LLC vs sole proprietorship: which fits a small online shop

LLC vs sole proprietorship: the short answer

The main difference between an LLC and a sole proprietorship is personal liability. In a sole proprietorship, the SBA says you can be held personally liable for the debts and obligations of the business. An LLC is a business structure allowed by state statute, so you form one with a filing in your state, and the SBA says LLCs protect you from personal liability in most instances.

For one owner, the default federal tax treatment is the same. The IRS treats an LLC with one member as an entity disregarded as separate from its owner, so its profit goes on the owner's personal return, and an owner who runs a trade or business through it is subject to the tax on net earnings from self employment in the same manner as a sole proprietorship.

That leaves cost and paperwork. A sole proprietorship starts the moment you sell: you're automatically considered to be a sole proprietorship if you do business activities but don't register as any other kind of business. An LLC takes a state filing fee to form, and some states add a yearly fee, tax or report to keep it active.

LLC and sole proprietorship side by side

The table compares the two structures for one owner selling online in the US. Federal rows come from the IRS and SBA. State fees differ, so the state rows use California as one example and your state may charge more or less.

Personal liability: what an LLC changes

Liability is the main reason to consider an LLC. The SBA says sole proprietorships do not produce a separate business entity, and that you can be held personally liable for the debts and obligations of the business. In practice, the shop's debts are your debts.

An LLC puts a legal line between the business and you, but the line has gaps. The SBA says the protection an LLC or corporation gives your personal property from lawsuits has limits, and that business insurance can fill in any gaps in coverage. The SBA does not say where those limits fall, so ask an attorney in your state if a specific risk worries you.

Keeping money apart is one habit the SBA points to. It says business banking offers limited personal liability protection by keeping your business funds separate from your personal funds, and that as soon as you start accepting or spending money as your business, you should open a business bank account. Paying shop costs from that account and keeping records of what goes in and out make the split easier to show.

Taxes: a one-owner LLC files like a sole proprietor by default

The IRS does not give every LLC the same tax treatment. Depending on elections made by the LLC and the number of members, the IRS will treat an LLC as either a corporation, partnership, or as part of the LLC’s owner’s tax return (a “disregarded entity”). An LLC with one member is treated as an entity disregarded as separate from its owner, and an LLC with two or more members is classified as a partnership. In both cases the default can be changed with Form 8832.

A sole proprietor reports business income on Form 1040 with Schedule C, Profit or Loss from Business, and pays self-employment tax on Schedule SE (Form 1040). A one-owner LLC that keeps the default ends up in the same place: when the owner is an individual, the IRS says the LLC's activities generally go on Form 1040 or 1040-SR Schedule C. The IRS sets the self-employment tax rate at 15.3%, made up of 12.4% for Social Security and 2.9% for Medicare, and you owe it when net earnings from self-employment are $400 or more.

One difference exists even with the default: the IRS treats a one-member LLC as a separate entity for employment tax and certain excise taxes. That matters once you hire staff. A bigger change comes only if the LLC elects to be taxed as a corporation with Form 8832. That election brings different returns and rules, so it is a question for a tax professional.

Cost and paperwork for each structure

A sole proprietorship has no formation filing. The SBA says that if you conduct business as yourself using your legal name, you won't need to register anywhere. If you sell under a shop name instead of your own, the SBA says most states require you to register your DBA if you use one. Either way, you still need whatever seller's permit, sales tax registration and local licenses your state and city require.

An LLC adds a state filing fee to form it, and in some states a recurring fee, tax or report. Fees are set by each state. California is one example: the articles of organization filing is $70, the Statement of Information costs $20 and is due within 90 days of forming and every two years after that, and the annual tax of $800 is due even if the LLC is not conducting business, until you cancel the LLC. Check your own state's business filing office for its numbers.

At the federal level, an EIN from the IRS is free for either structure. For a one-owner LLC, the IRS says most new single-member LLCs classified as disregarded entities will need to obtain an EIN, and that you should form your entity through the secretary of state before you apply for an EIN. For beneficial ownership information (BOI) reports, FinCEN now says U.S. companies are exempt from beneficial ownership information reporting and no longer have to file BOI reports.

How to choose between an LLC and a sole proprietorship

These questions put the general rules above in order for a small online seller. For a decision about your own business, talk to an attorney or accountant in your state.

1. Look at what could go wrong

   The SBA calls a sole proprietorship a good choice for low-risk businesses and owners who want to test their business idea, and an LLC a good choice for medium- or higher-risk businesses and owners with significant personal assets they want protected. Ask how a problem with your product could hurt someone or lead to a dispute, and what you own that a claim could reach. Food, skincare and children's products raise different questions than a digital download.

2. Look up your state's LLC costs

   Find the formation fee and any yearly fee, tax or report on your state's business filing office site. Weigh a yearly charge, such as California's $800 annual tax, against what a shop that is still testing an idea expects to earn.

3. Think about money you may borrow

   The SBA says banks are hesitant to lend to sole proprietorships. If you expect to need a business loan, ask your bank which structure it looks for before you decide.

4. Decide whether to start simple and switch later

   You can start as a sole proprietor and form an LLC later, once sales are steady. The next section covers what the switch involves.

Switching from a sole proprietorship to an LLC later

Moving from a sole proprietorship to an LLC usually means forming a new LLC with your state, then moving the business into it: open a bank account in the LLC's name, and update your marketplace, payment processor, sales tax and license records. The SBA adds a caution: you may convert to a different business structure in the future, but there may be restrictions based on your location.

On the federal side, the IRS says that as a sole proprietor you need a new EIN if you incorporate, form a partnership or declare bankruptcy. Forming a single-member LLC is not on that list. For LLCs, the IRS says you do not need a new EIN if you use your sole proprietor EIN for your single-member LLC and don’t choose to be taxed as a corporation or an S corporation and don’t have employees or owe excise tax.

Rules for each step vary by state and sometimes by city. This page is general information, not legal or tax advice, and a local attorney or accountant can tell you how the change works where you live.

Where Nation fits

Questions about LLC vs sole proprietorship