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The personal liability protection of a Limited Liability Company (or LLC) is appealing to many solo entrepreneurs, however the sole proprietorship may be a better choice. The decision whether or not you should form an LLC depends on a number of factors including what your business sells, potential exposure to lawsuits, and business funding needs.
What is a Sole Proprietorship?
A sole proprietorship is essentially a business operating through the owner. To establish this type of business, the owner doesn’t necessarily need to file any documents, unless they plan to operate under a fictitious name (known as an assumed name, doing business as or DBA in some states).
There are virtually no fees required in order to start operating your business as a sole proprietorship as the individual and business are legally the same. The only fees you may need to get started are those for registering a fictitious name or any required business licenses or permits. There are no formation filing fees or annual report fees that need to be paid for this type of entity.
Overall, operating as a sole proprietorship makes it easier to manage funds. There is no separation between your business and personal accounts in a sole proprietorship. In order to maintain an LLC, you must be very careful to maintain your personal and business accounts separately or else risk losing the limited liability protection. There is no such concern about commingling funds in a sole proprietorship.
One of the downsides of operating a sole proprietorship is that you may find it difficult to grow your business quickly. While it is always possible to convert a sole proprietorship into a different entity down the road, forming and operating as an LLC, partnership, or corporation from the beginning can make it easier for you to take on partners, and raise funds from investors.
The biggest issue with operating as a sole proprietorship is that there is no personal liability protection for the owner. What belongs to the owner also belongs to the company in the eyes of the law and creditors. If the business is sued, the owner’s personal assets are potentially at risk.
Also, the options for a sole proprietor to raise capital is limited. The business owner typically needs to rely on loans and lines of credit to finance the venture.
What is a Limited Liability Company?
A limited liability company (or “LLC”) is a business structure that is a distinct entity from its owners upon formation.
The main advantage of establishing an LLC is the limited liability protection provided to the owners through the use of the entity. As long as the entity is properly formed and maintained, LLC owners (referred to as “members”) are protected from the business’s creditors seeking compensation from personal assets and funds.
Read – How Does an LLC Protect You
LLCs do not necessarily have an easier time raising money from investors, but they may have less trouble securing funding from financial institutions. Not only may an LLC appear more like a genuine business operation, but the entity also affords more protection to the owner from liability for business debts later on.
In contrast, owners may not like LLCs for the reason that they are subject to more regulations than sole proprietorships. In addition to the initial paperwork of filing the articles of organization with the Secretary of State and operating agreement, states also require annual statements or reports to be filed in order to maintain compliance.
For this reason, starting and maintaining an LLC is also more expensive than starting as a sole proprietorship. Each filing mentioned above requires a new fee to be paid to the state.
How to Choose Between the Sole Proprietorship and LLC
There are many important differences that need to be taken into consideration when deciding between entities, but the most important are discussed below.
Setting Up the Business
As discussed above, forming a sole proprietorship is as simple as starting to conduct business. There are no required documents that need to be filed with the state, other than a DBA (“doing business as”) certificate if the business plans to operate under a fictitious name.
Forming an LLC may require the completion and filing of Articles of Organization and the associated state LLC filing fee. LLCs should also have an operating agreement in place, even if there is only a single member. The operating agreement helps establish the guidelines for business procedures and can demonstrate that you have complied with LLC formalities in case your liability protection is jeopardized later in litigation or collections.
Sole proprietors pay self-employment taxes on income earned by the business. The owner and business are considered one tax-paying entity and all income from the business is viewed as the personal income of the owner.
LLCs can be taxed in a variety of ways. Single-member LLCs can be taxed as a sole proprietorship, meaning that the business tax obligations pass through to the LLC member. An LLC can also choose to be taxed as a corporation by filing an election with the IRS to be taxed either as a C Corp or S Corp.
The liability protection of LLCs may be particularly attractive to owners of certain businesses in higher liability industries. Although there are specific instances, such as negligence or intentional misconduct, LLC owners are not usually personally liable if there legal actions against the company.
Sole proprietorships do not offer any such protection. If the business is sued, the owner is at risk personally.
While there is really only one way to operate a sole proprietorship, there are many options for how you can structure an LLC. Even as a single-member LLC, there can also be managers with different responsibilities within the company.
As a sole proprietor, the business owner makes all the business decisions unilaterally with fewer regulatory and administrative constraints on the business.
A single-member LLC can also provide the owner with control of the business, but the owner has the added responsibility of filing initial paperwork and complying with annual reporting and maintenance fees.
The choice between sole proprietorship vs LLC isn’t an easy one, but choosing a legal entity is one of the most important decisions for new business owners. Weighing the risks and benefits unique to your business can help guide you to whether a sole proprietorship or LLC is the best structure.
Choice of Organizational Form for the Start-Up Business: https://scholarship.law.umn.edu/cgi/viewcontent.cgi?article=1111&context=faculty_articles
IRS-Sole Proprietorships: https://www.irs.gov/businesses/small-businesses-self-employed/sole-proprietorships