Choosing Between a Sole Proprietorship and an LLC
Every new small business faces a slew of decisions right out of the gate: picking a business name, choosing business partners (if any), and setting up a business structure, to name a few.
One of the core decisions you may face is deciding whether you should operate your small business as a sole proprietor or as an LLC (Limited Liability Company).
This decision will impact the type of business you can run, your tax rate, your personal liability, and more.
Changing your business structure is possible, but it often costs time and money. To avoid having to restructure your business early on, it's important to understand the differences between sole proprietorships and LLCs so you can make the right choice for your goals.
Sole Proprietorship vs. LLC
Two common business entities for solo entrepreneurs are sole proprietorships and LLCs. While the two are common, they are quite different, each bringing different perks to the table.
First, let's take a look at sole proprietorships. Then, we'll examine LLCs and look at factors you can use to decide between these two business types.
The Benefits of Being a Sole Proprietor
A sole proprietorship is a simple way to start and organize a business.
Simply put, it's a one-person company where the person and the business aren't separated. This means the founder is liable for financial damages in the case of a lawsuit, leaving your personal assets at risk. Still, there are perks that come with this simple business type:
- Easy to establish: Businesses don't get easier to start than sole proprietorships. Because a sole proprietorship isn't a separate entity from the person starting it, very little paperwork is required to establish sole proprietor status.
In fact, you only need to speak with your local small business center to see if your state requires any paperwork or filings. It's possible none are required, in which case the only paperwork you'll need is to copyright or protect your business name and branding.
- Clean taxes: For tax purposes, sole proprietorships are hit and miss. The good news is that come tax time, filing taxes is fairly simple. Your tax return is essentially your personal income, because you are your business in a sole proprietorship. You'll also avoid corporate taxes, which can be costly in some cases. However, you will miss the potential tax perks that can come with being an LLC or corporation.
- Easy to operate: When it comes to managing business, sole proprietorships are about as easy as it gets. As the single member of your company, you're the only person you need to manage. This makes it easier to predict business costs, because often the only overhead you need to account for are utilities, supplies, and so on. There's no employee pay to factor in — except, of course, your own cost of living.
- Cheaper to start: All businesses have a cost, but sole proprietorships come with very few, at least out of the gate. There's very little, if any, registration to pay with a sole proprietorship. With a corporation or LLC, you'll need to consider articles of organization, corporate taxes, business licenses, and more.
Sole proprietorships are the epitome of straightforward. As a one-person operation, the perks are largely centered around being exactly that— a one-person operation. You know what to expect at tax time, you know how to operate and manage your people (you), and you know what kind of costs to anticipate.
Now, what about an LLC?
The Benefits of LLCs
LLCs are popular and for good reason: They're straightforward, flexible, and offer a number of perks. An LLC is a flexible business structure that allows for pass-through taxation.
This means business income isn't taxed at a corporate level, but instead at a personal level when the LLC owners file their taxes. This is unlike corporations, in which double taxation can occur, meaning business income is taxed at a corporate level and then again as personal income.
LLCs can be structured in any number of ways, meaning you can have various owners, a board, or operate as a single-member LLC. This flexibility is largely what makes LLCs popular, as they don't require the same strict setup as a C corp or S corp, in which you need a board of directors.
The perks of an LLC are many, but some of the more prominent ones are the following:
- Tax flexibility: LLCs have much more tax flexibility than many other business types. While LLCs can choose to be taxed like a C corporation, in which the income is taxed at the corporate level and at the personal income level, LLCs are also able to be taxed as individuals or S corporations where their income is only taxed once on members' personal returns.
- Liability protection: Unlike a sole proprietorship, LLCs offer personal liability protection. This means your business is a legal entity, separate from you. In the event of a lawsuit or a situation where damages must be paid, your personal assets will be safe from forfeiture.
