LLC vs sole proprietor: which first, and when to switch

LLC vs sole proprietor: a sole proprietorship is you trading alone with no state filing, personally liable for its debts. An LLC is a business registered with your state that keeps most business debts and claims off your personal assets.

Most first-time founders should start as a sole proprietor and form an LLC when a specific event makes it worth the cost. If you are selling a physical product online with pre-orders, those events tend to arrive in the order below.

This is general US information, not legal or tax advice, and state rules differ, so check your own state's.

LLC vs sole proprietor: what's the difference?

You become a sole proprietor automatically when you start doing business on your own. An LLC exists only once your state accepts your filing. For federal income tax, the default treatment is the same: the IRS treats a single-member LLC as a "disregarded entity", so its profit goes on Schedule C of your own return and you pay self-employment tax on it, as a sole proprietor would. Self-employment tax is 15.3% (Social Security plus Medicare), worked out on Schedule SE once your net earnings from self-employment reach $400 in a year.

The two differ in what they cost, in paperwork, and in who owes the money when the business can't pay.

A worked example: a camping lantern sold on pre-order

The founder and her numbers are invented. The state fees are real, checked on each state's own site in October 2026.

Priya lives in California and is launching a rechargeable camping lantern at $60 under the brand name Ridgeline. She plans to test demand with ads, take pre-orders, then place a factory order. Each step below shows what she does at that point.

1. Start as a sole proprietor, with an EIN and a separate account

You are a sole proprietor from the day you start selling. To run as one properly:

• Get an EIN from the IRS. It is free, an approved online application gets one immediately, and you can give it instead of your Social Security number on business forms such as the W-9.
• If you trade under a brand name, most states require you to register it as a DBA (an assumed or fictitious business name) with the state, county or city. Choose the name first: see how to name your business.
• Open a separate bank account and run every business payment through it. Your bookkeeping needs it, and once you have an LLC, mixing business and personal money can cost you its protection (step 4).

Priya gets an EIN, files a fictitious business name for Ridgeline with her county, opens a business account and runs her ad test. She doesn't form an LLC yet. In California the $800 annual LLC tax is due every year until you cancel the LLC, even in a year the business doesn't trade, so an LLC formed before the test would cost her $800 even if the test told her to stop.

2. Take pre-orders as a sole proprietor

Each pre-order customer has paid for something you haven't made, and if you can't deliver, you owe them a refund. The amount at stake is the money they paid, and you can cover it by leaving that money in the business account until you place the order. That risk doesn't need an LLC. How much of the money can safely go toward a factory deposit is covered in what is MOQ.

Priya takes 200 pre-orders at $60 as a sole proprietor, and $12,000 sits in her business account.

3. Decide before you sign the manufacturer contract

The factory order is usually the first contract you will live with for months: a supplier account, payment terms, perhaps a mold you pay for. It usually follows a round of quotes from several factories. Sign it in the name of the business you plan to keep. Moving contracts, the bank account and the payment provider to an LLC later means redoing each one, and the SBA warns that converting a business structure can bring tax consequences.

The contract itself rarely adds debt, because factories usually take a deposit when you order and the balance before the goods ship. If step 4 or step 5 will apply within the next few months, form the LLC before you sign.

Priya's factory quotes $6,000 for 300 lanterns, with a $1,800 deposit now and $4,200 before shipping. The lantern has a lithium battery and will be in strangers' tents within months, so step 4 applies, and she forms the LLC first. In California that costs $70 to file the Articles of Organization, $20 for the Statement of Information due within 90 days, and the $800 annual tax, due by the 15th day of the fourth month after filing. The first-year exemption you may read about covered only tax years 2021 to 2023. Her first year costs $890, which is 7.4% of her pre-order money, or the sales from about 15 lanterns.

In Texas the same LLC would cost $300 to form, with a yearly report to the Comptroller and no franchise tax for a business her size. Forming in Delaware wouldn't avoid California's charge, because every LLC doing business in California owes the $800 there as well.

4. Get product liability insurance before the product ships

Once your product is in customers' hands, it can injure someone or damage their property. Product liability insurance covers financial loss when a defective product causes injury. An LLC keeps most claims against the business away from your home and savings, but it doesn't pay them, and the business still owes them. Get quotes once the product's final spec is fixed, and have cover in place before the first unit ships.

In Estate of Canavan v. National Healthcare Corp. (2004), a Florida appeals court let a negligence claim go ahead against an LLC member personally without setting the LLC aside. On veil piercing, Cornell's Legal Information Institute notes that courts may pierce the veil when an LLC operates more or less as an extension of its owner, and that the rules differ a lot by state.

Priya buys product liability cover before the factory ships, pays the $4,200 balance from the LLC's account, and keeps personal spending out of it.

5. Form an LLC before a co-founder starts work

A sole proprietorship has one owner. The IRS defines a partnership as two or more people doing business together, each contributing money, property, labor or skill and sharing the profits and losses, so taking on a co-founder without forming anything can make you partners. The SBA lists unlimited personal liability for partners, unless the partnership is set up as a limited partnership.

An LLC with two members is taxed as a partnership by default. Write an operating agreement before the co-founder starts: who owns what share, who decides what, and what happens if one of you leaves.

Six months after launch, a friend offers to run Ridgeline's marketing in exchange for a share. Priya already has the LLC, so she asks a lawyer to draft the agreement and an accountant to handle the change in how the LLC is taxed.

6. Ask about a tax election once profit is steady

An LLC changes nothing on your federal tax return by default. It can elect to be taxed as a corporation with Form 8832, or as an S corporation with Form 2553. An S corporation has to pay an owner who works in the business a reasonable salary through payroll, and employment taxes apply to that salary. Profit paid out above it as a distribution is not subject to employment taxes, which is how some owners end up paying less than self-employment tax on all of their profit. In exchange you run payroll and file a separate business return. Whether it saves money depends on your profit, so ask an accountant once you have a year of steady numbers.

A sole proprietor can't make either election. If an accountant recommends one, that is a reason to form the LLC.

How to move a sole proprietorship into an LLC

When a different order makes sense

• If you plan to sell shares to investors, ask a lawyer about a corporation instead. The SBA points out that corporations can raise money by selling stock.
• If you already have significant savings or a home with equity, a claim has more to reach, so the cost of an LLC is easier to justify from the first sale.
• If you sell a service or a digital product with little risk of injury, the events above may not come for years, and a sole proprietorship with an EIN can serve you until they do.
• If you live outside the US, these rules don't apply. Most countries have their own sole trader registration, and it is usually the simpler place to start.

Related questions

Before you register anything, test whether people will buy. Pre-orders usually come from a small ad test, and the factory contract in step 3 comes after you find a manufacturer.