Handbook / Business structure

LLC vs sole proprietorship: how to decide for a one-person business

"Should I form an LLC?" is one of the first questions people ask when they start working for themselves, and the answers online range from "always" to "never". The honest answer depends on what you do, what could go wrong, what your state charges, and how much paperwork you are willing to take on. This guide compares the two structures most solo businesses choose between, using SBA and IRS descriptions, so you can make the decision on facts.

The sole proprietorship in one paragraph

The SBA says you are automatically a sole proprietor if you do business activities but do not register as any other kind of business. There is no separate business entity, so business assets and liabilities are not separate from personal ones, and you can be held personally liable for the business's debts and obligations. You can still use a trade name. It is easy to form and gives you complete control. The guide on sole proprietorships covers it in detail.

The LLC in one paragraph

The IRS describes an LLC as a business structure allowed by state statute, whose owners are called members. The SBA says an LLC combines benefits of corporations and partnerships, and that LLCs protect you from personal liability in most instances, so personal assets such as your home and savings are not at risk if the LLC faces bankruptcy or lawsuits. You create one by filing with your state, and states charge fees and often require ongoing reports.

Liability: the main difference

The structure question is mostly a liability question. Ask:

• What could realistically go wrong? A client injured on a job site, damage to someone's property, a costly professional mistake, a contract dispute.
• How large could a claim be relative to your personal assets?
• Would insurance cover it?

Two cautions. First, an LLC does not usually shield you from consequences of your own actions; it separates business obligations from personal ones. Second, banks and landlords often ask small business owners to guarantee loans or leases personally, which can bypass the protection. That is why many advisers treat insurance as the first line of defence and the LLC as a second. The guide on general liability insurance explains the basics.

Federal tax: closer than people think

For federal income tax, the IRS says a single-member LLC is disregarded as separate from its owner unless it elects to be treated as a corporation by filing Form 8832. In practice, a disregarded single-member LLC owned by an individual reports business income much like a sole proprietor. An LLC with two or more members is treated as a partnership by default.

There are a few differences. The IRS treats a single-member LLC as a separate entity for employment tax and certain excise taxes, so if it has employees, it reports employment taxes under its own name and EIN. And the SBA notes that LLC members are self-employed and pay self-employment tax under default treatment.

An LLC can elect corporate taxation. That can change how owners are paid and taxed, but it also brings payroll, separate returns and other costs. It is a decision for a tax professional, not a default.

Paperwork and cost

Sole proprietorship:

• no state formation filing
• possibly a trade name registration if you use a name other than your own
• the same local licenses and permits as any business

LLC:

• a formation filing and fee with your state
• a registered agent in the state, which the SBA says is required for LLCs
• often an annual or periodic report and fee, and in some states a franchise tax
• possible foreign qualification if you operate in other states
• the discipline of keeping LLC money separate, which helps preserve liability protection

The guide on forming an LLC walks through the steps.

Practical differences

• Banking: banks generally require formation documents to open an LLC account; for a sole proprietor, requirements vary.
• Contracts: an LLC signs as the business, which makes the separation visible to clients.
• Credibility: some clients prefer working with an entity, though many do not care.
• Exit and changes: the SBA notes some states may require an LLC to dissolve when members change, depending on the state and the operating agreement.

A decision checklist

An LLC may be worth considering if:

• your work carries meaningful risk of claims beyond what insurance covers
• you have significant personal assets
• you sign contracts with large clients or take on substantial obligations
• you plan to bring in partners

Staying a sole proprietor may make sense if:

• your work is low-risk and well insured
• you are testing an idea and expect to change course
• your state's fees are high relative to your income

Getting advice

The SBA suggests consulting business counselors, attorneys and accountants, and that advice is worth paying for here because state law varies. Go in with your risk list, your income estimate and your state's fees, and ask specifically what an LLC would change for you.

Start with the risk, buy insurance for what you can, then decide whether a state entity adds enough protection to justify its fees and filings.