When setting up a small business, deciding which business entity to register as is one of the most crucial decisions you will make.
Although it may seem like a sole proprietorship and a limited liability company (LLC) look very similar, there are differences that can have a major impact on your business later down the line.
The type and amount of paperwork you must deal with, the amount of taxes you pay, and what happens if someone decides to sue you are all affected by whether you’re a sole proprietor or an LLC.
While we always recommend seeking professional advice about which business entity to choose, here are some pointers to help you understand which structure may be most suitable for your business.
A sole proprietorship is the easiest and least expensive way to set up a business. It consists of one owner of an unincorporated company who registers their trade name and obtains any necessary business permits before commencing operations.
If you are the sole individual who owns and runs a business with no other owners or business partners, then you are by default a sole proprietorship. Examples of this would be an individual who freelances as a business consultant, an electrician, a plumber, a personal trainer, someone running an online business, a retailer, etc.
In most cases, you can identify a sole proprietorship by the name of the business, which is usually the owner’s name, however, the owner can choose a different business name if they wish.
The key point of operating as a sole proprietorship is that there is no distinction (legally) between the sole proprietor’s business finances and personal finances. Therefore, the sole proprietor is personally responsible for any debts and financial obligations that arise from the business.
An LLC offers a more flexible business setup and combines parts of a sole proprietorship with elements of a partnership and corporation.
Owners of an LLC (yes, there can be more than one) are considered separate from the LLC which has its own legal identity. What this means is that any business debts and financial obligations are also separate from the owner’s personal finances. Therefore, creditors cannot chase personal assets should the LLC fall into debt or be unable to meet its financial obligations.
LLC businesses are easily identified because they will either have “limited liability company” or “LLC” after the business name.
LLCs are created by filing papers within the state it’s situated and they are either taxed the same way that a sole proprietorship is or as a corporation would be. The owners can pick the most beneficial tax regime for their LLC which is a major draw for choosing this option.
So, which one should you choose for your business? Well, that depends on several things:
Forming a sole proprietorship is easy and there’s very little – if anything – that you must do in order to begin operating.
However, there may be business licenses and permits to obtain first. These differ by state so check your local council to understand what’s required. You may also be required to register a trade name if you plan to use something other than your name.
In addition to any permits and trade name registration, an LLC is also required to complete an “articles of organization” document which must be filed within your state of operation and costs $50 – $200 to file.
The sole proprietorship features just one person at the top and whether they choose to hire employees or not, they are solely responsible for making business decisions.
An LLC will have an “operating agreement” which determines the business’s operational and management structure and outlines who is responsible for what.
Business decisions are jointly made among the owners of an LLC and each individual’s weight on matters is related to how much of a stake they have in the business.
Both an LLC and a sole proprietorship are “pass-through” entities. This means that business income is reported on Schedule C within a personal tax return, and the income gets taxed at the owner’s personal income tax rate.
For multi-owned LLCs, each member pays taxes on their share of the business income. Additionally, Form 1065, U.S. Return of Partnership Income must also be filed with the IRS.
LLCs can elect to be taxed as an S-corporation or C-corporation instead of using pass-through taxation. An S-corporation is considered a pass-through entity while a C-corporation pays a corporate income tax at the federal level.
Paying taxes as a corporation offers the opportunity to save money on taxes. For example, dividends are taxed at a lower rate than business income and corporations get access to more deductible options and tax credits.
A sole proprietorship means business and personal finance and liability are legally one and the same. That means if a sole proprietorship goes bankrupt, the owner will go bankrupt too.
Additionally, if someone sues a sole proprietorship they can come after the owner’s personal assets.
An LLC affords more protection because the owners and business are separate legal entities. If an LLC goes bankrupt, the owner’s personal assets are protected, same if someone sues the business.
If you’re just starting out on your business journey or intend to remain as a freelancer then a sole proprietorship is the easiest and most straightforward option.
However, once you begin to grow and take on more financial risk, an LLC affords you more protection, particularly where your personal assets are concerned.
Before you decide, though, we recommend talking to financial experts and getting some advice. At Finvisor, we employ highly qualified financial professionals and business experts who can help you navigate this tricky choice.
Get in touch with our team at Finvisor to find out more.
To learn more about what we do, or to request a quote, contact us at email@example.com or 415-416-6682. We’re here to help you navigate deferred revenue journal entries so you can make the most of your assets!
*This blog does not constitute solicitation or provision of legal advice and does not establish an attorney-client relationship. This blog should not be used as a substitute for obtaining legal advice from an attorney licensed or authorized to practice in your jurisdiction.*