Choosing the structure of your business as an entity is one of the most important decisions to make when it comes to being a small business owner, but it can be confusing. You need to understand your choices fully to make this decision since it will impact how much you pay in taxes, what paperwork you need to keep track of, and what happens if someone sues your company.
While most businesses operate as sole proprietorships, a business structure with an LLC can provide several benefits to your company. In this article, we’ll look at the difference between LLCs vs. sole proprietorships, so we can explain exactly how they differ in terms of formation, taxes, legal protection, and more.
What is a sole proprietorship?
A sole proprietorship also referred to as a sole prop, is the most basic type of business and easiest to understand. This structure means that your company is an unincorporated business owned by a single individual, where there is no legal separation between entity and owner.
As the owner of a sole prop, you have total control over the business and everything related to it. In this case, your business profit will be taxed like personal income, and you can do whatever you want after taxes.
Nonetheless, this structure has less protection for your assets than most other business structures. You will have to assume all the legal responsibilities for your business losses and liabilities.
This type of company is simple to create and operate, making it a popular choice among the self-employed, like freelancers or small business startups. You probably have sole prop without realizing it since it is the default type of company when you start working independently. Besides, no formal registration or process is required to establish your small business as a sole proprietorship.
Advantages of a sole proprietorship
As we mentioned, all the profits and losses are passed through you - the owner - and your personal tax return. These are typically reported on the Schedule C tax form that is filed with the owner's personal tax return.
You don’t need to fill in any required state paperwork, unless you need a specific licensing such as an occupational licence and/or business licence.
This also applies to the required annual state filings, unless there’s specific industry filings required by the industry you’re in.
Also, you may enjoy the tax benefits of being self-employed, such as deducting certain business expenses, like using your car for your business, for instance, and generally writing off regular business expenses such as marketing costs, business travel costs, just to name a few.
Disadvantages of a sole proprietorship
Since you operate as a single owner, there’s no liability protection against commercial debts, lawsuits and other obligations, meaning you can be sued personally for any commercial activities, putting your personal assets at risk.
It’s more challenging to find equity financing for your business, since many investors choose not to invest in a Sole Proprietorship.
It can be difficult to establish business credit, since again, many financial institutions will categorise your request as a “personal loan” rather than a “business loan“.
You might face a lower amount of market credibility by not operating under a trade name.
What is an LLC?
On the other hand, an LLC or limited liability company, is a structure that combines characteristics of both a corporation and a sole proprietorship. There are many types of LLCs with different characteristics. The single-member LLC is the most similar to a sole proprietorship, since it also consists of just one owner, who controls 100% of the business.
LLCs are popular amongst business owners because of their flexibility and protection. This is reasonably the next step after launching as a sole prop, because it is recognized as a legal separate entity, which protects your personal liability as the owner.
Additionally, single-member LLCs are generally treated as “disregarded entities”, which means that the business’ income tax obligations “flow through” to you as the owner and are filed in conjunction with the sole owner’s personal income tax filings, just as it would with a sole proprietorship.
LLCs have to be formed in the state in which they operate, and that can come wiith specific requirements, but overall, the process is relatively simple and affordable.
Advantages of an LLC
You get a higher level of market credibility, since it’s a registered company.
Protection of liability against commercial debts, lawsuits and other obligations. You don’t mingle personal and commercial assets, and avoid personal guarantees, so the liability protection will remain in place and creditors won’t be able to go after your personal assets in the event of a lawsuit.
It’s easier to obtain equity and debt financing if you have a separate business entity, and you can get a hold of small business loans, and other types of funding.
It combines the best of both worlds, since you get the benefits of being a sole prop as a single member LLC. By electing tax treatment as a sole proprietor, all profits/losses flow to the owner’s personal tax return as well as the tax benefits of being self-employed, just like the prior option.
Disadvantages of an LLC
You’ll have to deal with state-related paperwork that will be required, as well as any specific industry licensing.
LLCs have to comply with all annual state filings, its associated fees, and any specific industry licensing fees.
You might be required to pay State Business Taxes and Unemployment Taxes, as well as your personal federal, state, local and the self-employed version of FICA taxes..
The tax return costs of an LLC may be higher than that of a sole proprietorship.
Sole proprietorship vs LLC
Now that we’ve explained what they are, let’s dive into the differences. Below are the highlights of a sole proprietorship vs. LLC:
Taxes: Tax-wise, sole proprietorships and single-member LLCs have the same tax status, unless certain elections are made with respect to the single-member LLC.
Costs: Sole proprietorships are free to start and you probably already count as one, whereas LLCs require registration and have ongoing fees.
Liability: LLCs grant more protections to you as a person in case of legal issues.
Funding: Getting a hold of external financing options it’s generally easier to get for an LLC than for a sole prop.
Management and control: Even though it can depend on your particular business, sole proprietorships can offer more control than LLCs, but it also comes with more responsibility and certain risks.
For first-time business owners, building a company from the ground up will bring a lot of considerations that will define your path and your growth. Deciding the legal structure of their business is one of those very first considerations. Due to the many advantages aforementioned, we tend to recommend entrepreneurs to incorporate their businesses. The fastest and most efficient type of incorporation is in fact an LLC.
Disclaimer: The content of this article is based on the author’s opinions and recommendations alone. This material has been prepared for informational purposes only. It is not intended to provide and should not be relied on for tax, legal, or accounting advice. We suggest consulting with your tax, legal, and accounting advisor before engaging in any transaction.