Are you considering starting a business as a sole owner or co-owner with other partners? Then operating a business as a sole proprietorship or LLC can be a hard choice.
For starting a business, choosing the right business structure is very crucial. Most small businesses or start-ups prefer two common structures, sole proprietorship or Limited Liability Company (LLC). However, consider a few things before deciding, such as foundation cost, liability protection, tax implications and Government regulations to follow.
Meanwhile, let’s understand the key difference between sole proprietorship vs. LLC. A sole proprietorship is owned and ran by one person. The owner empowers all profits and is solely responsible for the company’s debts, loss and liabilities. On the other hand, LLC is a legal entity where the owners’ liability is limited to their investments. In a word, the owners or members are not personally responsible for any debt.
Further, the sole proprietorship doesn’t provide you liability protection. For example, to clear business debts, creditors go after your personal assets and property, whereas LLC offers personal assets protection.
Moreover, LLCs provide a pass-through income taxation benefit. It means these businesses’ earnings pass straight through the owner or owners, without paying federal income taxes. Instead, they pay taxes at their individual tax rates. But as a sole owner, your business is not taxed separately.
This article presents more important factors on sole proprietorship vs. LLC to make the best choice for your business.
Key Facts About A Sole Proprietorship
A sole proprietorship is the simplest and common business structure. It is suitable for an individual without a partner, associate or any state, local or federal legal concerns.
Let’s know some interesting key facts about a sole proprietorship.
- Less expensive to establish a business.
- But initially, funding is not easy.
- No annual paper filling or legal documentation is required except for an industry-specific license.
- Difficult to build business credit.
- Pay only federal, state, local self-employment and Federal Insurance Contributions Act (FICA) tax.
- Fully responsible for every debt, loan, loss or lawsuit.
- No liability protection. Hence, personal assets are at risk if debts are not cleared.
What Are Advantages and Disadvantages Of Forming A Sole Proprietorship?
There are many advantages and disadvantages of sole proprietorship for many entrepreneurs. Unlike other corporations, it’s easy to set up and doesn’t need any legal procedures. However, it’s important to know the limitations, especially when you’re solely responsible for all liabilities.
Advantages of a Sole Proprietorship
The advantages for forming a sole proprietorship are:
Full Decision-making Authority: As there is no other co-member, you’re your own boss here. Thus, you’re free to act and make decisions by yourself.
Full Control on Revenue: As a sole proprietor, you’ve full control over the business. In a word, you control all revenues the business makes.
Minimum Paperwork: It’s the easiest and inexpensive business form to start. Here you won’t need to fill tons of paperwork. Unlike LLCs, you don’t have to register the business with the state. It means there is no requirement for annual state filling.
However, you need a business license or permit, depending on the local or state government regulations. All you need is to fill a registration form under your name or “Doing Business As” (DBA) form.
No Business and Un-employment Tax: Another advantage is that business profits or losses are filed on the owner’s personal income tax return. Hence, you don’t have to pay business taxes and unemployment taxes separately. You’ll only pay personal state, local, federal or FICA taxes. Also, unlike other corporations, tax rates are low.
Reinvest Personal Expenses: There are some other tax-benefits for being a sole owner, such as turning personal expenses into business expenses, for example, using your car for product delivery.
Additionally, you can make tax-deductible contributions with self-employed retirement plans like Simplified Employee Pension Individual Retirement Accounts (SEP IRAs) if you’re eligible. Or else, write off daily business expenses like marketing costs, business travel costs, meals and beverage costs for client entertainment etc.
Disadvantages of a Sole Proprietorship
Although the advantages are pretty compelling, the sole proprietorship may not be appropriate for all businesses. Here are the main drawbacks you need to consider.
No Liability Protection: As the business is not registered under state regulations, you’re considered self-employed. It means you’re on your own and won’t get any protection against business legal issues. As a sole proprietor, you’ll be personally liable for the company’s debts, losses, lawsuits and other legal obligations.
So, when the company is sued, creditors will go after your personal asset like car, home etc.
Limited Funding: Generally, banks and investors prefer to invest in established companies. Hence, it’s not easy to secure loans or get equity financing in a sole proprietorship, compared to other business structures. Thus, it limits the available funding for the business to start, develop and sustain.
Difficult to Build Business Credit: Furthermore, since all liabilities come from a single owner, the business relies alone on your investments and credit history. Hence, many banks and other financial institutions categorize your request as a personal loan instead of a business loan with a higher interest rate. Eventually, it becomes difficult to build business credit as a sole proprietor.
Additional Fees: When you don’t operate under a trading name, you’ll have lower market credibility. In turn, your business may look unprofessional. So, to solve this issue, register for a “Doing Business As” (DBA) name if your business has a separate name from your name.
