When it comes to starting your own business, you have options on how to structure it. Two of the most common structures include a sole proprietorship or limited liability company (LLC). The benefit of a sole proprietorship comes down to simplicity and low cost, whereas the benefits of an LLC are connected to flexibility and liability protection for business owners. This article will take a deep dive in defining each of these business structures and how they differ from each other.
A sole proprietorship simply refers to an individual who owns a business and is the responsible party for any debts associated with the business. In terms of business structures, this is the simplest option due to its ease of setup and minimal cost. Some business owners begin with this business form and then gradually progress to more complex business setups. When setting up a business as a sole proprietorship, the business’ name can include the owner’s name or a fictitious name. If you decide to use a fictitious name, this will not be considered as a legal entity separate from you, the sole proprietor owner.
What do you need to set up a sole proprietorship? You will need to register your name and secure any relevant local licenses before you can be up and running. While this ease of setup is appealing, there are drawbacks to this business structure. The most distinct disadvantage of a sole proprietorship is that the business owner is still personally liable for any debts that business accumulates. For example, if your business runs into any financial trouble, creditors can file lawsuits against you. Any financial outcomes associated with these actions would fall to you and require that you pay for those costs with your personal funds.
When it comes to day-to-day operations as a sole proprietorship, business owners will often sign contracts with their name, have customers make checks out to the business owner’s name, and mix business and personal funds which is something that LLCs are not able to do. Additionally, as a sole proprietor, you can set up your bank account in your personal name. Taxation for sole proprietors is also fairly simple. Since you and your business are interchangeable, whatever income you earn through your business is directly earned by you, the owner. You will report your income and/or losses and expenses on a Schedule C in addition to the standard Form 1040. Your profits and losses are recorded on the Schedule C form and filed alongside your 1040. The “bottom-line amount from the Schedule C form is applied to your personal tax return, which is appealing for some business owners because business losses that you experience could potentially offset earned income from other sources.
It’s important to think carefully before setting up your business as a sole proprietorship. This setup comes with sizable risk if you face any kind of legal action that is brought against you or if your business collapses and you are unable to pay back loans that you initially took out. While there are clear disadvantages of a sole proprietorship, the benefit of a business structure such as this one is that you own 100% of your business and are not responsible for holding shareholder meetings or taking votes when it comes to management decisions. At its simplest form, you are the sole decision-maker for all aspects of your business. The alternative? Next, we’ll cover the ins and outs of a Limited Liability Company or LLC.
Unlike a sole proprietorship, the main purpose of an LLC is that it ensures business owners are not personally liable for debts or liabilities associated with their business. If an LLC filed for bankruptcy, its members would not have to use their personal funds to pay for any of the company’s debts. In terms of taxes, the IRS treats LLCs similar to a sole proprietorship or partnership. An LLC does not pay income taxes itself. Instead, you, as the business owner, list your business’ profits and losses on your personal tax return. As an option, an LLC can choose to tax itself as a corporation and would need to follow corporation tax law and filing requirements in order to do so.
When setting up an LLC, a business owner needs to follow a few steps including filing formal documents with their state, paying a filing fee, and complying with other regulations. Want a detailed breakdown on how to set up an LLC? Check out our article that covers the four key steps. In contrast to a corporation, an LLC is not required to issue stock and does not need to hold annual meetings or record meeting minutes.
For those who decide to start their business using an LLC, the benefits include flexible membership, meaning that there is no limit on the number of members that are a part of the business. In terms of management, business owners can manage the LLC themselves or elect a management group to do so. Additionally, an LLC offers more credibility for a business than a sole proprietorship. LLCs also experience fewer state-imposed compliance requirements and continual formalities. The main challenges that LLCs encompass include cost to form and maintain. And difficulties with transferring ownership of the LLC. In most cases with LLCs, all members must be in agreement on adding or removing members, and/or altering the existing members’ ownership percentages.
Now that we have defined an LLC and sole proprietorship, let’s take a closer look at the key differences.
Setting up a sole proprietorship requires very little cost outside of obtaining any required licenses or permits. LLCs require more upfront and maintenance costs. To get started, you will need to register with the state which will require initial registration and filing fees. Once you have obtained an LLC, you will be required to pay annual fees to maintain your registration and keep your LLC is in good standing.
LLCs are also required to abide by state laws that do not pertain to sole proprietorships. State regulations could require an LLC to have an operating agreement or a registered agent. This involves additional paperwork including annual information statements or reports that have to be filed by a certain date.
When it comes to naming your business, state regulations require that LLCs include the word LLC or Limited Liability Company at the end of your company’s name. Sole proprietorships must only ensure that they are not using a name already being used by another business in the same state.
If you’re running your business as a sole proprietorship, intermingling your business and personal funds is not an issue because the law regards them as the same. However, a Limited Liability Company requires that you keep your LLC funds and records completely separate from your personal funds. If you violate this rule, you risk the loss of your limited liability protection.
As a sole proprietor, you will be taxed as a self-employed individual. Additionally, the income from your business is classified as your personal income when it comes to taxes. Remember, in the eyes of the law, your personal and business funds are considered the same. The key difference here is that an LLC can be taxed either as a sole proprietorship, a partnership or a corporation. This comes down to the decision by the LLC. An LLC can decide to be taxed as a corporation. If not, it will be taxed as sole proprietorship or partnership, which ultimately comes down to the number of members it has.
When you start a business, you have many important decisions to make, including how you are going to structure it. The LLC and sole proprietorship structures are two of the most common. Both structures carry their own unique advantages and differences. Before deciding on one, it’s crucial to have a thorough understanding of both in order to decide which one is the best decision for you and your business.