What Is the Difference Between a Sole Proprietorship & a Limited Liability Company?

By Carrie Ferland

Starting your own business is an exciting, challenging adventure, but certainly not without its difficulties. Even deciding what type of organization to register as can cause confusion, and making the wrong choice can be costly -- something a new business can rarely afford. Before you formally file your business as a new entity, consider your company’s needs, budget and the personal risks you could face if the initial execution doesn’t go as smoothly as you plan.

Limited Liability Companies

A limited liability company, often referred to as an “LLC,” is a formal for-profit entity comprised of one or more individuals. LLCs are separate from the individuals who own the organization and not considered a part of the owners’ personal assets. LLCs often start as a sole proprietorship, but as the business grows, the need for a more formal designation and legal protection becomes more apparent. For this reason, LLCs are most appropriate for larger individually- or multi-owned businesses that already have an established presence in the marketplace.

Sole Proprietorships

A sole proprietorship -- or simply proprietorship -- is a “self-owned” for-profit entity owned and operated by one person, called a proprietor. Sole proprietorships are a legal extension of a single person, often a natural step up from working as a contractor or “freelancer.” In fact, most states consider any individual doing business as another name other than his own to be a sole proprietorship, even if he never formally established himself as such. A sole proprietorship is a good choice for an individual who wants to own and operate his own business, especially if he has limited initial funding. The proprietor can also re-file as an LLC in the future as his business needs evolve.

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Advantages of a Limited Liability Company

Perhaps the most desired benefit is protection from personal liability -- your personal assets are not at risk when someone files a claim against your company. LLCs also enjoy various credits and other tax benefits not available to sole proprietors, provided there is at least one other individual operating or employed by the organization other than you.

Advantages of a Sole Proprietorship

Registering a new sole proprietorship is usually free, allowing any individual to establish her own business in a cost-efficient manner. Sole proprietors can apply for a free federal tax identification number, which they can use to establish a separate bank account for business expenses and tax purposes.

Disadvantages of a Limited Liability Company

To form an LLC, you must register your company with the state, which can be a costly up-front expense for a new business. In addition, the Internal Revenue Service does not recognize the existence of LLCs, which means you could have to claim the LLC’s revenue as your own income in addition to filing a tax return for the organization, which can get very confusing and very expensive.

Disadvantages of a Sole Proprietorship

One major drawback to a sole proprietorship is liability: while an LLC offers protection against personal liability, a sole proprietorship does not. If someone brings a claim against your company, your personal assets -- including your family home -- are at stake. Income taxes are also a little more involved for sole proprietors, and unless you removed your anticipated state and federal income taxes on a monthly or quarterly basis, you may end up with a substantial tax liability at the end of your fiscal year.

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Ways to Protect From Liability in a Sole Proprietorship

When you choose to run your business as a sole proprietorship rather than creating a separate entity for it, the principal disadvantage is that you’re personally liable for all debts you incur through the business. This is because state governments and the IRS don’t consider your business activities as being separate from your personal transactions. However, there are ways to protect yourself from liability.

Net Operating Loss for a Sole Proprietorship

It isn’t uncommon for sole proprietors to report losses in some years, which are the result of incurring business expenses that exceed total revenue. You may be able to use these losses to offset some of the other income reported on your tax return. However, if after combining your sole proprietorship losses with your other income the result is still a loss, you may have a net operating loss, or NOL, that you can deduct from the taxable income you report in different tax years.

Can a DBA Company Own an LLC?

You can own an LLC if you are a sole proprietor or partnership using a DBA, or "doing business as." A DBA is not an official company structure, but an identity -- usually called a "fictitious name" or "trade name" -- for business and/or recognition purposes. Your state will recognize your DBA identity, but the legal structure will typically be a single owner business or a partnership. Since states make the rules for DBA recognition, check with your jurisdiction to learn the legal way to own the LLC.

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