However, this requires additional establishment fees and ongoing fees to continue with the name. You can check your state/country office to know the payment and filing method.
Hard to Sell Business: Finally, as you solely operate the business, it’s hard to sell it to someone else. So, in the event of your death, physical impairment or other inabilities to continue the company, the business ends.
Key Facts About A Limited Liability Company (LLC)
What is a limited liability company (LLC)? An LLC is a popular and flexible business structure in the US. It combines pass-through taxation like a partnership or sole proprietorship and limited liability to the owners and shareholders like a corporation.
Eventually, an LLC can have unlimited members who may be individuals, corporations or even other LLCs.
Let’s look at some key facts before forming an LLC.
- Easy to obtain financing.
- Limited liability protection against commercial debts and lawsuits while securing personal assets.
- More market credibility.
- Lots of paperwork, including annual state filing.
- Additional fees and taxes.
- Most LLCs require Employee Identification Number (EIN) if it has employees.
What Are Advantages and Disadvantages Of Forming An LLC?
Forming an LLC comes with some potential advantages and disadvantages. Whether you’ll choose it or not depends on your objectives and business requirements.
Advantages of an LLC
Let’s highlight on advantages of an LLC.
More Flexibility: First and foremost, the business structure is more flexible than a corporation or sole proprietorship. Business owners can create an LLC operating agreement depending on their own needs and requirements.
Limited Liability Protection: One of the biggest advantages of an LLC is it separates your personal assets from business assets. In other words, like S-corporation or C-corporation, you and your business are two different entities. Hence, LLC provides limited liability protection against any commercial debts, loss or lawsuit that the business incurs.
It means business debts can be cleared only using LLC assets. The owners only lose their invested money, not any personal assets. So, before starting a business as LLC, you need to consider the following potential liability risks as an owner.
- Personal liability for your LLC’s debts.
- Personal liability for your wrong action related to the business.
- Personal liability for wrongdoing by your co-owners or employees related to the business.
- LLC’s liability for member’s personal debts.
In the long run, as long as you fund LLC with working capital and don’t guarantee to pay off debts personally, your liability protection remains in place. The creditors won’t sue you or go after your personal account, car or home to collect debts.
Easy Funding and A Reliable Business Credit Score: When you run a business as an LLC, it becomes easier to generate funds and equity for having a separate business setup. Consequently, you can build a good business credit score. In other words, financial institutions and equity partners approve your request as a business loan instead of a personal loan.
Additionally, it gives you the advantage of all debt financing options to pay off high-cost debts, like small business loans, business credit card payments, rent, trade credit, debt factoring etc. Thus, you can reduce monthly debt payments and boost cash flow.
Pass-Through Taxation Benefits: Though corporations and LLCs may have some common features, there is no double taxation in LLCs. Generally, in LLC, losses pass through individual co-members, allowing them to claim the loss on their personal income tax returns.
Furthermore, being an LLC, you can pay tax either as a sole proprietorship, S-corporation or C-corporation.
- Paying tax as a sole proprietorship means all profits or losses go through the owner’s personal tax return.
- Paying tax as an S-corporation means all profits or losses go through the owner’s individual personal tax return. But there is a chance of reducing FICA taxes if only they can establish a reasonable salary and receive the remaining profit as dividends.
- Paying tax as a C-corporation means the business and owners are taxed separately. It pays taxes on its income at the corporate level. Then the shareholders pay taxes on the dividends paid by the corporation. It’s referred to double taxation.
High Market Credibility: You’ll have a high degree of market credibility with an LLC.
Disadvantages of an LLC
Despite having several benefits, here are some drawbacks with an LLC.
State Paperwork: Unlike a sole proprietorship, LLC needs state paperwork along with an industry-specific license.
Annual State Filing Fee: Additionally, you need to pay for an annual state filing, including an industry-specific license fee.
Additional Taxes: Unfortunately, you’ve to pay state business tax and unemployment tax along with state, local, federal and FICA taxes.
Higher Cost For Tax Return: Lastly, the cost is higher for completing a tax return in LLC than a sole proprietorship.
Sole Proprietorship vs. LLC- What Are The Differences?
Are you still confused about which business structure to choose? Let’s take a quick glance at the key differences between a sole proprietorship vs. LLC.
Forming the Business Structure
For instance, the sole proprietorship is the easiest and simplest form of business. There is no need for state-filing except for a license, permit and zone clearance from the local government. For this, you can create a legal business entity and file a DBA name for your business. Moreover, if you hire an employee or file any excise or pension plan tax return, obtain an Employee Identification Number (EIN).
In contrast, forming an LLC requires more paperwork. You need to file a unique name for the business. Additionally, you need to elect someone for tax and legal purposes. It can be either you as a sole proprietor or any partner if you’ve multiple business owners. Not to mention, IRS considers a single-member LLC as a sole proprietor automatically during taxation.
