Sole Proprietorship Vs. LLC: What’s The Difference?
It is most likely for individuals and small business owners to structure their businesses as either sole proprietorships or LLCs. Suitability of structuring your business as one or the other arises because of slight differences in formations and protections of each entity.
- The easiest business structure is the sole proprietorship, as it has minimal startup costs for entrepreneurs. The set-up of a formal structure is not required.
- They are run by a single individual who owns all the business assets and is responsible for all the liabilities.
- The IRS automatically considers a business structure operating in a natural person’s name as a sole proprietorship.
- A sole proprietorship’s owner is personally liable for any financial losses and debts that may arise during trading.
Limited Liability Company (‘LLC’)
- An LLC is a business entity that can have one or more owners. A formal structure is required as owners must file articles of organization with the secretary of state to form the LLC.
- An LLC provides its owners (referred to as members) with limited liability, meaning members are not personally liable for business debts and claims.
- An LLC is a pass-through entity; by default, the IRS classifies single-member LLCs as sole proprietorships and multimember LLCs as partnerships for tax purposes. The members may also elect to have the LLCs taxed as S-Corporations or C-Corporations by filing the necessary forms with the IRS.
- An LLC can be member-managed, or an election can be made to have third parties manage the entity.
Why Change A Sole Proprietorship To An LLC
Changing your business from a sole proprietorship to an LLC may be worthwhile if you’d like to grow your business and to engage in more risk than before. LLCs provide members with limited liability protection, which does not apply to sole proprietorships.
Multiple owners can also own LLCs, while individuals may be more willing to invest in an LLC than a sole proprietorship as they will be entitled to some share of the business profits.
The Pros And Cons Of Each Business Structure
Pros of Sole Proprietorships
- Forming a sole proprietorship is less expensive and requires less paperwork. (Licenses and permits could still be mandatory depending on the nature of the business)
- The net business income of the sole proprietorship is included in the owner’s personal income tax returns. The tax rate applied to the business profits depends on the owner’s individual tax rate.
- The owner of a sole proprietorship is solely responsible for all management decisions and responsibilities. Therefore, board/member resolutions are not required when any decisions regarding the business need to be made.
Cons of Sole Proprietorships
- Owners have personal liability for all debts and claims of the company, and their personal assets may be at risk to settle unpaid debts and other legal liabilities of the business.
- Owners of sole proprietorships will be required to use their own resources (capital or credit facilities) to fund their startups, as they cannot provide external investors with any securities in the form of stocks.
Limited Liability Company (LLC)
Pros of an LLC
- An LLC is considered as a separate entity from its members. Subsequently, members are not personally liable for the business’s debts and other legal liabilities (i.e., they have limited liability protection).
- Members of LLCs include the business profits in their individual tax returns because the LLC is classified as a pass-through entity. Furthermore, members may be able to apply the 20% pass-through deduction to business profits.
- LLCs may have fewer state-imposed filing requirements than corporations.
Cons of an LLC
- Forming an LLC is more expensive than setting up a sole proprietorship, and depending on the state requirements, ongoing fees may be imposed annually.
- Members of LLCs receive units in proportion to their contribution/LLC agreement. These units are not as easy to transfer as stocks in a corporation. This difficulty in transferring ownership is one of the reasons that external investors/venture capitalists prefer investing in corporations over LLCs.
Where should I form my LLC?
An LLC typically forms in the state in which the business activities of the entity will be conducted. It is possible to create the LLC in a different state; however, the LLC will then be classified as a Foreign LLC, which may lead to additional filing requirements with the secretary of state and higher administrative costs in most states. The IRS has special rules for foreign LLCs and must be considered if this option is elected.
Responsibilities As An LLC Owner
The members’ responsibilities will be decided in the LLC operating agreement. This will detail whether the owners have elected to have the LLC be member-managed or manager-managed. If the LLC is member-managed, the members will be responsible for the day-to-day management of the LLC. If the LLC is manager-managed, the members are responsible for electing suitable individuals to make management decisions and oversee the entity’s operations.
Members also need to ensure that the business complies with the formalities and filing requirements of the relevant state to ensure that the LLC does not lose its limited liability protections.
How To Transition A Sole Proprietorship To An LLC
Dissolving or canceling any registered Fictitious Business Names or Doing Business As (DBAs)
If the sole proprietorship was trading under a different name, the necessary documentation must be filed with the state to dissolve or withdraw the current DBA. After that, you can use the same name to register your LLC if the name is not already registered to another LLC.
Choosing a business name
The new LLC name needs to be distinguishable from all other registered entities. You can start searching on the state’s business search tool.
Selecting a registered agent
A registered agent is an individual or company who will be responsible for receiving legal correspondence and documentation on behalf of the company. It may be one of the members or an attorney/accountant.
Filing Articles of Organization
While it may differ from state to state, this document needs to detail the name and address of the LLC, the contact details and names of the owners, the application date, and a description of the new business.
Drafting an operating agreement
The operating agreement is an internal document that needs to be drafted by members and will set out the rules for ownership and the management of the newly formed LLC. It will detail what will happen if additional members are introduced to the LLC, if the LLC will be liquidated, or if members leave the LLC.
Applying for an Employer Identification Number (EIN)
As LLCs are pass-through entities, an application for a new EIN number needs to be obtained if the LLC will be multimember or if the election is made by its members to be taxed as a corporation.
Opening a bank account
A bank account for any new business needs to be opened in the name of your LLC to ensure a clear separation between the LLC funds and the members’ personal funds. This also eases the management of assets and allows for more accurate recordkeeping.
Contacting licensing agencies
Suppose the nature of the business requires the LLC to obtain business licenses or permits to operate. In that case, the relevant agencies need to be contacted to ensure that the licenses or permits are transferred from the sole proprietor to the newly formed LLC.
Updating business information
Inform clients and other stakeholders of the new business to ensure they issue invoices and payments to the newly formed LLC and no longer to the sole proprietor. Insurance companies must be advised of the change from a sole proprietorship to an LLC to advise if a new business insurance policy may be required.
Reviewing your current contracts
Please review the current contracts between the sole proprietorship and its clients to ensure they can be transferred to the newly formed LLC. These contracts need to be updated between clients and your LLC and are no longer the personal name of the owner of the sole proprietorship.
Documents required for the transition from a sole proprietorship to an LLC include (but may not be limited to in some states):
- Articles of Organization
- Operating Agreement
- Form 8832 if the members elect to change the default classification of the IRS.
Stop using your Sole Proprietorship
Ensure that all the payments and checks have cleared and close the bank account of the sole proprietorship. Update all existing contracts and insurance policies to include the newly formed LLC, not the sole proprietorship.
Maintaining Your Limited Liability Protections
Members of the LLC need to ensure that they do not pierce the corporate veil by providing that business assets do not get mixed with their personal assets. Should this be the case, your LLC risks losing its limited liability protection.