Sole Proprietorship vs. LLC in California: Which One Is Right for You?

With a diverse population, robust job market, and innovative culture, the state of California offers numerous opportunities for success. 

However, starting a business in California can also be complex and challenging due to various legal requirements and regulations.

Luckily, doola’s Formation and Compliance services can help businesses navigate through California’s legal landscape with ease by handling all aspects of setting up an LLC on their behalf.

We take care of everything, from conducting name availability searches to preparing articles of organization, filing necessary documents, and obtaining necessary licenses and permits.

But before you dive headfirst into entrepreneurial waters in sunny California, you have to choose between sole proprietorship vs. LLC in California.

Let’s unravel the key differences between these two, as well as their benefits and drawbacks, so you can make an informed choice that aligns with your goals. 

Understanding Sole Proprietorship vs. LLC in California

Sole Proprietorship

As the name suggests, a sole proprietorship is owned and operated by one individual. It is the simplest form of unincorporated business structure with one owner. 

For example, if you sell goods and services online by yourself, you’re by default a sole proprietor unless you’ve adopted another business structure.

Unlike corporations or LLCs, there is no legal separation between the business and its owner, so the owner is personally liable for any debts or legal issues the business incurs. 

While sole proprietorships can operate under a business name, they mostly use the owner’s name as the business name.

Limited Liability Company (LLC)

An LLC is a legally separate business entity that combines elements of both corporations and partnerships/sole proprietors in terms of taxation, management structure, and liability protection. 

The standout feature of an LLC is its liability protection, which ensures that the owner’s personal assets are not at risk in case of legal action against the business. So, if a business goes under or is sued, the legal authorities can’t pursue its owners’ personal assets. 

Additionally, LLCs have pass-through taxation, which means that profits and losses are reported on individual tax returns, avoiding double taxation. This means they can opt to be taxed as a sole proprietorship (a single-member LLC disregarded for tax purposes), an S Corporation, or a C corporation.

This depends on which will save its members as much money as possible when tax season comes around. 

Key Differences Between Sole Proprietorship and LLC in California

While both sole proprietorship and LLCs offer a way to establish a business in California, they have distinct differences in their legal structure, finances, and operations. 

Let’s check out these key distinctions in details so you can decide which structure is best suited for your business needs.

Legal Distinctions

A sole proprietorship is an extension of the owner, with no separation between personal and business assets.

An LLC provides limited liability protection to its owners, which means the liability of an LLC is limited to its own assets.

Financial Distinctions

In a sole proprietorship, all business profits are reported on the owner’s personal tax return as self-employment income. The owner is also responsible for paying self-employment taxes in addition to regular income taxes.

In LLCs, owners can choose to be taxed as a corporation or as a partnership (if it has multiple members). It also allows more tax benefits, such as deducting expenses before calculating profits and distributing them amongst members according to their ownership percentages.

Operational Distinctions

A sole proprietorship offers complete control over all business operations since the owner is solely responsible for all the business’s successes and failures.

In an LLC, the decision-making process can be shared among multiple members. This can bring a diverse range of ideas and expertise to the table. LLC owners must also file annual reports with the state of California and pay franchise taxes based on their profits. 

Pros and Cons of a Sole Proprietorship in California

A sole proprietorship is the simplest and most common form of business ownership, but it also has its own set of advantages and disadvantages. 

Here are the pros and cons of having a sole proprietorship in California to help you make an informed decision about whether it is the right fit for your business.

Pros:

• Easy Formation Process: In California, there are no registration requirements for forming a sole proprietorship, which means that it can be started quickly and with minimal paperwork.

• Full Control: As the sole owner, you have complete control over all decisions, including financial matters and day-to-day operations.

• Lower Costs: There are no registration fees or ongoing annual fees like those associated with corporations or LLCs. Additionally, you are not required to file separate business tax returns.

• No Double Taxation: Your business’s profits and losses are taxed at an individual level through personal income tax filings (Form 1040). This means that any profits earned by the business will only be taxed once.

Cons:

• Personal Liability: There is no legal distinction between yourself and your business entity; therefore, you are personally responsible for all debts and liabilities incurred by your business.

