over all decisions made for the business without needing to consult any partners or members as they would within an LLC. While this type of freedom may appeal to some entrepreneurs, it's important to remember the risks and added burdens associated with a sole proprietorship.

Put simply, opting for a sole proprietorship structure often means a high-risk, high-pressure experience where a business's success—or failure—depends almost entirely on the individual at its head.

2. Personal liability protection

Protection within an LLC

With an LLC, one of the most attractive benefits is personal liability protection. Because the business is treated as a separate legal entity with its own assets and debts, individual members of an LLC typically cannot be sued or held responsible for the business's debts.

And, while most businesses don't plan on being sued, many of the moves necessary for a company to grow will also open that company up to potential litigation, including hiring employees, maintaining a physical location, or simply selling goods and services.

Protection as a sole proprietor

In a sole proprietorship structure, there is no separation between you and the business. While this means that you are entitled to 100% of your company's profits, it also means that you can be held personally liable for any debts, lawsuits, or other obligations associated with your business (including the actions of any employees).

In the event that a business's assets cannot cover a debt or lawsuit, a sole proprietor's personal assets may be seized to cover the difference.

3. Mixing personal and business funds

Mixing funds as an LLC

When you structure your business as an LLC, it is absolutely crucial to maintain a careful separation between personal and business banking records, both to keep things above board with any other members the LLC may have and to protect yourself from liabilities.

In cases where LLC members combine personal and business funds, they may lose the limited liability protection that the LLC provides in the first place.

Mixing funds as a sole proprietor

Unlike with an LLC, sole proprietors don't have to worry about mixing business and personal accounts from a legal standpoint. This is because, in the eyes of the law, a sole proprietor is regarded as one and the same with their business.

That said, mixing funds is still discouraged by most experts as it can complicate taxes (and any potential audits that may happen).

4. Registering a business

Registering an LLC

State regulation of LLCs includes required words that must be included in an LLC name—for example, "LLC" or "limited liability company" might be required at the end of an LLC's name. Registering your LLC does give your name protection within your state.

Registering a sole proprietorship

Sole proprietors don't face the same requirements. However, if the business owner plans on operating under a company name instead of under their own name, they will need to register for a "fictitious business name," or DBA ("doing business as"), in their home state.

5. Tax considerations

Taxation in an LLC

By default, all profits made by an LLC are only taxed once, a process known as pass-through taxation. As the owner, the tax liability belongs to you and passes through to your personal tax return. For multi-member LLCs, pass-through taxation occurs for all members according to the amount of profit they receive from the company that year.

To file taxes, you report your operating results, including profit or loss, by submitting Profit or Loss From Business (Sole Proprietorship) (Form 1040, Schedule C) with your personal 1040 tax return. An LLC is very flexible and can also be taxed as a sole proprietorship, a partnership, or a corporation.

Both LLCs and sole proprietorships are required to collect and remit local sales taxes where appropriate.

Taxation in a sole proprietorship

A sole proprietor also benefits from pass-through taxation, so you'll report your business's income or loss in the same way. Unlike with an LLC, sole proprietors don't have the option to file as a corporation.

You're also not required to pay taxes on the full amount of your sole proprietorship's income. Instead, you'll only pay taxes on the profit of your business.

Finally, sole proprietors are typically required to pay self-employment taxes, which, in turn, usually necessitate quarterly payments. These extra taxes make it especially important for sole proprietors to maximize deductions wherever possible.

How to activate each structure for your business