Sole proprietorships vs. LLCs: how to verify small businesses

Know Your Customer (KYC), Know Your Business (KYB), and anti-money laundering (AML) laws require financial institutions to verify a company’s (and its beneficial owners’) identity before offering the business financial services or products.

These laws are important because they ensure the business is not participating in financial crimes such as identity theft, money laundering, human trafficking, or terrorist financing. KYB and KYC processes can also protect financial institutions against fraud by helping them identify bad actors at origination — which is becoming increasingly important as small and mid-sized business fraud continues to rise.

Setting up your KYB processes can be complicated because different types of businesses require different verification processes to comply with the corresponding regulations. While some smaller businesses can go through your standard KYC workflows — more on this later when we talk about sole proprietorships! — other businesses need further due diligence and require separate KYB processes.

Beneficial ownership rules for business onboarding

Regardless of size, financial institutions need to verify the businesses they do business with. But how does that change from sole props to LLCs? A big piece of business onboarding compliance are the Beneficial Ownership provisions in FinCEN’s Customer Due Diligence (CDD) rule, which requires a bank to identify and verify the beneficial owner(s) of a variety of business types which the rule calls “legal entity customers.”

What is a legal entity customer under the Beneficial Ownership Rule?

Corporations, limited liability companies, or other entities created by filing a public document with a Secretary of State or other similar office are considered legal entity customers unless the rule provides an exception. As long as the legal entity customer meets its state requirements, it is considered to be separate from the business owners and officers. The business can own property in its name, be held separately accountable, and operate and own bank accounts.

What is a beneficial owner?

A beneficial owner is anyone with more than 25% ownership or control of the legal entity business. Beneficial owners can be individuals or another business. There will always be at least one beneficial owner, but there can be multiple additional beneficial owners. We went into greater detail on beneficial owners in a previous blog post, so check it out to learn more!

What does this mean for sole props and LLCs? Put simply, sole props are not legal entities and therefore are not subject to the beneficial ownership rule. Whereas LLCs are legal entities and therefore are subject to the beneficial ownership rule.

What is the difference between a sole proprietorship and LLC?

Let’s unpack the two most common types of small businesses and how to verify them.

What is a sole proprietorship?

Sole proprietorships — also known as sole props — are businesses that are owned and run by a single person or spouses, with no legal separation between the owner(s) and the business, even though such businesses may file with the Secretary of State to register a trade name or establish a tax account. A popular business model among freelancers, contractors, and smaller local businesses, sole props are often the default for a business that does not register as a legal entity customer under a state’s laws — and, thus, is not subject to the beneficial owner rule.

How do you verify a sole proprietorship?

Because a sole proprietorship is not a separate legal entity from the associated individual(s), beneficial ownership is not inherently obscured. From a compliance perspective, you should route the sole proprietor(s) — regardless of whether they have an Employer Identification Number (EIN) or not — through a KYC workflow. We also recommend performing fraud checks on the owner before onboarding them.

At a minimum, your KYC workflow should reasonably verify the individual’s full name, date of birth, physical address, and SSN. We also recommend you run checks on IP address and device, email address, and behavioral data.

What is an LLC?

An LLC (limited liability company) combines the characteristics of a sole proprietorship and a corporation. An LLC can have single or multiple owners, but unlike sole proprietorships, the owners are personally protected from being responsible for the business’s debts and liabilities. LLCs must file articles of organization with the state, and regulations for LLCs vary from state to state.

How do you verify an LLC?

You should route LLCs through your KYB workflow while simultaneously routing the businesses’ UBOs (Ultimate Beneficial Owners) through your KYC and fraud workflows.

Your KYB workflow should check the LLC against a business identity data source to verify the business is legitimate. Authenticate the business’s Secretary of State business registration and address, ensure the business and its beneficial owners are not on any government sanctions lists, and run all beneficial owners through a KYC workflow.

How do you know if you’re dealing with a sole prop or LLC?

The Beneficial Ownership Rule allows a financial institution to rely on the information the customer provides, but the easiest way to identify a sole prop is to have an additional field on your business onboarding application for the applicant to self-identify.

Balancing fraud prevention and compliance

If you noticed, as we talked about all the compliance requirements for onboarding these various types of businesses, we included fraud checks every step of the way. Financial institutions that are just thinking about compliance when they are onboarding sole props and LLCs are overlooking an important step. We believe most small business fraud can be stopped at onboarding, and whether you’re seeing small business fraud right now or not, it poses a huge threat in the financial services industry.

How does Alloy fit in?

Whether it be a sole proprietorship, LLC, or corporation, Alloy empowers financial institutions to automate more business onboarding decisions while protecting financial institutions from compliance and fraud risks. Alloy enables financial institutions to comply with KYB requirements in parallel with KYC, AML, and fraud checks on businesses and UBOs through a single API call for instant business verification.