There are many things you need to think about as a small business owner. One is the structure for your company. Not only is it vital for moving forward, but it is quite confusing, especially if it is the first time you are starting a business. And since it affects things like taxes, paperwork, and legal responsibility, you have to choose carefully.
Two often confusing options for new small business owners are sole proprietorships and LLCs. Therefore, to make matters easier, the article will go through the different aspects of both. Read on to learn about the pros, cons, and similarities between the two company structures.
What Is Sole Proprietorship?
The first of the two structures that will be discussed is a sole proprietorship. It is an unincorporated business, and it also only has a single owner. It can even be considered the default structure for anyone who owns and operates a business independently. Some examples include:
- Online Business
It can be considered a sole proprietorship as long as you own and operate your own business and do it by yourself. And there are some basic benefits to consider from the start, including simplicity and low expenses.
Another feature that sets it apart is that there is no separation between the owner and their business. For instance, debts and other business-related expenses are on the shoulders of the owner. That also includes things like legal responsibility, which causes any potential legal problems to be tied to the individual owner of a sole proprietorship.
What Is An LLC?
LLC stands for a limited liability company. Unlike a sole proprietorship, there is less on the owner’s shoulders when it comes to taxes and legal matters. In fact, there are still some benefits that you might see with a sole proprietorship, but since it is a corporation, there is additional protection.
The reason for the extra protection is that a limited liability company is a separate entity. It is split from the person when it comes to legal circumstances, including for things like debts and assets. While the owner of the company still has to deal with taxes, it provides a buffer for other things, ensuring security when it comes to:
- Financial Obligations
Of course, that is only in regard to the operation of the LLC. Therefore, it is a great choice for those who are worried about creditors or legal trouble. That being said, it might not be the best choice in all situations, which you will learn more about below.
An LLC can be owned by a single person. In fact, it is one of the most common structure types in the US. It is usually registered in the state it is formed and does business. Regardless of that, it is simply an LLC that has a single owner, with everything else remaining the same.
Therefore, as you go through the key points below, keep in mind that an LLC owned by multiple people or a single person has the same advantages and disadvantages. That means it might be a great choice for those considering building into a business with multiple owners in the future.
Key Comparison Points
There are many places where LLCs and sole proprietorships can be compared. In some ways, they are the same, and they each have their own advantages and disadvantages. However, to showcase the key points between the two, several categories are explored below, including:
Each of the above things directly affects the business, and they can be key points in deciding which is right for you. While other things will be discussed, these will be the primary focus.
Formation of the Business
There is a major difference between the formation of a sole proprietorship and an LLC. In fact, you might have an established sole proprietorship without even knowing it. As mentioned above, it is the default structure. That means that anyone selling a good or service without another specified structure is a sole proprietorship.
That is not to say there is no paperwork involved. While you can have a sole proprietorship without knowing it, there are certain licenses involved in specific businesses that need to be filed for proper formation. Examples include things like:
- Business Licenses
- Zoning Permits
- DBA Certificate
Business licenses and zoning permits depend on the business location. As for the DBA certificate, it stands for “doing business as” and is necessary when you operate a business with a trade name. However, when it comes to a sole proprietorship, that is the limit of what you need to think about. Things are a bit different with an LLC.
An LLC might require all of the things a sole proprietorship needs, but it also needs other things. The first and most vital is the articles of the organization. It is what officially establishes an LLC, and it must be filed locally – within the state of operation. If you are operating in multiple states, there might be additional required paperwork.
Operations and Management
One of the key points of a sole proprietorship is that it is a simple business structure. Because of that, operations and management are also simple. In fact, because it is a single person running the business, decisions are easily made. All it takes is the owner making up their mind, and then the decision is made.
That being said, sole proprietorships still have employees, and they still hire experts to help with certain aspects of the business. But while those factors might alter decisions, they do not control them. At the end of the day, the owner takes on all of the risks, so they have to make decisions to cover the company’s debt, including employee salaries.
Once again, things change with an LLC. There is even more often an operating agreement that details how things will work. It is not a requirement in many states, but it is still often used to make the more complex structure easier to navigate. Of course, it is more important when there are multiple owners, but it covers things like:
- Ownership Stake
- Voting Rights
- Profit Share
If there are multiple people involved, there are also two management structures at the top. One is when the responsibility is shared by everyone involved. The other is when a manager is appointed to take care of the business. Once again, if it is a single-member LLC, then there is not much to worry about, but multiple people complicate things.