- Flexible management: A C corporation requires a board of directors, which limits your flexibility as far as management is concerned. LLCs can be structured in any number of ways, meaning you can have a single-member LLC, a partnership, or something in between. This makes LLCs especially appealing if you plan on growing but don't have a partner the day you open.
- Members can often be protected: LLCs can offer protection to members, depending on their role in the company. If you file articles of organization and have numerous people involved, those people can have the same level of personal liability protection. This can make it easier to get partner buy-in, as they will know their personal assets are safe if they decide to go into business with you.
- Business bank account options: Sole proprietorships can qualify for some business banking opportunities, but LLCs have access to much more. If you're interested in securing business loans, LLCs make it easier to separate your business and personal finances. This allows you to build your business credit more easily and can open more doors as far as business loans and bank accounts are concerned.
Where sole proprietorships are all about simplicity and being streamlined, LLCs are all about flexibility. Corporations can be strict in their structure and tax regulations, but LLCs are made for customization.
Deciding between a Sole Proprietorship and an LLC
Both sole proprietorships and LLCs serve different purposes. As a result, neither one is the "best choice" for all business owners. To ensure your new business chooses the right organization, ask yourself the following questions.
Do you want to hire employees?
Sole proprietors can technically hire employees but are responsible for taking care of all personal income taxes and fees. You can also choose to use contractors, in which case you won't have to handle taxes in the same way but will likely have to issue I-9 forms.
If you plan on hiring numerous employees, an LLC can make more sense. This is because you'll have a clearer tax setup, and you'll have a management structure. This is especially true if you have a multi-member LLC, which allows you to assign hiring and employee management to an LLC member — this member could be you or could be another business partner.
How many people will you be in business with?
If you're planning on going into business with numerous people, a sole proprietorship is likely the wrong choice. You can have numerous LLC members, each able to take advantage of limited liability protection.
If you're not planning on flying solo, an LLC is the wiser choice to make. With an LLC, you and your partners can take advantage of legal protection, split business profits evenly if you desire, and ultimately customize the LLC to be the right form of business to suit your needs.
Do you have an accountant?
If you don't have an accountant, a sole proprietorship can be much easier to manage than an LLC when it comes to business taxes. This is because a sole proprietorship doesn't separate personal and business finances, making tax time a little simpler.
If you have an accountant or financial advisor, an LLC is going to be easier when it comes to taxes. As an LLC, your income tax returns can vary, depending on how the LLC is setup. An accountant will be able to easily handle your LLC taxes, whether you're running your LLC as a pass-through entity, have a member that's a disregarded entity and not included in taxes, and so on. No matter the case, a registered agent will be able to handle your taxes with ease.
Is this a high-risk business?
It's important to determine if your business is in a high-risk industry or selling a service or product that is a bigger gamble. For example, if you're a new business that hasn’t established credit or you’re in an industry where there are typically a lot of chargebacks, you could be classified as a high-risk business.
In either case, if you feel your business is high-risk and more susceptible to a lawsuit, an LLC is the logical choice. The last thing you want is for your personal assets to be subject to forfeiture because of a lawsuit, and an LLC will help prevent that. If in doubt, ask a financial advisor or business consultant to help determine which avenue is right for you.
What are your goals?
Think about your business goals before establishing your business. If you plan on keeping your business as a one-person operation, a sole proprietorship could suit you just fine. If you see rapid growth and plan on hiring additional employees, securing funding, and eventually selling your company, consider an LLC.
While you can restructure a sole proprietorship into an LLC down the road, establishing your business as an LLC now saves you the trouble and time when you're already established and swamped with work.
Both sole proprietorships and LLCs bring a lot to the table. The above questions will help you determine which is right for your business, but ultimately the decision is yours.
Sole proprietorships, LLCs, and your business
Your business, whether new or established, is subject to a number of decisions. Many of these decisions you can account for, while others will be unexpected and out of the blue. Right now, you have the opportunity to plan ahead by choosing a structure based on how it will impact your future business and financial decisions. With the right preparations, you can decide on a business type that helps your business not only succeed, but thrive.