Sole proprietorship vs single-member LLC: Key differences

If you're a freelancer or solopreneur seeking to start a new company, there are two different types of business entities to consider: a sole proprietorship and a single-member limited liability company (LLC). Both options have unique advantages and disadvantages. We’ve put together everything you need to know to determine which structure is best for your new small business.

• Sole proprietorship
• Single-member LLC
• Starting a sole proprietorship 
• Creating a single-member LLC
• Taxation as a sole proprietor
• Taxation as a single-member LLC
• Benefits and disadvantages of each

The basics

Before we go into the pros and cons of sole proprietorships and single-member LLCs, it's important to know the essential components of each.

Sole proprietorship

Sole proprietorships are the most basic form of business structure. They are not a separate legal entity from the owner because once you begin conducting business, you operate as a sole proprietor by default. So the owner takes on all the legal liabilities associated with the business, such as any debts or business obligations the company accumulates.

Sole proprietors must keep company assets separate from their personal assets. Owners should use a business bank account and open a business credit card. It's important that they don’t use either for personal transactions.

Single-member LLC

A single-member LLC is a limited liability company with a single owner. (LLCs refer to an owner as a “member.”) Single-member LLCs are disregarded entities, which means they don't file a separate business tax return and the IRS ignores them for tax purposes. Instead, the IRS collects an LLC’s taxes through the owner’s personal tax return. 

Single-member LLCs are considered a separate legal entity because of how liabilities are treated. They can protect an owner’s personal assets from being seized to pay for business debts.

Forming the business

There are critical differences in how to form a sole proprietorship versus a single-member LLC.

Starting a sole proprietorship

“A sole proprietorship is the simplest and most common structure chosen to start a business” and prospective owners “do not have to take any formal action to form a sole proprietorship,” according to the Small Business Administration. 

It's inexpensive and straightforward to form a sole proprietorship. You need to choose a name, obtain proper business licenses and permits, and open a business bank account and credit card. Once you’ve completed these few steps, you can begin to:

• Hire employees.
• Open a brick-and-mortar location.
• Market your company.

If operating as a sole proprietorship, you may want to operate under a “Doing Business As ” (DBA) name. For instance, “John Doe” may elect to do business as “JD Marketing.” Registering a DBA can help protect your identity and can be a branding tool. If your company operates under a name other than your own, you’ll need a DBA to file for licenses, permits, and a business bank account.

Creating a single-member LLC

Setting up a single-member LLC does require more paperwork than a sole proprietorship. You’ll need to file paperwork with your secretary of state's office.

Although requirements vary from state to state, you typically file Articles of Organization, pay a filing fee, and indicate the chosen name for your company.

Another requirement to form a single-member LLC is selecting a registered agent. This person is responsible for accepting legal correspondence on behalf of your company at an address registered to your business. The registered address can be different from your company address, but it cannot be a P.O. Box.

Some states will allow you to serve as your own registered agent. But it's important to know that you must be physically present at your registered address during regular business hours. 

There are also maintenance and compliance requirements associated with a single-member LLC, and you’ll need to file an annual report with the secretary of state’s office. Failing to file an annual report could cause the state to shut down your business.

Step-by-step guide to register your small business | Start your business

How do taxes work?

Once you set up your business, you need to understand how the taxes are filed and paid. When it comes to taxes, sole proprietors and single-member limited liability companies are treated differently.

Taxation as a sole proprietor

Taxation as a sole proprietor is straightforward. As a sole proprietor, you pay self-employment taxes. Sole proprietors use their Social Security Number to file federal taxes. If the sole proprietorship employs individuals, the business must obtain an IRS Employer Identification Number (EIN) for payroll tax purposes.

You’re responsible for paying the worker and the employer share of FICA taxes, which is currently a 15.3% tax rate. The sole proprietor deducts the employer half of FICA taxes as a business expense. The IRS allows sole proprietors to “pass-through” business income and losses to the personal tax returns (Form 1040). You’ll do so on IRS Schedule C. 

As a sole proprietor, you post business income and expenses on Schedule C, and your business profit is added to other sources of income on your personal tax return. Keep accurate records throughout the year to simplify the process of filing your income tax return.

Taxation as a single-member LLC

A single-member LLC can elect to be taxed as a C corporation. In this case, the company files a tax return and pays federal and state taxes at the corporate tax rate. If an LLC doesn’t elect to be taxed as a corporation, it’s treated as a sole proprietorship for tax purposes. The LLC’s profit is posted to the personal tax return through Schedule C. Both single-member LLCs and sole proprietors are required to pay self-employment tax and require an EIN if they hire employees.

Liability issues

Sole proprietors are not protected from any business liabilities. For example, if a business were to take on debt, file bankruptcy, or dissolve, its creditors can go after the owner’s personal assets. By contrast, single-member LLCs are attractive because they can shield owners from the liabilities associated with the business. However, the limited liability protection isn’t as robust as it is for traditional LLCs (those with multiple members).

A court may overturn any business owner’s liability protection. Limited liability is based on the idea that the company and the individual are two separate entities. Because a single-member LLC is a disregarded entity, owners are less likely to keep personal and business affairs separate and more likely to pierce the corporate veil. If the corporate veil is pierced, the court may allow a creditor to go after the personal assets of the LLC owner.

Single-member LLC owners should maintain a formal operating agreement that governs how the LLC functions, ensuring that the business complies with both federal and state law. It is critical that owners keep all business and personal financials separate from each other.

Benefits and disadvantages of each business structure

Both sole proprietorships and single-member LLCs have unique advantages and disadvantages. Consider the following when deciding which organizational structure is right for your new company.

Sole proprietorship

Advantages of sole proprietorships include:

• Easy to form: Once you begin conducting business, you run a sole proprietorship by default. You don’t need to file complicated forms.
• Easy to dissolve: When business operations come to a close, it’s easy to dissolve the company. Owners can dissolve the company whenever they choose to do so.
• Provide pass-through taxation: Filing tax forms is easy. All you need to do is complete IRS Schedule C.

Disadvantages of sole proprietorships can include:

• No protection from liability: Single owners are responsible for all tax liabilities, even if they hire employees.
• A limited lifespan for the business: Were something to happen to the owner, business operations would cease immediately. This could be unanticipated and untimely, and could negatively affect any employees.
• Challenges raising capital: Other entity types, like LLCs and C corporations, can offer an ownership stake to investors. A sole proprietorship doesn’t offer that option, which can make it challenging to raise additional capital.

Single-member LLC

Advantages of a single-member LLC include:

• Liability protection: So long as owners protect the corporate veil, they won’t be held accountable for the liabilities of the business.
• Passing on ownership: Because the LLC exists as a separate entity, it’s easy to give ownership to another individual.
• Flexibility with taxation: Owners can elect pass-through taxation (using the personal tax return) or select corporate tax treatment.
• Easy to expand ownership: You can change from a single-member LLC to a multi-member LLC by filing an amendment with your respective state.

Disadvantages of single-member LLCs include:

• Complex formation: You’ll need extensive paperwork to form an LLC, because you’re creating a separate entity.
• Necessary compliance: You’re required to complete various compliance forms to remain in good standing. You’ll also need to make sure you protect the corporate veil to keep your liability protection intact.

Sole proprietorship vs LLC: Which is best for you?

If you’re operating as a single owner, you’ll need to choose between a sole proprietorship and a single-member LLC. Each has its perks. If you have basic business operations without any liabilities, a sole proprietorship is likely in your best interest. If you’re looking to put more credibility behind your business’s name, a limited liability company could be the better choice.