Is an LLC a sole proprietorship?

Depending on how an LLC is set up, it can be treated as a sole proprietorship. As per the IRS, this distinction is mainly on taxation matters.^[1] Some types of LLCs – single-member LLCs (LLCs formed by one person) are taxed like sole proprietorships.

But this doesn’t make LLCs sole proprietorships. There may be similarities between LLCs and sole proprietorships in how each entity is formed, managed and taxed. However, there are also differences in these areas and others like compliance and liability protection. Continue reading for more in-depth information.

LLC vs. sole proprietorship: Formation

Is an LLC a sole proprietorship in regards to formation? The differences and similarities between LLCs and sole proprietorship formation can be explored based on many factors, from the number of people required to the implications of formation and more.

• Number of people in formation: While LLCs may be formed by multiple people, both LLCs and sole proprietorships are usually formed by one person. As mentioned above, an LLC formed by one person is referred to as a single-member LLC.
  
• Name used in formation: During formation, both LLCs and sole proprietorships can operate under a trade name. Sole proprietorships can also operate under an owner’s name. However, they can also assume a trade or brand name. The main difference is that LLCs will have the abbreviation LLC or “limited liability company” as part of the legal business name.
  
• Legal entity upon formation: The formation of an LLC automatically means that the LLC is a separate legal business entity. On the other hand, in a sole proprietorship the owner and the business are considered a single entity.
  
• Documentation/filing requirements: When forming an LLC anywhere in the U.S., the articles of organization must be filed with the respective state.^[2] What's more, any applicable business permits must be acquired. Also, LLCs that wish to use a trade name must register such names. Sole proprietorships don’t need to file anything with the state. However, a sole proprietor must acquire the relevant business permits and trade name (if they are using one).  Both an LLC and sole proprietorship doing business under a trade name must get a “doing business as” (DBA). In summary, sole proprietorships have far less paperwork requirements during formation when compared to LLCs.
• Cost of formation: The cost of forming an LLC is significantly higher, given that the cost of filing articles of organization alone varies from $50 to $200 depending on the jurisdiction. Sole proprietors don't incur this cost.

LLC vs. sole proprietorship: Management

In business, management is largely about decision making and factors supporting good decision making. The management of LLCs and sole proprietorships differs in a couple of key aspects:

• Decision making: In multi-member LLCs, decisions are shared (made collectively by owners based on agreed criteria). For instance, decision-making can be based on % of ownership. Decisions can also be made by appointed managers. In sole proprietorships, the owner has ultimate authority over all decisions, even if there are employees or experts hired to help out.
  
• Structure: LLCs have a more complex management structure when compared to sole proprietorships. This structure is outlined in the documentation (operating agreement) when an LLC is being formed. However, it's worth noting that operating agreements aren't a mandatory requirement during formation in some cases i.e., when an LLC is formed by one person.

For LLCs with multiple members, operating agreements are critical and complex with details such as the ownership stake of individual members, their voting rights, profit sharing, etc. LLCs can be managed by the owners collectively, or a management team can be appointed. Generally, decision-making is based on ownership. Individuals with larger stakes have more say.

While a sole proprietor assumes a simple structure, with the owner at the top acting as the sole decision maker, LLCs are more complex, with members having a say in decisions and receiving profits in line with their ownership stake. Generally, the vote of an LLC member with a 50% ownership stake is equivalent to a half vote on every company matter.

LLC vs. sole proprietorship: Liability protection

LLCs separate the owner/s from the business. In a sole proprietorship, there's no legal separation i.e., the owner is treated as the business. If the business files for bankruptcy, a sole proprietor must also file, and both business and personal debts and assets will be included during the bankruptcy proceedings. What's more, anyone who sues a sole proprietorship can sue the owner and go after their personal property. In simple terms, sole proprietors are personally responsible for liability (such as debt) attached to the business.

LLCs are separate entities from their owners. If a business goes bankrupt, the owners won't be financially responsible for the business's debt obligations. In most cases (especially when fraud and negligence aren't involved), individuals who sue an LLC can't sue the owners. While LLCs and other business structures can't offer absolute protection to owners, the legal separation offers more protection than in the case of sole proprietorships.

LLC vs. sole proprietorship: Taxes

When comparing LLCs and sole proprietorships in regards to taxation, LLCs fall into two main categories, namely single-member and multi-member LLCs. Comparisons can also be made in tax flexibility, additional taxes and tax rates.

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• Taxation for single-member LLCs: Can an LLC be taxed as a sole proprietorship? Yes, particularly single-member LLCs. On tax treatment, LLCs resemble sole proprietorships in that both are treated as pass-through entities by the IRS i.e., the business isn’t required to pay income tax. However, owners must report business income on Schedule-C (form1040) that attaches to a person's tax return, and income is taxed according to an individual's income tax rate.^[3]
  
• Taxation for multi-member LLCs: Multi-member LLCs (LLCs formed by multiple people) get different tax treatment when compared to sole proprietorships. For instance, all owners in a multi-member LLC must report and pay taxes on the income they receive from the business. This is done via form 1065.^[4] Additionally, all members must attach a Schedule K-1 to show their percentage share of business income when filing personal tax returns.
  
• Additional taxes: There may be similarities in additional taxes imposed on both LLCs and sole proprietorships. Assuming both have employees, payroll taxes must be paid. Sales taxes may also be applicable for businesses that sell taxable goods/services. These taxes vary based on the jurisdiction and other factors like the goods/services in question.
  
