When starting a small business, one of the most important steps is deciding which business structure fits your idea the best. Although the process and amount of circulating information may be overwhelming, the legal entity of your business is crucial to your success. Two of the most common forms available for startups and small businesses are the LLC and Sole Proprietorship.
Limited Liability Company (LLC)
The Limited Liability Company (LLC) is one of the most popular business structures. It combines elements of a corporation and partnership, while eliminating some of the negative features of each. Like a corporation, the LLC provides limited liability to its owners and shareholders; like a partnership, the LLC offers a pass-through income taxation.
How do you know if an LLC is the right decision for you? To help you answer this question, you must first understand both the advantages and disadvantages of an LLC. Let’s talk about the advantages of an LLC first.
Advantages of an LLC
Setting your business up as an LLC can provide you with many benefits. These include:
- FLEXIBILITY: The management structure of the LLC is much more flexible than that of a corporation. Business owners can create an operating agreement based on their own requirements and needs.
- LIMITED LIABILITY: One of the most important features of an LLC is that it protects members of the company from personal liability for business debts.
- TAX OPTIONS: Income does not need to be taxed at a corporate level. Losses can be passed directly through to the individual shareholders, allowing them to claim the company’s losses on their personal tax returns. This feature is beneficial to LLCs because it avoids double taxation, allowing profits to stay within the company for possible future growth.
Disadvantages of an LLC
Although there are many advantages of LLCs, that doesn’t mean that there isn’t a potential downside to this option as well. In fact, there are a couple different disadvantages of LLCs, such as:
- PASS-THROUGH TAXES: Although previously stated as an advantage, pass-through taxes can also be a disadvantage of LLCs. As profits and losses are reported on each shareholder’s personal tax return, the pass-through taxation may be unfavorable when the shareholders do not receive dividends.
- INVESTORS: Because of the flexibility of the LLC business structure, investors may be hesitant to loan or invest their money.
- ADDITIONAL TAXES AND FEES: The lack of a governing structure could eventually lead to issues down the road, requiring upfront costs, such as state and attorney fees. Also, in many states, such as New York, California, Tennessee, Alabama, Kentucky, Pennsylvania and Texas, LLCs are required to pay a franchise tax or capital values tax. This tax can be based on revenue, profits, and the number of owners, the amount of capital employed in the state or any combination of these factors.
A sole proprietorship is a business structure that is owned by one individual, the sole proprietor, where there is no legal difference between the owner and the business. This structure is designed for individuals in business for themselves without associates, partners or strict state and federal regulations. However, just as there are advantages and disadvantages of LLCs, there are also advantages and disadvantages of sole proprietorships, too.
Advantages of a Sole Proprietorship
If you’re considering being a sole proprietor, then it’s important to realize that there are a few benefits of a sole proprietorship. What are they?
- EASY AND INEXPENSIVE: A sole proprietorship does not require legal documentation, fees or filings other than the necessary license or permits. At the most, sole proprietors must register their business name with the state’s corporate filing agency.
- FEW REGULATIONS: The advantage of having one business owner is complete control of any and all decisions. There are no state or federal regulations regarding shareholders or the organizational structure of a sole proprietorship, making this a major benefit of sole proprietorship.
- NO BUSINESS TAXES: There are tax benefits of sole proprietorship as well, one of which is that the business is not taxed separately. Company profits are filed on the business owner’s personal income tax return (which is why it’s often called a “pass-through sole proprietorship”) and can be reinvested for company growth or given directly to the owner. Tax rates for a sole proprietorship are also the lowest of the business entities.
Disadvantages of a Sole Proprietorship
What are some reasons you wouldn’t choose a sole proprietorship vs an LLC? Here are two to consider:
- NO LIABILITY PROTECTION: Sole proprietors are vulnerable to lawsuits and fully responsible for any damage incurred. If the company is sued, creditors can go after not only the business assets, but also the owner’s personal assets. This one of the biggest disadvantages of sole proprietorship and one which convinces a lot of entrepreneurs to go with an LLC vs being a sole proprietor.
- LIMITED FINANCING OPTIONS: Due to the structure of a sole proprietorship, additional 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 their personal savings or consumer loans.
Common LLC vs Sole Proprietorship Questions
Because this is such a big decision—as to whether to be sole proprietor or an LLC—many new small business owners have a lot of questions. Here are some of the most common:
Can a sole proprietorship be converted to an LLC if I change my mind later?
A sole proprietorship can eventually be an LLC, but conversion costs may be substantial. At a minimum though, you’ll need to make sure your business name isn’t taken, file the necessary paperwork, and get a new Employer Identification Number (EIN) from the IRS. You’ll likely need a new bank account for your LLC too.
Because there are advantages and disadvantages of LLCs and advantages and disadvantages of sole proprietorships, how do I know for sure which one is best for me?
It is important to understand the difference between all business entities and decide which structure best fits your personal requirements as well as the needs of your business. For instance, you may decide the tax benefits of sole proprietorship is enough to go that route. However, if you require investors to take your small business to the next level, keep in mind that that’s a benefit of an LLC, potentially making that the better option.
Can anyone help me decide whether I should be an LLC or sole proprietor?
It’s best to consult a lawyer for help with this process, but with thorough research, it’s possible to make the decision on your own. Another option is to talk to someone you trust, another business owner in a similar position perhaps, and see what he or she thinks. Here are some questions you can ask (although you’ll likely get some of the answers we’ve already discussed, it’s nice to get their take based on their individual experiences):
- What’s the biggest advantage of sole proprietorship?
- What’s the biggest disadvantage of a sole proprietorship?
- What do you see as the top advantage of an LLC?
- What do you see as the top disadvantage of an LLC?
- What’s the biggest or most important difference between sole proprietorship vs LLC?
- What has been your experience regarding tax benefits of an LLC (or tax benefits of sole proprietorship, depending on which one the person you’re speaking with does)?
- What are the tax disadvantages of an LLC (or tax advantages of sole proprietorship, as the case may be)?
Asking these types of questions and discussing the answers may make it clearer which direction you should take when considering LLC vs sole proprietorship.