When building a small business, one of the most essential steps is deciding which business structure fits your company the best. Although the process and may be overwhelming, the legal entity of your business is critical to its success. Two of the most common entities available for startups and small businesses are the Sole Proprietorship and LLC.
A sole proprietorship is a structure that is owned by one person, the sole proprietor, where there is no legal difference between the owner and the business. This structure is reserved for individuals in business for themselves without partners, associates, or strict state and federal regulations. However, as there are advantages and disadvantages of LLCs, similarly, there are also advantages and disadvantages of sole proprietorships.
Considering being a sole proprietor? Then it’s important to realize that what a few benefits of a sole proprietorship are.
EASY AND COST EFFECTIVE: A sole proprietorship does not require legal documentation, fees or filings other than required license or permits depending on your services, products offered. At most, sole proprietors have to register their business name with their state’s corporate filing agency.
LESS REGULATIONS: One advantage of having one business owner is complete control of any and all decisions. A major benefit of a sole proprietorship is there are no state or federal regulations regarding shareholders or the organizational structure.
NO BUSINESS TAXES: The tax benefits of sole proprietorship can be rewarding, one of which is that the business is not taxed additionally. Profits are filed on the business owner’s personal income tax return and can be reinvested for company expansion or given directly to the owner. Tax rates for a sole proprietorship are also the lowest as well.
What are some reasons you wouldn’t choose a sole proprietorship over a business entity like LLC?
NO LIABILITY PROTECTION: Sole proprietors are susceptible to lawsuits and fully and personally responsible for any damage incurred. If the company is sued, creditors can go after everything including the owner’s personal assets. This is one of the main disadvantages of sole proprietorship and one which convinces many business owners to go with an LLC vs being a sole proprietor.
LIMITED FINANCING OPTIONS: Because of the structure of a sole proprietorship, funding from an investor is not allowed. Another entity, such as a partnership or LLC, is required. According to the Small Business Administration, sole proprietors are often limited to funding their businesses through consumer loans and credit lines.
The Limited Liability Company (LLC) is an extremely popular business structure. It combines elements of a corporation and partnership, however eliminating some of the difficulty of each. The LLC provides limited liability to its owners and shareholders very much like a corporation; and the LLC offers a pass-through income taxation like a partnership.
Do you know if an LLC is the right entity for you? To help you answer this question lets look at the advantages and disadvantages of the LLC.
Setting your company up as an LLC can provide you with many benefits.
FLEXIBLE: The structure of the LLC is more flexible than that of a corporation. Business owners create an operating agreement based on their own requirements and needs in there business.
LIMITED LIABILITY: A main feature of an LLC is that it protects it’s members of the company from personal liability for business liability and debts.
TAX OPTIONS: Income isn’t taxed at a corporate level. Losses are passed directly through to the individual shareholders, allowing them to claim the company’s losses on their personal tax returns. This feature is favorable to LLCs because it prevents double taxation, allowing profits to stay within the company for possible future expansion.
Although there are several advantages of LLCs, that doesn’t mean that there isn’t a downside to this entity option as well. In fact, there are a couple distinct disadvantages of LLCs, such as:
PASS-THROUGH TAXES: Previously stated as an advantage, pass-through taxes can also be a disadvantage of LLCs. As profits and losses are provided on each shareholder’s personal tax return, the pass-through taxation may be compelling when the shareholders do not receive dividends.
INVESTORS: Because the LLC business is flexible, investors may be reluctant to loan or invest their money.
TAXES AND FEES: Lack of a governing structure could cause issues down the road, requiring upfront costs, such as state and attorney fees. Also, in many states, such as California, New York, Alabama, Tennessee, Kentucky, Texas, and Pennsylvania, LLCs are required to pay a capital values tax or franchise tax. This tax can be based on profits, revenue, and the number of owners, the amount of capital in the state or any other factors.
Many new small business owners have a lot of questions related to LLC vs Sole Proprietorship. Here are some of the most common:
Can a sole proprietorship be converted to an LLC if I decide to do so later?
A sole proprietorship could eventually convert to an LLC, but conversion costs may be high. At a minimum though, you’ll need to make sure your business name isn’t taken, file paperwork, and get a new EIN from the IRS. You’ll need a new bank account as well.
Being so many advantages and disadvantages of LLCs and advantages and disadvantages of sole proprietorships, how do I choose which one is best for me?
It is essential for you to understand the difference between all business entities and decide which structure best fits your requirements as well as the needs of your organization. You may believe the tax benefits of sole proprietorship are enough to go that direction. But, if at some point you require investors to take your small business to the next level, keep in mind it’s a benefit of an LLC, making that the most viable option.
Can anyone help me decide whether I should be a sole proprietor or LLC ?
It’s best to consult an attorney for help with this decision and process, however with complete research, it’s possible to make the choice on your own. Another option is to talk with another business owner you trust, one in a similar position perhaps, and see what he or she thinks. Here are some questions you can ask:
Asking these questions and discussing the answers may make it clearer which decision you should make in considering LLC vs sole proprietorship.