• Other taxes may be applicable for sole proprietors who qualify as self-employed business owners. Such individuals must pay self-employment taxes that cater to Medicare and social security. The taxes stand at 15.3% for the first $147,000 earned as of 2022. ^[5] Additional taxes may apply depending on the jurisdiction. They include business tax, LLC tax, and or franchise tax. Some local income taxes may also be applicable.
• Tax flexibility: While LLCs can choose a corporate tax status, sole proprietorships can’t do the same. In simple terms, LLC owners can decide how their business will be taxed. Sole proprietorships don’t have this advantage. LLC owners can select the default tax treatment i.e., pass-through taxation (where business income is passed over to the owners who pay personal income taxes for their ownership of the business) or choose to be taxed as S-Corporations or C-corporations.
• S-corporations are pass-through entities. C-corporations pay corporate income tax plus some corporate taxes if applicable in the state or locality. Most importantly, taxes are paid after offsetting losses, credits, and deductions. What's more, dividends enjoy a lower tax rate when compared to tax on ordinary business income. Retained earnings are also safe from income tax. This comes with huge savings.

LLC vs. sole proprietorship: Compliance 

Sole proprietorships are easier to form than LLCs. This is because a sole proprietorship with the owner's legal name as the business name doesn't need registration. As mentioned earlier, you also don't need to file articles of organization. Once you acquire the relevant business permits and register a trade name (which is not mandatory), you simply need to file taxes (as you would with personal individual income) and renew business permits when need be to run a compliant sole proprietorship business. 

LLCs have more complex compliance requirements. First and foremost, you must file articles of organization. LLCs must also file state-required annual reports (or statements of information) to maintain good standing with the state’s regulatory body, alert the state on business detail changes (i.e., address/phone no. changes) and pay applicable state renewal/filing fees.

What's more, LLC members have more responsibilities such as filing business taxes, drafting operating agreements, and recording ownership transfers. While some responsibilities aren't mandatory by law, they are necessary for running LLCs smoothly.

Is an LLC a sole proprietorship? LLCs may have similarities to sole proprietorships such as in taxation of single-member LLCs. However, they are different in many ways as discussed above. 

Frequently asked questions

Can you convert sole proprietorships to LLCs?

Yes. It is easy to convert your sole proprietorship into an LLC, and comes with plenty of benefits, including limited liability protection and tax flexibility. You can choose to file your LLC with the state yourself, or use LLC formation services like Nearside or Legal Zoom to skip the paperwork.

If you choose to convert your business to an LLC, start by selecting a name for your LLC. States may have unique LLC name requirements. Follow such requirements and include “LLC” or “Limited Liability Company” at the end of your name. Your LLC will also need a registered agent. Your attorney or you can act as the designated registered agent, or you can hire a service like Nearside to act as your registered agent.

You’ll also need to file articles of organizations which include the address, business name, registered agent, member names, etc. Before you finish, you should also register your business with the IRS. The tax agency has all the required information online in regards to LLCs and taxation. ^[6] LLCs may have new licensing obligations, which can be checked on the U.S. SBA (Small Business Administration) website. Finish by taking the relevant insurance policies and updating your bank details. You may also want to open a business bank account for your LLC.

When should a sole proprietor become an LLC?

If a sole proprietor wants to enjoy legal protection, setting up an LLC is recommended. An LLC owner is a separate entity from the business. This safeguards their personal property in the event of liabilities like debt. LLCs also come with benefits like tax flexibility. Converting can allow you to receive favorable treatment as a corporation that has many mechanisms of legally saving on taxes.

In most cases, sole proprietorships will also need to be converted to LLCs to allow growth. The structure of LLCs creates credibility and attracts pros like external funding. If a sole proprietor needs capital to grow their business, converting to an LLC will help to attract investors.

Is an LLC better for taxes?

LLCs offer more tax flexibility. While sole proprietorships are treated as pass-through entities by the IRS, where the business isn't required to pay income tax, this tax structure can't be altered. However, LLCs can be set up as C-corporations that offer huge tax savings for growing businesses. It is possible to offset losses, deductions, credits, dividend tax, and more by setting up an LLC as a C-corp. Sole proprietors don't have such advantages. Their only tax advantage is in the simplicity since taxation is treated as individual income, so there's no need for complex filing and other business tax compliance issues.

Sole proprietorship vs. S-Corp

For an S corporation to be formed, specific IRS code requirements must be met. An S Corp refers to an LLC/corporation that has chosen to be taxed as an S-corporation.^[7] Sole proprietorships are simply unincorporated businesses that lack legal separation from the owner.

LLC vs. Corporations

The differences between LLCs and corporations can be explored based on formation, taxation, and flexibility. LLCs are simpler to form than corporations (i.e., they require less paperwork). In regards to taxation, LLCs and corporations are similar in some ways, since the IRS allows LLC members to be taxed as sole proprietorships, partnerships, or corporations. In regards to flexibility, corporations are better in how they treat excess profits. While LLC income flows through members, S corporations can pass income/losses to shareholders.

References

1.IRS:  https://www.irs.gov/businesses/small-businesses-self-employed/sole-proprietorships

2. Legal information institute: https://www.law.cornell.edu/wex/articles_of_organization

3. IRS: https://www.irs.gov/forms-pubs/about-schedule-c-form-1040#:~:text=Use%20Schedule%20C%20(Form%201040,activity%20with%20continuity%20and%20regularity.

4. IRS:  https://www.irs.gov/forms-pubs/about-form-1065

5. SHRM: https://www.shrm.org/resourcesandtools/hr-topics/compensation/pages/2022-wage-cap-rises-for-social-security-payroll-taxes.aspx

6. IRS: https://www.irs.gov/businesses/small-businesses-self-employed/limited-liability-company-llc

7. IRS: https://www.irs.gov/businesses/small-businesses-self-employed/s-corporations