Updated: Dec 20, 2022
For decades, I operated a business as a sole proprietor. As the sole owner of my small business, I made the assumption I didn’t need to pay attention to the other legal business entity types. I was wrong. Even if you are a single business owner, you have options you should consider. In this post, I’m going to review the difference between a sole proprietor vs LLC.
For the purposes of this article, I will be focusing on the Single Member LLC (one owner member), versus the Multi-Member LLC (two or more owners/members of the business).
The most significant difference between a sole proprietorship and a Single Member LLC (SMLLC) is the liability status. A sole proprietor’s business assets and liabilities are NOT separate from their personal assets and liabilities. Meaning, if someone sues your business, your personal assets are at risk.
In most cases (meaning there was no fraud or criminal activity), forming an LLC protects the business owner’s personal assets in the event your business is sued. LLCs are a good option for medium to high risk businesses, owners with significant personal assets, or owners who want to pay a lower tax rate than they would under a corporation status.
Benefits of an SMLLC
Provides liability protection
You can structure it to provide the same pass-through taxation as a sole proprietorship
Easy to Maintain
Does not require a Board of Directors
Steps to become an LLC
Select your business name and verify the name is not taken, or can't be confused with another business by running a search of registered names in your state.
Select a Registered Agent to accept legal documents and tax notices on your LLC’s behalf. Some states allow the owner to serve as your own LLC’s registered agent.
File the Articles of Organization (called Certificate of Organization or Formation in some states) with your state to officially create your LLC.
Create an Operating Agreement to outline the ownership, operating procedures and member duties of your LLC. These do not need to be filed with the state but it is a legal requirement you have one and some banks will require them when opening your accounts.
After you register your business, you will file for an EIN (Employer Identification Number) through the IRS. As a sole proprietor or SMLLC without employees, you are not required to file for an EIN - it is optional. However, if you plan to hire employees, add additional owners, open a bank account (certain banks) and/or for privacy reasons, you may file an for and EIN. Otherwise, you will be using your social security number for your business. Visit your state's website to identify whether you will need to get a state tax ID number to pay your state taxes.
Open your separate business bank account. You must keep all business transactions separate from your personal accounts.
Calendar the annual renewal prior to your renewal date to avoid late fees.
Can I convert my sole proprietorship into an LLC? Yes, it’s fairly easy to do. The steps will be similar - check with your Secretary of State to see your state's process.
Do LLCs have shareholders? LLC’s cannot sell shares as it is owned by the members, who split the business earnings)
How long does it take to form an LLC? It depends on the state, but it usually only takes a few weeks. Many states offer online filings which expedite the process. While you are waiting for approval, you can create your LLC Operating Agreement, apply for an EIN (if needed), open your separate business bank accounts/credit cards, apply for your business licenses and calendar your annual filing so you’re in compliance with renewals.
Do I need a lawyer to form an LLC? No, you do not. If you have questions, you should consult an attorney experienced in these filings.
What are the tax differences between a sole proprietorship and SMLLC? These business entities resemble each other closely in terms of tax treatment. Both are pass-through entities, which means the business doesn't pay income taxes, the owner reports the business income on a Schedule C. The income gets taxed at the owner’s personal income tax rate. There may be additional state level taxes that apply to your LLC, such as Franchise Tax, Unemployment Tax, or Sales Tax. Some LLCs also file for S Corp status, a tax designation given by the IRS where the owners are taxed as employees vs paying self-employment tax. Please consult with your CPA in regard to your state’s tax requirements and if your LLC should consider filing for S Corp status..
What if I want to bring on a partner? You can file to modify your LLC to a Multi-Member LLC and your partner(s) become additional members of the LLC. Check with your state's Secretary of State.
Do I still need to have insurance on my business if I become an LLC? LLCs will keep your personal assets safe; however, liability insurance will help protect your business assets from lawsuits. Check with your insurance agent on the correct type of insurance.
What are the costs associated with an LLC? The costs to set up and maintain an LLC will vary from state to state, but will include set up fees, such as filing fees plus annual/bi-annual fee of your LLC (in CA, that fee is a minimum $800 for the franchise tax + $20 filing fee every year as of 2022). Maintenance fees are required until you file the correct paperwork with the state to cancel your LLC. You should also consider the costs if you need to hire a lawyer, use a professional service provider to form or maintain your LLC on your behalf and any additional costs charged by your CPA to complete your annual tax returns.
Conclusion: For many small businesses, especially for those just starting out, a low risk business that will likely remain a single owner can be structed as a sole proprietorship. If you plan to expand the company to more than one owner in the future, have a significant amount of personal assets you want to protect, want to take advantage of potential tax savings, or have a medium to high risk business, you should consult your CPA about the formation of an LLC.
Disclaimer: The information provided on this website does not, and is not intended to, constitute financial or legal advice; instead, all information, content, and materials available on this site are for general informational purposes only. Information may not constitute the most up-to-date legal or other information. Readers should contact their CPA and/or attorney to obtain advice with respect to any particular matter.