Sole Proprietorship vs LLC – The Best Entity for Service-Based Businesses

When starting a small business like a handyman service, HVAC business, or other local service business, one of the first things you must do is choose between a Sole Proprietorship or an LLC for your legal business structure (aka business entity).

This is an important decision because it affects how much you pay in taxes, your personal liability, and how much boring paperwork you have to deal with.

Unfortunately, it can be a tough decision because most articles out there give you vague advice and speak far too generally.

So in this article, I’m going to keep things specific to home-based service business, so I can make this decision easy for you.

What’s the best business entity for a small service business?

There are several types of business entities you can choose as your legal business structure, including Sole Proprietorship, Partnership, C Corporation, or LLC.

However, only two of these make sense for 99% of local service businesses: LLC or Sole Proprietorship.

Let’s talk about the differences and benefits of each.

Sole Proprietorship vs. LLC: A quick comparison

Sole Proprietorships are great if you’re running a side business and have no employees and just want to keep things simple. They are free to set up, require no paperwork, and are simple to manage.

LLCs are slightly more complicated and expensive to set up but have some advantages as your business becomes established. Generally speaking, the benefits of an LLC are that it provides more legal protection for your personal assets and potential tax savings. The downside is that an LLC is slightly more expensive and complicated to set up and maintain.

What is a Sole Proprietorship?

This is the most common business structure.

In fact, Sole Proprietorships make up 87% of non-employer small businesses (source).

Sole Proprietorships are easy to set up and provide you with complete control over your business. Many handymen, consultants, freelancers, and other small businesses choose this structure for its simplicity.

Owners of a sole proprietorship are responsible for taxes on the net business income, which is taxed at individual rates on their personal tax returns. This is referred to as pass-through taxation because all of the business income simply passes onto the owner’s tax return and is added to other income the owner may have. Owners are responsible for paying self-employment taxes (social security and medicare) as with all business entities.

In a sole proprietorship, the owner is generally liable for all debts and financial obligations of the business. This essentially means that your business is looked at as an extension of your person by the IRS and the law. If the business is in debt, the owner is in debt. If the business gets sued, the owner is essentially getting sued. Unlike a corporation, a sole proprietorship is NOT a separate entity. If you have employees working for you, then you are liable for any mistakes they make, so businesses with employees typically choose a different structure.

Here’s a quick breakdown of the pros and cons of a Sole Proprietorship.

Advantages

• It’s easy to set up. There is no state registration required unless you plan on using a fictitious name (any name other than your own). You do this by filing a DBA.
• If you work from home and use your own name for the business, you may have no startup costs at all.
• Much less paperwork and record keeping when compared to a corporation.
• Tax preparation is very straightforward and less costly when outsourced.

Disadvantages

What is an LLC (Limited Liability Company)?

LLCs are also very popular as they provide business owners with many of the benefits of a corporation without most of the downsides.

Like a corporation, an LLC can provide a financial and legal barrier for the personal assets of its members. A business owner who files under an LLC has basic liability protection from having his or her personal assets seized for debts or obligations of the business. This is especially valuable if you have employees and do not want to be held liable for their mistakes.

In addition to providing protection to personal assets, an LLC also works the other way around. It prevents the business’s assets from being seized from personal creditors trying to settle a personal debt. A creditor can only go after the portion of the profits that the partner who was indebted has allocated to him or her. Put simply; an LLC protects you from your business’s and partner’s debts and financial obligations. That’s a very good thing if you have a business partner or take on a lot of debt with your business.

By default, an LLC is taxed just like a Sole Proprietorship. The earnings pass through to the individual members (owners). The members are then responsible for income tax and self-employment taxes. This is known as a pass-through entity. However, members of an LLC can elect to be taxed as an S corp, saving big time on self-employment taxes.

