Updated: Aug 26, 2021
by Ben Gran
LLC vs. Sole Proprietorship – The Legal Business Entity
Perhaps the biggest and most important difference between LLC vs. sole proprietorship is that when you form an LLC, you are creating a legal business entity (limited liability company) that has a separate legal identity that is separate from your personal identity as the business owner.
This might sound like something minor, but it matters. Setting up a legal business entity for your business makes your business “official.” Instead of just doing business as an individual person and having your customers pay you directly, setting up an LLC gives you the ability to do business as a business.
Making sure you have a business that exists as its own separate legal entity can help you in numerous ways. Here are are the benefits:
Separate Your Business and Personal Finances
One of the first things to do after forming an LLC is to get an Employer ID Number (EIN) and set up a business bank account for your business. This is an important step in creating a separate identity for your business because it gives you a place to keep your business income, a way to get paid in the name of your business, and a way to start building business credit.
Having a business bank account and an Employer ID Number makes it easier to separate your business and personal finances. When you have an LLC, and when you clearly separate your business and personal finances, you can expect a higher level of protection for your personal assets in case of a lawsuit. Doing business with an LLC can give you a “corporate shield” over your personal assets, protecting your personal finances from some of the worst-case scenarios of being in business.
If you are doing business as a sole proprietorship, without any of the legal protections or separate business finances that go with having an LLC, you might be vulnerable to losing your personal assets and life savings in case of a lawsuit. Doing business as a sole proprietorship leaves you unprotected in a way that forming an LLC does not.
Saving Time and Money on Your Taxes
Doing business as a sole proprietor or an LLC means you pay tax on all of your business income when you pay your personal tax return — the business income simply passes through to your personal tax return. However, a sole proprietor without any separate financial accounts could be wasting too much time juggling business and personal paperwork at tax time. You might be missing out on business-related tax deductions due to your combined personal and business bank statements.
When you have an LLC with a separate business bank account, business credit card, business line of credit, or other financial tools for your business, you will have an easier time managing your business finances and keeping track of tax-deductible business expenses to maximize your tax deductions.
Forming an LLC can also help you minimize your tax burden, compared to a sole proprietorship. That’s because LLC owners have the option of choosing to have their LLC file taxes as an S Corporation, which has different tax treatment for business income and can potentially reduce the amount of money that you have to pay in self-employment taxes.
Depending on how much you earn, how much you pay yourself in salary, and other details, you might be able to save thousands of dollars per year in taxes by forming an LLC and filing taxes as an S Corporation.
Bring on Investors or Business Partners
If you’re doing business as a sole proprietorship, by definition, your business cannot really grow; you’re in business for yourself, and mostly “by yourself.” Forming an LLC gives you the legal ability to expand your business by bringing on a business partner or bringing on investors who can buy a share of ownership in your business.
If you have already been doing business on an informal basis with other business partners while being a sole proprietor, forming an LLC is an even better idea: it gives you a formal business entity with a flexible management structure. You can run your LLC as a single-member LLC, or set it up as multi-member LLC. And you can change your LLC’s structure and Operating Agreement over time as your business evolves.
The bottom line is that doing business as a sole proprietorship can be too risky. By forming an LLC, you can:
benefit from various legal protections and financial advantages