If there is more than one person at the top, you have to consider shares. Shares in the business reflect voting rights and profits. As part of a single-member LLC, you obviously have complete control over the decisions and profits, but you also have the flexibility to bring more people in.
How Taxes Differ
There is little more important to business owners than taxes. That makes it of particular importance when considering the structure of your business. Fortunately, there is no hidden complexity you have to worry about. In fact, the tax differences between a sole proprietorship and LLC are minimal, especially if it is a single-member LLC.
Both of them are pass-through entities. Therefore, the business is not responsible for paying income taxes. Instead, it is reported and attached to the owner’s personal taxes. The same works for a multiple-person LLC. In that case, each member reports their own share of the income. Though, there is one difference.
If there are multiple people involved, a business tax return must be filed with the IRS. Members will also need to include another form attached to their personal taxes: a Schedule K-1. It is all to detail their share of the income. Some other tax responsibilities these businesses might be faced with include:
- Payroll taxes if there are employees
- State and local sales taxes
- Self-employment taxes
There is also a chance that local law might require additional taxes to be paid by LLCs. Names for these types of taxes include LLC tax, franchise tax, and business tax. Therefore, you should keep that in mind when deciding between the two structures for your business.
LLCs Have the Ability to Choose Corporate Tax Status
While the two do not differ much at the base level, there are other options with an LLC. The key is in the ability to choose, with LLCs giving owners the ability to choose between pass-through taxation or corporate taxation. Here are some things to consider when it comes to corporate taxes:
- Some states and local entities levy corporate taxes
- Corporate taxes might save an LLC money
- Dividends are usually taxed at a lower rate
- Retained earnings are not taxed if it is set up for corporate taxation
- There is access to additional tax deductions and credits
However, LLC members are not allowed to treat their income as dividends. That means that all of their profit is taxed, even if some of it is retained by the company. Therefore, while the basics might be the same, there are some big opportunities tax-wise for an LLC.
The Legal Protection Involved
Although it has already received some attention above, the key point about a sole proprietorship in regard to legal protection is that there is none. Essentially, anything that goes wrong is put on the owner. That includes debt, but it also includes legal action, such as the company being sued. The same is true of bankruptcy.
Everything is tied to the owner, and the failure of a sole proprietorship can be devastating for the business owner. An LLC provides a sense of security, providing a buffer between the owner and the business. Of course, that is not in all aspects, but it does help with what is discussed above:
- Legal Action
To be clear, it is not absolute protection. If a debt is personally guaranteed, it still affects the owner. In the same way, some legal action, especially when it concerns fraud or negligence, still centers on the person involved. However, the burdens are lessened considerably.
By forming an LLC, business owners can settle debt or file for bankruptcy at the company level. It is separate from personal finances, so they do not have to declare personal bankruptcy. It is also rare that legal action, such as suing the business, affects the person instead of the company.
Paperwork and Compliance Involved
When it comes to paperwork and compliance, it can require a lot of time and effort. Moreover, it starts from the moment the business is started. To begin a sole proprietorship, you might not need any paperwork. Even if you do, it is unlikely to require much. Moreover, sole proprietorships only need to do a few things after launch.
Keeping up with taxes is always important, and any permit renewals also need a prompt response. But the limited responsibilities only apply to sole proprietorships. When an LLC is involved, the paperwork and compliance requirements increase considerably. Just to start, the articles of the organization might be required. Other things include:
- Drafting an operating agreement
- Issuing member units
- Recording transfers of ownership
- Holding member meetings
Those apply to LLCs with multiple members, and while they are not strictly required, they are worth doing. They protect the members and make sure things run smoothly going forward. In addition, if you decide to dissolve an LLC, you will have to take extra steps and do more paperwork. Sole proprietorships do not have that concern.
Making a Choice
While there are minor differences as well, the above outline the major comparison points. Therefore, now you have to decide what will work best for your business. If you are a simple freelancer, you can easily get away with remaining as a sole proprietorship. But some might save money or find extra protection with an LLC.
Moreover, if you have any plans to bring more people in down the line, then you will want to look into forming an LLC. Not only can you continue to do things in much the same way as a single-member LLC, but you have more protection against potential legal issues and debt. You also have more flexibility.
Starting a business can be a difficult thing. But figuring out which company structure you are going to go with can give you a clear path. For most people, an LLC offers more flexibility and potential, but for small ventures without much risk, a sole proprietorship is effortless. Either way, it all depends on what you and your business need.