Sole Proprietorship or LLC?

One of the most frequently asked questions I get is “Should I be a sole proprietorship or a single member LLC?” There is no one answer to the sole proprietor vs LLC issue, but the small business owner is often surprised to hear that in some cases the answer is that it is fine to conduct his business as a sole proprietor.

What is a sole proprietorship?

The first step in answering the question of sole proprietorship vs an LLC is to understand exactly what a sole proprietorship is, and what it is not.

A sole proprietorship is simply the individual business owner. There is no separate entity. Although it is a good practice for a sole proprietor to keep separate accounting records and to segregate his business assets and liabilities from his personal assets and liabilities, there is no legal distinction between them. All of the assets of the business are subject to the owner’s personal liabilities and all of the owner’s personal assets are subject to the liabilities of the business.

Many people refer to a sole proprietorship as a “DBA” and use those two terms interchangeably, but it is incorrect to do so. A DBA (short for “doing business as”) is simply an assumed or fictitious name that the business uses which is different than the true legal name of the business. While many sole proprietors conduct their business under an assumed name, or DBA, so do most partnerships and many corporations and LLCs. A “DBA” is not a form of business entity; it is an attribute shared by many types of entities.

Advantages of a Sole Proprietorship

There are several advantages to choosing a sole proprietorship over an LLC:

Lower start up costs. A sole proprietorship is not required to register as an entity with the state, saving filing fees which may range from $50 in some states to hundreds of dollars in states like Illinois and Massachusettts, or where there is a high annual minimum tax like California. Offsetting the savings to some extent, a sole proprietor who uses a business name other than his own name must register an assumed name, usually at the county level. That involves not only a small filing fee but also the cost of publishing a legal notice of the assumed name filing in a local newspaper.

No annual compliance. Unlike an LLC which must file annual reports with the state and pay annual fees to maintain its legal status, a sole proprietorship has no annual compliance requirements.

Ease of accounting. Other than keeping adequate records for tax purposes, there are no specific accounting requirements for a sole proprietorship. While it is wise for a business owner to keep his personal and business affairs separate, legally a sole proprietor can freely mingle his own assets and liabilities with those of the business, since there is no legal distinction between the individual and the business. An LLC, on the other hand, must segregate its assets and liabilities from those of the individual in order to preserve the limited liability protection offered by choosing the LLC form of business.

Ease of tax preparation. Both a sole proprietorship and an LLC typically have identical tax treatment because the IRS, by default, treats a single member LLC as a “disregarded entity.” In other words, the income and expenses of a SMLLC are usually reported on the owner’s Form 1040, just like a sole proprietorship. However, a SMLLC may choose to be treated as either a regular corporation or an S corporation instead of a disregarded entity. An SMLLC electing treatment as a corporation or S corporation is required to file corporate level returns as well as employment tax returns.

Disadvantages of a Sole Proprietorship

While a sole proprietorship offers advantages of simplicity and cost over an LLC, those advantages do come at some sacrifice.

Personal liability. The most significant disadvantage of a sole proprietorship vs. a limited liability company is that the owner of a sole proprietorship is personally liable for every debt and obligation of the business. This is true even if the debts are incurred in the name of the business. It is not necessary for a creditor to obtain a guaranty or to pierce through the business to reach the owner. The personal obligation is automatic as a matter of law. An LLC, on the other hand, generally limits the exposure of the owner (member) to losing the assets of the LLC. His personal assets are insulated from the liabilities of the business. While the limitation of liability is not absolute, it certainly is better in many cases than no protection at all.

It may limit ability to raise future capital. The downside of the freedom to keep minimal accounting records is that an owner’s failure to carefully segregate the income and expenses of the business may make it more difficult to accurately establish the financial results of the business for a bank or future potential equity investors. In addition, the fact that the business assets are potentially subject to the claims of personal creditors of the sole proprietor may reduce the value of the business or impair the ability to raise capital at all.

It may limit the transferability of business assets. A business may sign a contract or lease or obtain a permit or license. If the business is an LLC, bringing new owners into the LLC does not change the fact that the LLC is entitled to all of the benefits of that contract, lease, license or permit. That is true even if the entire LLC is sold. Many contracts, leases, licenses and permits do not allow assignment to another entity without consent. When a sole proprietor brings in new investors or transfers assets to a buyer, the sole proprietorship ceases to exist. A sole proprietor may find that he is restricted from transferring contracts, licenses or similar business assets to a newly-formed partnership or other entity or to a buyer of the business.

What is the best choice for your business?

There is no single answer to whether a sole proprietorship or an LLC is the “best” entity. Generally, if you have no expectation of growing the business into a substantial entity with outside capital; you do not expect to need to ever transfer intangible assets like contracts or permits to a buyer of the business and you do not foresee the possibility of incurring significant liabilities in the business, then the advantages of a sole proprietorship may make it the best choice for you. For example, if you build whimsical birdhouses and sell them at summer craft fairs, you may find no benefit from establishing your business as an LLC.

On the other hand, you should strongly consider forming an LLC if you see your business growing beyond your own activities and efforts, if you see potential business risks that might threaten your personal assets or if you might want to transfer intangible business assets to a buyer of the business.