• Difficulty in Raising Capital: As a sole proprietor, you cannot sell stocks or ownership shares like a corporation, and banks may be hesitant to lend money to a business structure without liability protection.

Pros and Cons of an LLC in California

Many business owners start out as sole proprietors, particularly those testing a business idea, because of the minimal paperwork and cost.

However, an LLC structure can also be a good fit for many business owners, especially if they want liability protection, a more organized management structure, and tax flexibility. 

Pros:

• Limited Liability Protection: In case of lawsuits or bankruptcy, only the company’s assets are at risk and not your personal assets, such as your home or car.

• Flexibility: Unlike corporations, LLCs have fewer formalities, making it easier to manage and operate compared to other business entities.

• Pass-Through Taxation: LLCs benefit from pass-through taxation, where profits and losses are reported on the owner’s personal tax return rather than at a corporate level.

• Credibility: Forming an LLC lends credibility to your business and can improve your chances of securing loans or obtaining contracts from larger companies.

• Easy Maintenance: LLCs have less paperwork and record-keeping obligations, making them easier to maintain than other business structures.

Cons:

• Cost: Starting an LLC requires filing fees with the state, depending on the type of formation and the number of members. Additionally, there may be ongoing yearly fees that need to be paid.

• Legal Compliance: LLCs are required to file annual reports with the state of California and, depending on the nature of their business activities, may also need to obtain licenses or permits.

Choosing the Right Structure for Your Business

A sole proprietorship in California is only a reasonable choice if you are not expecting significant net income, do not have (or do not plan to have) employees, and are not concerned with protecting your personal assets from business risks.

Instead, you might want to consider forming a California LLC. It would allow you to reduce your tax liabilities, limit your personal liability, and open your business to more growth opportunities.

Other factors you should consider are:

📌 Cost

Forming a sole proprietorship is relatively easy and inexpensive compared to creating an LLC. However, an LLC may save you more money in the long run with tax deductions and credits.

📌 Business Expansion

An LLC can easily bring on new members, whereas a sole proprietor may face challenges in expanding their business without changing its structure entirely.

📌 EIN and Sales Tax

LLCs can obtain an Employer Identification Number (EIN) from the IRS. As an LLC, you will also need to obtain a seller’s permit from the California State Board of Equalization to collect and remit sales tax.

📌 Finances

As an LLC, you can open a separate bank account for your business. This helps separate personal and business assets and makes record-keeping easier.

📌 Hire Employees

As a sole proprietorship, you are personally responsible for all employment taxes and insurance. In an LLC, the company is responsible for employment taxes and insurance.

Starting A Business in California? doola Can Help

doola’s Formation and Compliance services are tailored specifically for those looking to start a business in California. 

We understand that forming a business can be overwhelming, especially for first-time entrepreneurs. Our team of experts will guide you through each step and ensure that all legal requirements are met.

We will assist you in filing all the necessary paperwork with the California Secretary of State’s office to register your LLC officially.

Moreover, our experienced team will ensure that all necessary licenses and permits are obtained before commencing operations. This includes annual filings, tax returns, statements of information, and other documents to keep your business in compliance.

Book a free consultation with our experts to learn how we can make this process smoother for you!

FAQs

What are the tax implications of each structure in California? 

Profits from sole proprietorships are considered personal income and subject to individual income tax rates.

On the other hand, LLCs can be taxed as either a partnership or a corporation.

Which business structure offers better legal protection?

An LLC provides more substantial legal protection than operating as a sole proprietorship because it separates personal and business assets.

How much does it cost to register an LLC in California?

The filing fee for registering an LLC in California is $70 plus an additional $20 if you choose to file online instead of by mail.

Do I need a business license for a sole proprietorship or LLC in California?

In most cases, sole proprietors and LLCs are required to obtain some form of local or state license or permit before conducting business within California.

Can I change my sole proprietorship to an LLC later?

Yes, you can convert your sole proprietorship into an LLC at any time by filing the necessary paperwork with the state of California. This process involves applying for a new EIN and transferring any existing contracts or licenses to your new LLC.

However, this conversion may also involve complex filings and legal expenses.

Before making any changes to your business structure, book a free consultation with a formation expert.