Getting ready to start an ecommerce business? Your store launch checklist is likely packed with fun things like finalizing your logo and branding, sourcing the perfect products, and building out your marketing plan. And while starting your own business is certainly exciting, it often requires some not-so-exciting decisions.
One of those decisions could be whether to launch as a sole proprietorship or an LLC. It’s important to understand the differences between the two, because the decision could impact your tax reporting and compliance obligations, your personal liability, and your business’s growth.
In this post, we drill down into a sole proprietorship vs. LLC comparison to help you determine which business type is right for you.
Table of contents
What is a sole proprietorship?
A sole proprietorship, or sole prop, is the most basic type of business. This structure is an unincorporated business owned by a single individual, with no legal separation between entity and owner.
If you own a sole prop, you have total control over the business and all of its income. Your business profit is taxed just like personal income, and you can do whatever you want with what’s left over. Many other business structures have multiple owners who share control and have to agree on how you allocate income.
A sole prop has less protection for your personal assets than most other business structures. Owners assume complete legal responsibility for the business’s losses and liabilities. Other business structures, like LLCs, legally separate the person and the business as separate entities—which limits personal liability.
Creating and operating a sole prop is a relatively simple process, which makes it a popular choice among the self-employed, like freelancers or small business startups. You might have even done this at some point without realizing it.
Anyone who turns a profit while working independently is considered a sole proprietor by default. So if you’ve ever received payment for a service you provided on your own—not under the scope of another employer—you were operating as a sole prop. There’s no formal registration or filing process required to establish this status. Compared to other business structures, a sole prop is easy to establish and maintain—which makes it a common choice for entrepreneurs and online merchants with low-risk businesses—like print on demand, for instance.
Benefits of sole proprietorships
A sole prop is a common choice for new businesses and entrepreneurs because it offers the following advantages compared to LLCs:
- Simplicity. It’s relatively easy and inexpensive to establish. If you’re the only owner and employee performing your business activities, then you’ve already formed your own sole prop. Establishing other business structures, like an LLC, requires paperwork and processing.
- Income tax filing considerations. The owner and business are considered the same entity and generally will only have to file one federal income tax return and one state income tax return (per jurisdiction)—so income is only taxed once. Single-member LLCs could offer this same advantage If a second owner joins the businesses, the sole proprietorship will then be required to file partnership tax returns.
- Fewer guidelines. Sole props have fewer regulatory requirements than other business structures. LLCs require a formal registration process; including a separate and unique business name and registering an agent to correspond on behalf of the company. Many states charge filing fees for LLCs.
Drawbacks of sole proprietorships
A sole prop might not always be the best choice, depending on your business type and goals. Here are some disadvantages compared to LLCs:
- Personal liability. The owner is responsible for all debts or losses incurred by the business, including lawsuits.
- Difficulty raising capital. Banks and investors are generally less likely to provide financial support for sole proprietorships in comparison to LLCs because it’s a less “formal” business entity.
- Everything is on you. Without partners or investors, entrepreneurs are on their own when it comes to making business decisions in a sole prop. Owning and running your own business can be isolating at times.
What is an LLC?
An LLC, or limited liability company, is a structure that combines characteristics of a corporation and a sole proprietorship. There are many types of LLCs, each with different parameters. The single-member LLC is most comparable to a sole proprietorship and what we’ll be comparing in this post. A single-member LLC consists of just one owner, who controls 100% of the business.
LLCs are popular because of their flexibility and protection. For many, it’s the next step after launching as a sole prop. An LLC is recognized as a legally separate entity, protecting your personal liability as the owner.
While this personal-business separation is beneficial from a liability standpoint, single-member LLCs are generally treated as “disregarded entities.” This means, as with a sole proprietorship, the business’ income tax obligations “flow through” to the owner and are filed in conjunction with the sole owner’s personal income tax filings.
LLCs are formed in the state in which they operate, which can add to the complexity and cost of setting up and maintaining it. But overall, the process is relatively simple and affordable, though less so compared to sole proprietorships.
Benefits of LLCs
Single-member LLCs have a few benefits over sole proprietorships, in particular:
- Personal protection. While a sole prop puts your personal assets at risk with zero liability protection, an LLC legally separates the business entity from the person. So your personal assets have more protection and can’t necessarily be seized for company debts.
- Simple setup. Single-member LLCs require more setup than sole props, but the process is still straightforward and has fewer steps than other corporate structures. You file your articles of incorporation with the state and then it’s done.
- Income tax flexibility. With a single-member LLC, you can choose to be taxed like a sole prop or elect to be taxed as an S corporation or as a C corporation for income tax purposes. While S corporations could offer some of the “flow-through” benefits enjoyed by LLCs and sole proprietorships, they have very specific requirements (both in terms of eligibility and tax filings). Business owners should consult with a licensed tax advisor to determine the best structure. It’s always best to consult your own tax advisor.
