Chart a course for your company by deciding which business structure to use: a sole proprietorship versus a limited liability company (LLC). Most small businesses start with an idea and grow organically. As your company begins to expand, you may wonder whether the time has come to form a legal business entity. Discover the advantages and disadvantages of a sole proprietorship and an LLC before starting a business.
What Is a Sole Proprietorship?
A sole proprietorship is an informal business with a single principal. As the simplest, most ancient type of business entity, the owner files no formation documents with the state, and courts treat the company and the principal as indistinguishable. Any liabilities accrued by the business are imputed to the owner. Most business owners start with a sole proprietorship before deciding on a formal legal structure.
Benefits of a Sole Proprietorship
Many young entrepreneurs own a sole proprietorship without even knowing it because legislatures and courts have developed the notion of a sole proprietorship as a legal fiction. In essence, the sole proprietorship forms without any intent on the part of the owner. However, sole proprietorships offer several benefits. Below are the main advantages of a sole proprietorship over an LLC.
Fewer State Filing Requirements
One of the most significant benefits of sole proprietorships involves the amount of time and effort it takes to form them: none. A sole proprietorship forms the first time you book an appointment or make a sale. Depending on the state in which you do business, you will most likely not need to file any paperwork to establish your sole proprietorship. However, you may still need to:
● Acquire a business license
● Display any necessary certifications
● File industry-specific documents with governing trade authorities
● File a Form C with your personal Federal Income Tax Return
Greater Control of Daily Operations
In a sole proprietorship, the owner does not answer to anyone except the customers. A sole proprietor avoids even the mere possibility of disputes between partners or shareholder lawsuits. The owner can implement new ideas, execute contracts, and make other decisions at will. In short, a sole proprietor has greater control over the day-to-day operation of the business.
Simplified Tax Returns
Another perk to owning a sole proprietorship involves the amount of paperwork during tax season. In a sole proprietorship, all profits go to the owner. The revenues and expenditures of the sole proprietorship get listed on Form C of the owner’s federal income tax return. Most other types of business entities must file their own separate tax returns.
Drawbacks to a Sole Proprietorship
Operating a sole proprietorship creates a legal tradeoff. On the one hand, sole proprietorships cost almost nothing to set up. On the other hand, the owner remains accountable for all activities carried out in the company’s name. See some of the most significant drawbacks to a sole proprietorship below.
Zero Protection Against Potential Liability
Sole proprietors enjoy zero protection against the liabilities that their businesses incur. Proprietors may find themselves paying out of pocket for commercial debt and civil court judgments against their companies. In the worst-case scenario, creditors and government agencies may target a sole proprietor’s personal assets, such as vacation homes and leisure vehicles.
Difficulty in Obtaining Credit
Sole proprietorships experience more roadblocks when applying for loans and lines of credit than LLCs and other types of business entities. The ability to secure institutional funding or even open a bank account depends upon the owner’s financial history. Fortunately, owners who experience difficulties can open a business checking account online.
What Is an LLC?
An LLC is a formal business structure designed by state legislatures and acknowledged by the court system. If you start an LLC, your business will operate as a separate entity. Any business debt or other liabilities that the company accrues do not pass to the LLC’s members unless they involve themselves in wrongdoing.
Benefits of an LLC
Most business owners have some familiarity with LLCs. While they may know that a single-member LLC serves as one of the most popular business entities, few understand the manifold benefits of forming one. Explore some of the most significant advantages to starting an LLC below.
As the legal business structure’s name suggests, a limited liability company shields members from most types of commercial liability. Some of the liabilities that an LLC protects members against include:
● Debts the LLC incurs
● Court-awarded damages for LLC actions
● Product warranty claims
Simplicity and Affordability
Transitioning from a sole proprietorship to an LLC takes time and money. However, setting up and maintaining an LLC is easier and more affordable than creating and running a corporation. You will encounter fewer forms to fill out, fees to pay, and due diligence to perform.
LLC members can pay taxes much like a sole proprietor would. However, you can also choose to have the state and federal authorities tax your company like a corporation. This flexibility allows members to make on-the-fly adjustments to dramatic shifts in revenue and costs.
Drawbacks to an LLC
Despite all the benefits of forming an LLC, this business structure has some drawbacks. They include additional filing fees and tax requirements.
Filings and Fees
If you set up your LLC yourself, it will cost several hundred dollars. However, if you hire an attorney to help you form your business, then it may cost a few thousand dollars. In comparison, a sole proprietorship costs nothing to start.
Depending on your jurisdiction, your LLC may need to pay state business taxes, unemployment taxes, and more. Also, tax attorneys, accountants, and tax preparers may charge more to file your LLC’s tax returns than your personal income tax return.
LLC vs. Sole Proprietorship: The Final Verdict
When looking at a sole proprietorship versus an LLC, you must consider your company’s immediate needs and outlook for the future. If you believe it will take a few years for your company to grow, then maintaining a sole proprietorship may make sense for the time being. However, if you have already experienced considerable growth in business income and acknowledge the possibility of substantial liability exposure, you may want to protect yourself with an LLC.