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Sole Proprietorship vs. LLC: How to Choose the Best Business Structure
Explore the key differences between LLCs and sole proprietorships to choose the right business structure for your new venture.
So, you’ve started a small business. You know what you’re going to do and how to do it. But have you determined your business structure? Not sure what to register?
As you embark on this entrepreneurial journey, one of the critical decisions you’ll face involves choosing the right legal structure for your business. This decision can significantly impact your taxes, paperwork requirements, personal liability, and even your ability to raise capital.
For many new business owners, the choice often comes down to a limited liability company (LLC) or a sole proprietorship. Each of these structures offers distinct benefits and drawbacks tailored to different business needs. Understanding these differences is essential for making an informed decision that aligns with your business goals and personal financial considerations.
Let’s examine the unique characteristics of both LLCs and sole proprietorships, highlighting their distinct differences. This understanding will empower you to make a confident and well-informed decision about the structure that best suits your business needs and aspirations.
Sole Proprietorship vs. LLC: Which Business Structure Should You Choose?
What is a Sole Proprietorship?
A sole proprietorship is an unincorporated business with one owner, and it’s the simplest and least expensive type of business to form.
As a sole proprietorship, the owner’s name is the business’s name, though sole proprietorships can also operate under a brand name or trade name. The main characteristic of a sole proprietorship is that there’s no legal separation between the business and the business owner, so the owner is personally responsible for the business’s debts.
Here are some key takeaways to think about when considering a sole proprietorship:
- No required paperwork apart from industry-specific licenses
- No annual state filings
- Simplified tax filing
- No liability protection
- Difficult to obtain financing for the business name
- Harder to build business credit
What is an LLC?
An LLC (limited liability company) is a legally separate business entity that’s created under state law. It combines elements of a sole proprietorship, partnership, and corporation, and offers a lot of flexibility for owners. This structure is popular with many business owners due to the ease of setting it up and its cost-effectiveness. It’s also easier to maintain than other business structures such as S corps or C corps, and it can provide asset protection. One person can form a single-member LLC, or multiple people can form a multi-member LLC.
Here are some key takeaways to consider when forming an LLC:
- More market credibility
- Liability protection in the case of certain lawsuits and commercial debts
- More financing options
- Some paperwork
- Annual state filings
- Tax advantages and disadvantages
Advantages and Disadvantages of a Sole Proprietorship
Benefits:
- No required state paperwork unless there’s specific licensing, such as an occupational license and/or business license.
- No required annual state filings to complete unless there are specific industry filings required by your industry.
- All profits/losses are passed through to the owner’s personal tax return. These are typically reported on a Schedule C tax form that is filed with the owner’s personal tax return.
- May enjoy the tax benefits of being self-employed, from deducting certain business expenses to utilizing self-employed retirement plans.
Drawbacks:
- There’s no liability protection against commercial debts, lawsuits, and other obligations. This means you can be sued personally for commercial activities, putting your personal assets at risk.
- Many investors choose not to invest in a Sole Proprietorship, making it difficult to secure financing.
- Many financial institutions will refuse to establish business credit and will categorize loan requests as a “personal loan” rather than a “business loan.”
- You will have a lower amount of market credibility by not operating under a trade name. You can create a “Doing Business As” name (DBA) with your state’s Department of Revenue or the secretary of state, but this will require fees for the establishment and ongoing fees to continue to use the DBA name.
Advantages and Disadvantages of an LLC
Benefits:
- When you form an LLC, you are creating a business entity separate from yourself; you are not your LLC and your LLC is not you.
- You will have a higher level of market credibility.
- Liability protection against commercial debts, lawsuits, and other obligations as long as you set up and maintain your LLC properly, do not commingle personal and commercial assets, and avoid personal guarantees.
- It’s much easier to obtain equity and debt financing if you have a separate business entity as well as an established business credit score.
- With an LLC, you have the versatility to select from various tax structures. Typically, a single-member LLC opts to be taxed as a Sole Proprietor, where profits and losses directly impact the owner’s personal tax return. However, transitioning to S-Corporation status can offer financial benefits. In this scenario, while profits and losses still flow to your personal taxes, you can strategically reduce FICA taxes. This is achieved by assigning yourself a ‘reasonable salary,’ with the remaining profits taken as dividends. Significantly, only this salary portion is subject to Social Security and Medicare taxes, potentially leading to substantial tax savings.
- You can enjoy the tax benefits of being self-employed.
Drawbacks:
- State-related paperwork will be required, including any specific industry licensing.
- Annual state filings (and the associated fees) will be required as well, including any specific industry licensing fees that are required.
- Besides paying personal federal, state, local, and the self-employed version of FICA taxes, you might also be required to pay State Business Taxes and Unemployment Taxes.
- Costs for completing the tax return of an LLC may be higher than that of a sole proprietorship.
Sole Proprietorship vs. LLC: Which Business Structure Should You Choose?
Many business owners, particularly freelancers or consultants, start as sole proprietors because it’s easy and it’s attractive for new entrepreneurs, particularly those testing a business idea.
The best business structure for you will depend on many factors, and it’s best to consult a business lawyer and tax advisors before making this important decision. Make sure you take the right steps to establish your business.
Small Business Ideas that are Easy to Get Started
By Leslie Radford