Advantages of an LLC

• Member’s personal assets are protected from business debts and financial obligations.
• Not subject to corporate tax or double taxation. Taxes function similarly to a sole proprietorship.
• Limited paperwork and record-keeping when compared to a corporation.
• Fairly simple to set up.
• Has the ability to elect S Corp status, which can save a lot on Self-Employment taxes (see below).
• Boost in credibility to potential customers.

LLC Disadvantages

• More expensive to maintain than a sole proprietorship or partnership (usually a few hundred dollars per year).
• It takes slightly more work to set up than a sole proprietorship.

Additional Considerations for an LLC

To gain the legal and financial protection that forming an LLC has to offer, there are certain things you must do. The most important is to keep everything in your business separate from your personal assets. That means having separate bank accounts and credit cards and having all invoices and receipts have your LLC name on them. Make sure customers write out checks to the business and not you personally.

Also, there are very few legal protection benefits for a single-member LLC with no employees. That’s because if you make a mistake due to negligence, a customer can still sue you personally vs. the business. Often times the courts will “pierce the corporate veil” and consider you and the business as the same entity. The primary benefit of an LLC is that you can build up credit in your business’s name and take out loans based on that credit. In the event that your business failed for some reason, then creditors would most likely not be able to go after your personal assets to settle that debt. This is why obtaining the proper insurance for your service business is essential.

And finally, in many states, in order to be considered a separate entity from your business, you must have a partner with at least a 2% share of the business. Here’s a good article that explains this clearly.

How to Save Big on Self-Employment Taxes with an LLC

Despite having few legal benefits for a one-person handyman business, LLCs do have one huge benefit, which is that you can elect to be taxed as an S Corp.

You may have heard of the S corp and how it can save you a lot of money in taxes. And it’s true. When I elected S Corp status for my business, I saved over ten thousand dollars each year in taxes. This is why I recommend filing as an LLC to most full-time handymen, consultants, and freelancers. You cannot have a Sole proprietorship elect S Corp status.

The best part is that the more money you make, the more you save. Here’s an article that will give you an idea of how much money you can save with an S corp.

Which business structure is right for you?

There isn’t any single business structure that fits all handyman businesses. I recommend speaking with an accountant and potentially an attorney before making your decision. Every state has slightly different laws pertaining to business structures.

That being said, I typically recommend an LLC to most self-employed handymen, consultants, and freelancers who want to generate a full-time income or eventually hire employees.

A Sole Proprietorship is great if you operate part-time and never plan to hire employees or build your business into a full-time income.

I structured my handyman business as an LLC, and it was the right choice for me. This allowed me to later be taxed as an S corp and gave my business a boost in credibility.

It wasn’t difficult to set up, either. I simply went to the secretary of state’s website and filled out some online forms. Four hundred dollars in fees later, and I was the proud owner of an LLC.

If you need help applying for an LLC, then here is a place that can help you sort through the confusing documents. There is a fee involved, but it will save you some time.

Can you Convert a Sole Proprietorship to an LLC?

Yes, but it may lead to some headaches with any local business licenses that you’ve already attained.

Converting your Sole Prop to an LLC with the state is easy. Just file your articles of incorporation and list of members, just like when setting up an LLC (see link above). However, the problem comes with your city business license or permits. Those are most likely registered in your name and not your LLCs. So, you’ll likely have to jump through some hoops and pay some fees in order to change those licenses.

Quick Recap

• There are two main business structures a local service business should consider: Sole Proprietorship and LLC.
• A Sole Proprietorship is great for a part-time business with no employees or plans of growing.
• An LLC is the best business structure for most self-employed handyman businesses (and most self-employed people in general) because of the potential tax savings.
• Once you set up your LLC and start generating a full-time income, you can elect S Corp status to save a significant amount of money on self-employment taxes.

Now, listen to the podcast version of this article, which includes extra content. Listen right here or on your favorite podcast app!

HS029 – Sole Proprietorship vs. LLC – What’s the best entity for a service business?

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