A “sole proprietorship” is a business structure in which one person operates a company with no partners and unlimited liability for business debts. A limited liability company, or LLC, is an entity created by state law that allows one or more individuals to carry on a business and limit their liability in much the same way as corporations do. Whether a sole proprietorship or an LLC is the best structure for your business depends on several factors.
As a sole proprietor, your personal assets are at risk if a creditor sues you for business debts. By contrast, an LLC offers limited liability – creditors cannot sue you personally for business debts and must instead sue the LLC. If the LLC's assets are insufficient to pay its debts, creditors generally cannot come after your personal assets. There are a few exceptions, however, where a court may allow creditors to disregard your LLC’s limited liability and sue you personally for its debts. This could happen if you fail to publicly identify your business as a limited liability entity – by printing "LLC" or "Ltd." on your business cards, for example – or if you blur the LLC's separate existence by actions such as co-mingling business and personal funds in the same bank account.
Sole proprietorships and LLCs are bound by fewer formalities than corporations. A sole proprietor must only keep customary accounting records and report business income and expenses on his personal tax returns. An LLC must file articles of organization with the Secretary of State for the state in which the firm operates, pay a filing fee and an annual state LLC tax, and file a separate tax return with the Internal Revenue Service. A single-member LLC that elects to be taxed as an individual is not required to file a separate tax return; simply filing Form 1040 with the appropriate attachments to report business income and expenses is sufficient.
Taking on Partners
If a sole proprietor takes on a partner, the business automatically converts to a legal partnership, regardless of whether or not a formal partnership agreement is executed. The new entity is a general partnership with unlimited liability for both partners, and state partnership laws apply. A single-member LLC that takes on an additional member remains an LLC and continues to be governed by state LLC law. This difference can result in significant state and federal tax consequences as well as other differences, such as how assets are distributed upon dissolution.
Sole Proprietorship vs. LLC Taxation
Operating a sole proprietorship changes very little about your tax filing obligations. You must still file Form 1040 to report your earnings, including all income received from your business. You must attach Schedule C to your Form 1040 to report your business income and expenses, and your taxable income is adjusted accordingly. If you take on a partner, the IRS will tax you as a partnership. A single-member LLC may elect to be taxed as an individual or a corporation (either a C corporation or an S corporation, if it qualifies). An LLC with more than one member may elect to be taxed as a partnership or a corporation. The tax flexibility of the LLC is one of its major attractions.