Launching a startup is a fun and exciting process that requires a lot of forethought and wisdom. From selecting a business name to figuring out how to market your products, you have many things to think about when starting a new business. But before you can start selling anything, you need to decide what type of business you’re opening.

Two of the most popular small business structure options include an LLC (limited liability company) and a sole proprietorship. But which of these is the most appropriate fit for your new venture? Here are some of the key differences between the two and how to select the one that’s right for your startup.

What Is a Sole Proprietorship?

A sole proprietorship is the simplest business structure you can form. It’s composed of a single owner and is unincorporated. This structure is often selected by freelancers, retailers, online business owners, and other professionals who run a business by themselves. A sole proprietor holds personal responsibility for the debts of their business. This is because there’s no legal separation between the business owner and the business in the eyes of the law.

What Is an LLC?

An LLC is a business entity that’s legally separate from the owner. This type of business is set up under state law. It offers more flexibility because the owner has a say in their operational processes, management structure, and tax treatment. An LLC may be composed of multiple members or a single member. Forming an LLC provides the owner with liability protection from the financial obligations of the business.

What Are the Key Differences?

The business structure definitions above give a brief overview of some of the key differences between an LLC and a sole proprietorship. But before you can confidently choose between these two popular small business structures, here are a few more variances you should know about.

Formation

Forming a sole proprietorship is quite simple and involves minimal documentation. You just need to obtain state and city business permits or licenses as required in your particular location. You also need to register your trade name if you’re using one.

Forming an LLC is just a bit more involved. In addition to obtaining applicable state and city business permits or licenses and registering your trade name, you also need to file articles of organization. This is done through your state and may cost anywhere from $25 to $250. The purpose of filing articles of organization is to inform the state of your basic LLC information (including name, start date, address, and business purpose).

Personal Liability

In a sole proprietorship, you are personally liable for your company’s debts and any lawsuits that may be brought against your company. You’re also personally entitled to 100% of the profits your company makes. Some startup owners don’t like taking the personal risk that comes along with owning a sole proprietorship. If you have this business structure and your business assets can’t cover associated obligations, you may need to take care of those obligations yourself.  

One of the most attractive benefits an LLC offers is protection from personal liability. In this popular structure, the business is legally considered a separate entity. Therefore, it’s responsible for its own debts and financial obligations. Individual LLC members or owners cannot usually be held personally responsible or liable for the debts of their business.

Management Structure

A sole proprietorship means by definition that a single person handles all of the decision-making processes. As the owner of such a structure, you’ll have the final say on everything. This can be less complicated than taking important decisions to other managers or a board.

An LLC can be owned by multiple people or just one person. In a multiple-owner LLC, all owners may share in the decision-making process. A single manager may also be appointed to make important decisions on behalf of the company. In the case of an LLC that’s owned by just one person, the management structure and decision-making processes look similar to that of a sole proprietorship.

Separation of Business and Personal Funds

If you own a sole proprietorship, you can legally mix your business and personal funds. In the eyes of the law, there’s no difference between your business and you as an individual. However, most financial experts still recommend keeping your business and personal finances separate to make things easier when tax season rolls around. Utilizing accounting software can help track income and expenses efficiently, ensuring you’re prepared for taxes and financial reporting.

If your business is set up as an LLC, you must keep your business and personal banking records separate. This will make it much easier to file taxes and will help you maintain distance between your personal and professional liabilities.  

Taxes

Sole proprietors are only required to pay taxes on their business profit, not the full amount of their business income. They’re also taxed on a pass-through basis, meaning their profits are only taxed once. Sole proprietors are typically subject to self-employment taxes, which are typically paid quarterly.

Like a sole proprietorship, an LLC is also subject to pass-through taxation. However, if you own an LLC you may choose to be taxed as a corporation, partnership, or sole proprietorship. Both sole proprietorships and LLCs must collect and remit local sales taxes as applicable.

Which Business Structure Is Right for You?

It’s common for freelancers and consultants to begin as sole proprietors. It’s quick, easy, and affordable to get started this way, but there are associated liability risks. You can always set up a sole proprietorship and change to a different business structure down the road if you prefer.

If you want to create a clear legal separation between your personal financial obligations and those of your business, an LLC may be a better fit. You may be required to pay some initial registration fees as well as small annual fees to keep your LLC in good standing. Many professionals find that these fees are worth the peace of mind that comes along with this business structure.