When you're starting a new business, it's important to set up the right business structure. Most small business owners favor either a sole proprietorship or a limited liability company (LLC). But how do you know which one is the right choice for you? This guide will break down the differences between each entity to help you find the right option for your venture.
What's the difference between sole proprietorships and LLCs?
A sole proprietorship is an unincorporated business run by one person. It is one of the most common ways to start a business in the United States probably because it's also the simplest type of business to start and run.
If you want to operate as a sole proprietor, you do not need to take any action beyond the normal process of launching a new venture. Assuming you're the sole owner, you're automatically classified as a sole proprietor.
However, there is no legal distinction between you and the business. There are no liability protections separating your personal assets from your business assets. If something goes wrong in the business, you will personally be held responsible. And since the business is considered an extension of you, it's not taxed separately.
Consider setting up an LLC to protect your personal assets. An LLC is a legal entity formed at the state level. As an LLC, there's a separation between you and the business. This separation means you receive liability protection from any debt or lawsuits the business incurs.
To set up an LLC, you must register your business with your state's secretary of state. Every state has different criteria for setting up an LLC, so research the guidelines that apply to your area. Compared to a sole proprietorship, registering an LLC is time-consuming.
LLC taxes are also more complex. The IRS classifies LLCs as "pass-through entities" meaning that the LLC does not pay federal income taxes on business income. The income "passes through" to individual members of the LLC who pay taxes on income earned from the LLC on their individual returns.
Sole proprietorship: Pros and cons
Pro: Easy to set up
A sole proprietorship is the fastest way to start a business. There's no state paperwork to fill out or fees to pay, which makes it a popular option for freelance contractors. It may be a good choice if you're looking to test a service-based business.
Pro: Full ownership
As a sole proprietor, you're the only business owner, and you're not required to conduct shareholder meetings. You have complete control over the business, from operations to finances and anything else related to how your company functions. A sole proprietorship offers a level of freedom and flexibility that corporations and other business structures can't.
Pro: Straightforward tax filing
Like LLCs, sole proprietors are considered pass-through entities by the IRS. Therefore, sole proprietors don't file separate tax returns for their businesses.
You report any income you earn on your personal tax returns. During tax time, submit a separate form for your sole proprietorship taxes, Schedule C, which you file along with your personal income tax form, Form 1040.
Pro: Simplified banking
Sole proprietorships benefit from straightforward, simple banking.
"Sole proprietorships are the only kind of business entity that doesn't require a business checking account in order to operate a company," wrote NerdWallet.
As a result, you do not need to open a second bank account for business banking, unless you choose to do so. All you need to start your sole proprietorship is a personal checking account.
Operating as a sole proprietor can give you a lot of freedom, but there are drawbacks to consider.
Con: No liability protection
Sole proprietors are personally responsible for any liabilities the business incurs. That means if you're sued for damages caused by the business, your personal assets will be at risk.
"As an example, LLCs offer protections that keep creditors from being able to seize your personal assets (in most cases) and prevent people from suing you personally for business-related issues," wrote NerdWallet.
Con: Difficulty accessing business credit
Lenders and financial institutions typically prefer to work with established businesses. This preference doesn't extend to sole proprietors, who are considered riskier investments than LLCs or corporations.
As a result, you could struggle to access business funding as a sole owner. To get funding for your venture, you may need to take out personal loans, which have their own pitfalls.
[Read more: How to Choose the Right Business Entity: Sole Proprietorship]
If you're on the fence, it helps to consult with other business owners to learn what path they took when first getting started.
LLC: Pros and cons
Pro: Liability protection
It's in the name: limited liability company. Setting up an LLC creates a separate entity, limiting your personal liability regarding business operations. You're protected against lawsuits, debt, and other business obligations as an LLC. You'll only need to set up your LLC correctly and avoid mixing business and personal assets.
Pro: Credibility
LLCs are perceived as more credible by clients, lenders, and financial institutions. If you need to access funding, it's easier to do this as an established LLC. Banks and investors tend to view LLCs as having a lower risk than sole proprietorships.
Pro: Flexible management options
One or more members can own an LLC.
"Managers of an LLC can be either members or outsiders, allowing member-owners to be as involved in the management of their business as they want," wrote NerdWallet.
Bringing on additional partners can help lighten the workload of getting your business off the ground. It also allows you to access different skill sets that can help your company grow more quickly than if you were operating solo.
Pro: Simple tax filing
Like sole proprietors, LLCs are pass-through entities.
"As the owner, the tax liability belongs to you and passes through to your personal tax return. For multi-member LLCs, pass-through taxation occurs for all members according to the amount of profit they received from the company that year," explained LegalZoom.
An LLC can also be taxed as a sole proprietorship, a partnership, or a corporation. Speak to a tax professional to learn what options are available and right for your situation.
Con: More paperwork and fees
One of the downsides of setting up an LLC is the paperwork that comes with it. You'll have to complete any forms your state requires and pay the additional fees that go with it. Most states require that you file annually.
Con: Self-employment taxes
LLCs are subject to self-employment taxes, which means you are taxed at the individual level for profits made through your LLC. In practice, this means your LLC could push you into a higher tax bracket, leading to higher taxes than if you are taxed as a corporation.
[Read more: What Is a Limited Liability Company (LLC)?]
Which business structure is right for you?
Choosing a business structure is an important decision every entrepreneur must make. And the right choice for you depends on your goals and the type of business you run.
If you're looking to hit the ground running, operating as a sole proprietor is the quickest way to start. There's no paperwork to fill out, and you can focus solely on finding clients and generating revenue. However, you lose out on the liability protections that LLC members enjoy.
If you're on the fence, it helps to consult with other business owners to learn what path they took when first getting started. It can be beneficial to seek out the guidance of an attorney or a certified public accountant who has experience working with small businesses.
This article was originally written by Jamie Johnson.
[Read more: When — and Why — to Consider Changing Your Business Entity]
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