Drawbacks of LLCs
While LLCs have many advantages of sole proprietorships, there are some downsides to consider:
- Dealing with the state. When you have an LLC, you have to manage your business with the federal and state governments, and possibly more local jurisdictions, depending on the nature of your business. Sole proprietors don’t have to deal with state-level licensing, bureaucracy, and admin unless they’re in a qualifying industry.
- Cost. LLCs have more associated costs than sole proprietorships—an important consideration if your budget is tight.
Sole proprietorship vs. LLC: how they stack up
Whether you’re a sole proprietor or the owner of a single-member LLC (assuming the LLC made no special tax elections), you will report your business income and expenses on your personal income tax returns. Therefore, a business owner may find that there are no meaningful income tax consequences when deciding between sole proprietorship and a single-member LLC. However, many times business owners want the ability to elect different federal income tax treatment for its business, which only the LLC can offer.
In either case, if the business hires any employees, it must obtain an EIN. Further, as noted above, once there is more than one owner, the tax return requirements could change. It is important to speak to a licensed tax advisor about the best structure for your business and the corresponding federal, state and local tax compliance requirements.
Overall, LLCs have more protection in terms of personal liability than sole proprietorships—one of the major benefits of this business type.
In an LLC, the owner is only personally liable up to the amount of money they’ve invested in the LLC. So if the LLC has debts, the owner doesn’t risk any personal liability to pay off those debts in case the business is unable to on its own. However, you have to ensure your business and personal dealings are completely separate. Again, it’s always best to consult your tax professional.
With a sole proprietorship, all of your personal assets are at risk if your business finds itself in debt. This is an especially important consideration when making significant investments in your business.
Learn more: How to Get a Business License
A sole prop can be more affordable to establish than an LLC, since there’s no formal process or paperwork involved. While not required, some sole props may choose to register a Doing Business As (DBA) trade name. DBA registration costs depend on location. Both sole prop and LLC business owners will also need to check out local business operation regulations and obtain any licenses or permits necessary.
The cost of establishing an LLC depends on the location of the business, as requirements vary by state—so it’s important to research and follow state guidelines. Most states require LLCs to create a separate entity name and register it with the secretary of state. According to the US Small Business Administration, this registration process generally costs under $300 but can vary depending on location and type of business.
Learn more: How to Register a Business: What You Need to Do in 2021
When it comes to external funding, it’s usually easier for LLCs to raise capital than sole props. From an investment standpoint, an LLC is viewed as more secure than a sole prop because it’s a recognized separate business entity. These circumstances apply to business loans, business lines of credit, and investors alike.
Many investors are more likely to financially back LLCs because liability is limited to the business, which protects the investor’s personal assets. Sole proprietorships are more limited with financing options from banks too—many banks will only issue personal loans to sole prop owners, which are more restrictive than business loans. An LLC also has the option of bringing on additional partners to invest in the business, whereas sole props can only be owned and operated by one individual.
Management and control
Since sole props must be owned and run by one individual, all the responsibility of business operations and management falls completely on its owner. On the plus side, you have complete control. But it can also limit growth potential—and be a heavy burden to bear alone.
LLCs have more flexibility when it comes to management and control. Single-member LLCs can operate the same way as a sole prop, and they also have the option of bringing on additional members or employees. While the owner still maintains control, they have to balance the needs and wants of others.
Learn more: How to Start An LLC: Everything You Must to Know
Core differences between sole proprietorship and LLC
Here are the highlights of a sole proprietorship vs. LLC comparison:
- Taxes. From an income tax standpoint, sole proprietorships and single-member LLCs are generally taxed the same unless certain elections are made with respect to the single-member LLC.
- Liability. LLCs grant more protections in terms of personal liability.
- Costs. Sole proprietorships are free to start. LLCs require registration and ongoing fees.
- Funding. It’s generally easier to get external financing for an LLC than for a sole prop.
- Management and control. Sole proprietorships offer more control than LLCs, but with that comes more responsibility.
Move forward with your new business
Incorporating your business makes it official in the eyes of the government. You’ll protect your personal assets, build credit and history for your company, and even enjoy lower taxes in some cases. But the best benefits of business incorporation are perhaps intangible. Incorporation transforms your idea into a real, official business—the rest is up to you.
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DISCLAIMER: These guides are for informational purposes only and do not constitute professional legal or tax advice. Please consult independent legal advice and your own tax advisors for information specific to your country and circumstances. Shopify is not liable to you in any way for your use or reliance on these guides.