Further, you need to file a certificate of formation. This certificate is the legal document confirming that LLC is duly formed and officially recognized in the state where it’s formed. Also, you can create an operating agreement that outlines the rules and daily operations of the LLC. Even an EIN may be required in some states for tax requirements.
However, you need to pay an amount for filing paperwork. But still, these all documents will make your business a legal entity and helps to secure funds.
Generating Business Funds
No matter what type of business entity you file, funding is the main challenge. Many successful and experienced small business owners may suggest continuing your full-time job to save capital. This personal income can be the fund you need to take your business off the ground.
However, there is a risk of losing personal assets and savings with a sole proprietorship. But if you’re thinking of registering the business as a separate entity, it comes with a major benefit. By setting a business bank account, you separate the personal and business income, which provides liability protection. In short, you’re keeping personal assets safe when your business incurs any debt.
Moreover, unlike a sole proprietorship, it’s easy to get a business loan with a business bank account in an LLC.
But still, if your loan doesn’t approve, don’t worry. There are some other ways to generate funds for any start-ups. The most popular one is crowdfunding. Here you can offer gifts to donors for the contribution and try to make them a shareholder.
Additionally, many non-profit organizations offer microloans to new small businesses. You can reach to them and share the business idea to convince them to invest.
Meanwhile, research every possible way before moving forward as these financial structures are different from the regular ones. Some of them may or may not have tax benefits and legal protection. So, it’s better to consult an accountant for clarity.
Tax Implications on Business
The tax implication is slightly different in sole proprietorship vs. LLC. Once the business is registered, you’re separating personal and business finances. Your legal document contains the personal income tax return, other tax documentation and information on any debt you’ve.
Filing pass-through taxation in a sole proprietorship is much simpler than LLC. Moreover, unlike LLC, here you don’t even have to pay business tax and self-employment tax. The self-employment tax rate in the US is 15.3% that sole proprietors pay on their own.
Hence, it’s better to track money going in or out by keeping receipts, annual fees, mileage, 1099-S form etc., for tax purposes. Keep in mind the tax rate varies with your business type. So keep your NAICS code for statistical analysis.
On the other hand, as an LLC owner, the profits/losses will be listed on your and other members’ personal income tax return.
Furthermore, IRS (Internal Revenue Service) allows LLCs to select how the business will be taxed. It can be as a sole proprietorship, a partnership, a C-corporation or S-corporation. Another key point to remember is that IRS automatically considers an LLC a sole proprietor if it has a single member.
However, this is different in C-corporation, which subjects to double taxation. So, with LLC as a single member or sole corp, you can pay less tax.
Personal Liability Protection
Do you need legal protection for personal possessions? Then, LLC is the better option.
More or less, every new business has the risks of debts. Hence, you require legal protection to ensure the longevity and growth of your business. All you need is to identify the business type and associate potential risks.
In LLC, you won’t be held personally liable for the company’s debt or loss. It limits your liability to business assets only. In contrast, if you can’t pay off debts in a sole proprietorship, creditors or lenders will sue you personally. They will go after your personal assets to clear debts.
With this in mind, you can apply for liability insurance for additional protection to stay out of trouble.
Easy Supervising and Administrating
Sole proprietorship vs. LLC won’t be a hard choice if you desire to operate the business on your own terms.
As a sole proprietor, you’ll be the one who makes every decision and take all profit. However, running the business, tracking money and taking all responsibility for losses by risking personal belongings can be a burden. So why don’t you go forming an LLC?
It not only gives limited liability protection but also shares debts. Moreover, working with other personals and sharing the decision-making can take away the pressure on you. Though it has some shady parts, like a wrong commitment of partners can hamper your business reputation.
Altogether deciding which is better between sole proprietorship and LLC depends on your business entities. Focus on your requirement and business needs to find out which structure fits the best. So, start doing thorough research or even you can consult a lawyer for help.
Overall, if you look at the advantages of both, LLC may stand one step ahead. Personal assets protection and tax implications seem significantly beneficial for every new business. However, single-member LLCs are considered as disregarded entities. In effect, IRS collects business taxes through the owner’s personal income tax.
Additionally, as an LLC, you need to file an annual report with the secretary of state’s office. Otherwise, failing to file it can shut down your business. Conversely, there is no such headache you’ll have as a sole proprietor. Furthermore, unlike LLC, raising funds is a big challenge in a sole proprietorship.
In short, each has its perks. So, if you have a basic business operation without the need for liability protection, a sole proprietorship can be a good choice. Comparatively, if you need more market credibility and flexibility on taxation, a limited liability company is the best option.