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Selecting a legal structure is an important step in starting a business. The business entity choice affects many aspects of your business including taxes, personal exposure to lawsuits, funding and administrative tasks. Understanding the various financial and legal aspects of selecting the entity that best meets your business and personal needs may save considerable time and money to fix later.
There are four primary business structures to choose from including:
- Sole Proprietorship
- Limited Liability Company (LLC)
The sole proprietorship and Limited Liability Company are two of the most popular entities.
We will go into more detail on the advantages and disadvantages of the sole proprietorship and LLC to help provide some direction in making this decision. Keep in mind, that while we have a lot of experience in this area, we are not attorneys or accountants. This information shouldn’t be used in the place of professional advice.
The sole proprietorship is the most popular business structure. According to the SBA (Small Business Administration), over 70 percent of businesses form as a sole proprietorship.
Benefits of the Sole Proprietorship
The reason sole proprietorships are so popular is they are inexpensive, easy to set up and easy to administer.
Setting Up – The sole proprietorship is the easiest entity to form because there is no entity. Legally speaking, the sole proprietorship and the individual are the same.
Unless the sole proprietorship has employees, it won’t need to register for an EIN (Employer Identification Number). The business is identified by using the owner’s Social Security Number.
Ease of Operation – The sole proprietorship is the easiest of the four entities to administer. While there are aspects all entities will encounter, the sole proprietorship “entity” doesn’t add complexities such as state registration and recurring reporting requirements that are come with the LLC.
Cost to Form – Since there is no business entity to register, the sole proprietorship is the least expensive entity to form. In some states the owner is required to register their business name if they are doing business under a name that isn’t their full first and last name. This is called a DBA (Doing Business As) which is sometimes known as an Assumed Name or Fictitious Name. Expect to spend from $0 – $100 to register the DBA.
Disadvantages of the sole proprietorship.
Liability – The biggest disadvantage of a sole proprietorship is that it is not a separate legal entity. The owner is personally responsible for all debts and financial obligations incurred by the business. If the business is sued, the owner’s personal assets (such as homes, cars, personal property, etc) could potentially be used to satisfy any judgements.
How is a sole proprietorship taxed?
A sole proprietorship is considered a pass-through entity for tax purposes. The owner is taxed personally on the profits of the business. Business income is reported on IRS Schedule C which flows to the owner’s personal tax return.
Besides paying income taxes, owners pay self-employment taxes (Social Security and Medicare) based on the profits of the business.
How to form a sole proprietorship
The sole proprietorship “entity” isn’t an entity at all so there is nothing to form. Many states have business name registration requirements in order to operate.
Read more about the sole proprietorship and the registrations you may need.
Limited Liability Company (LLC)
Limited Liability Companies are a popular business entity choice for small businesses that want the ease of operation of the sole proprietorship but don’t want to risk their personal assets. The LLC provides the liability protection of a corporation without the administrative burdens that comes with a corporation.
Advantages of the LLC
Liability Protection – A Limited Liability Company is a separate legal entity from the owner(s) who are called member(s) of the LLC. This allows the assets of the business and the assets of the member(s) to be separate. The benefit is that if the business is sued or is responsible for debts or contracts, the member(s) are not typically personally responsible. This limits the risk of a member to the amount they invested in their business.
Sometimes people mistake this liability protection in thinking it will protect them if the business defaults on a bank loan. In almost every case when taking out a bank loan, the bank will require anyone owning 20% or more of the business to sign a personal guarantee stating the member(s) will repay the loan.
Taxation – One of the key benefits of the LLC is that it can be taxed like the other business entities (sole proprietorship, partnership and corporation (both C corporation and S corporation). This election is made with the IRS (Internal Revenue Service) and allows the opportunity to select the most efficient tax treatment. Even better, the tax election can be changed which can be useful as the business grows.
By default, the IRS considers a single-member LLC (SMLLC) to be taxed as a sole proprietorship, which is more commonly known as a “disregarded entity” for tax purposes. This means the LLC isn’t recognized as an entity by the IRS and profits or losses from the business are transferred from the LLC to the member. This pass-through taxation is the simplest to file and is usually the lowest tax burden for smaller businesses.
Regardless of how the LLC is taxed, it is still a separate legal entity providing liability protection for the members.
Electing corporation tax status may allow higher profit businesses to save on taxes. Assuming a reasonable salary is being taken by the owner, the remaining profits can be distributed as dividends which aren’t subject to self-employment taxes. The downside of this benefit is that an owner-operator has to become an employee and their wages are subject to payroll taxes and unemployment taxes. This also comes with the additional administrative tasks of filing payroll forms.
Credibility – Having the LLC designator at the end of a business name gives the perception to many customers that the business is larger and more professional.
Disadvantages of the LLC
Paperwork – Forming an LLC requires registering with a state and filing periodic reports, many of which are done annually. For a small business looking for liability protection and isn’t raising much money from investors, the LLC is often the better choice over the corporation because there are fewer administrative requirements.
Cost – Forming an LLC requires paying an initial filing fee, an annual fee in some states and in some states a franchise tax. The franchise tax is a tax on the privilege of doing business in that state a sole proprietorship usually doesn’t have to pay. See what it costs to form an LLC in each state.
How to form an LLC
Every state now allows single-member LLCs. Each state has different formation requirements, but the way it works in most states is that there is a filing with the state’s Secretary of State office (or similar state agency). Each LLC has to have a unique name, registered agent and physical address.
See more about the LLC and formation requirements.
Which Structure is Right for You?
While the sole proprietorship is the simplest and most popular entity for businesses starting, it won’t provide entrepreneurs with the legal and tax advantages they may be looking for.
Even though LLCs are promoted as having tax savings, those savings are usually not realized until a business is making $100k or more in profits.
Tax savings are great, but shouldn’t be the primary reason to form an LLC. Having the liability protection of an LLC can be considered as insurance to protect your personal assets in case the business faces legal issues. Owning a business brings a lot of risks. Operating as a sole proprietorship opens your personal assets to being used to pay for legal issues. The LLC helps keep those personal assets safe.
It’s hard to make a blanket statement as to what’s better between the sole proprietorship vs LLC. Every business has different levels of risk and every person has a different level of risk they are willing to accept. There is also the cost of formation and administrative requirements to take into account. Consider getting professional advice from an accountant and attorney before making your decision.