The decision to incorporate or not incorporate your business can be a very important choice. While most businesses operate as sole proprietorship, a formal business structure such as an LLC can provide significant benefits including asset protection and greater access to small business financing.
Limited Liability Company Versus a Sole Proprietorship
One of the key benefits of an LLC versus the sole proprietorship is that a member’s liability is limited to the amount of their investment in the LLC. Therefore, a member is not personally liable for the debts of the LLC. A sole proprietor would be liable for the debts incurred by the business. This liability, however, is dependent upon following the rules associated with an LLC. If you treat the LLC the way you would a sole proprietorship, you lose the liability protections.
For example, creditors can go after a sole proprietor’s home, car and other personal property to satisfy debts, while an LLC that is properly maintained can protect the owner’s personal assets.
What is a Sole Proprietorship?
When a business operates as a sole proprietorship, it simply starts doing business without forming a separate legal entity. This is the most common business structure used by small business owners in the U.S.. It is also the most risky. Here are some key takeaways to think about when considering a sole proprietorship:
- No required paperwork apart from industry-specific licenses
- No annual state filings
- Simplified tax filing
- No liability protection
- Difficult to obtain financing in the business name
- Harder to build business credit
Advantages of a Sole Proprietorship
When you form a sole proprietorship, you have the following benefits:
- No required state paperwork, unless there’s specific licensing such as an occupational license and/or business license. (It is recommended that the business file a fictitious name or “DBA” with the state.)
- No required annual state filings to complete, unless there’s specific industry filings required by your industry.
- All profits/losses are passed through to the owner’s personal tax return. These are typically reported on a Schedule C tax form that is filed with owner’s personal tax return.
- May enjoy the tax benefits of being self-employed, from deducting certain business expenses (business use of your home or car, for example), utilizing self-employed retirement plans like Simplified Employee Pension Individual Retirement Accounts (SEP IRAs), writing off regular business expenses such as marketing costs, writing off business travel costs, writing off costs to entertain clients and more.
Disadvantages of a Sole Proprietorship
However, with a Sole Proprietorship, you also have the following drawbacks:
- There’s no liability protection against commercial debts, lawsuits and other obligations. This means you can be sued personally for commercial activities, putting your personal assets at risk.
- Outside of friends and family, it’s nearly impossible to secure equity financing for a Sole Proprietorship, as many investors choose not to invest in a Sole Proprietorship. This could limit the amount of funds available to grow, develop, and sustain your business.
- It’s difficult to establish business credit to obtain debt financing for a Sole Proprietorship, as many financial institutions will categorize your request as a “personal loan” rather than a “business loan“, which brings all sorts of caps in terms of approval amount potential. (You can see whether your business has a credit score established and track it for free on Nav.com.)
- You will have a lower amount of market credibility by not operating under a trade name. Now this could be easily resolved by creating a “Doing Business As” Name (DBA) with your state’s department of revenue or the secretary of state, but this will require fees for establishment and ongoing fees to continue to use the DBA name.
What is an LLC?
An LLC, or Limited Liability Company, is a legal business structure for operating a business. It is popular with many business owners due to the ease of setting it up, the fact that it is often cost effective and easier to maintain than other business structures such as S corps or C corps, and because it can provide asset protection. Here are some key takeaways to consider when forming an LLC:
- More market credibility
- Liability protection in the case of certain lawsuits and commercial debts
- More financing options
- Some paperwork
- Annual state filings
- Tax advantages and disadvantages
The Pros & Cons of Forming an LLC
Choosing to form an LLC brings both advantages and additional costs. It will be up to you to weigh the costs against the benefits, however, for serious business owners, it is often well worth it.
Advantages of Forming an LLC
When you form an LLC, you are creating a business entity separate from yourself. In other words, you are not your LLC and your LLC is not you. With the LLC, you will have the following benefits:
- A higher level of market credibility.
- Liability protection against commercial debts, lawsuits and other obligations. This means, as long as you set up and maintain your LLC properly, do not co-mingle personal and commercial assets, and avoid personal guarantees, the liability protection should remain in place and creditors should not be able to go after your personal assets in the event of a lawsuit against the business.
- It’s much easier to obtain equity and debt financing if you have a separate business entity as well as an established business credit score. Instead of personal loans, you can get small business loans, including leases, factoring, trade credit and more.
- You can combine the “best” of the incorporation worlds, by electing your single member LLC to be taxed as a Sole Proprietor (which is the standard election), an S-Corporation or a C-Corporation. Electing tax treatment as a sole proprietor just means all profits/losses flow to the owner’s personal tax return. Electing to be taxed as an S-Corporation means the profits/losses flow to the owner’s individual return, but you have the chance to reduce FICA taxes by establishing a “reasonable salary” and receiving the remaining profit amounts as dividends, with only the “reasonable salary” being subject to FICA (Social Security and Medicare) withholding.
- And of course, you will enjoy the tax benefits of being self-employed. Check with your tax advisors.
Disadvantages of Forming an LLC
With an LLC, you have the following drawbacks as well:
- State-related paperwork will be required, including any specific industry licensing.
- Annual state filings (and the associated fees) will be required as well, including any specific industry licensing fees that are required.
- Besides paying personal federal, state, local and the self-employed version of FICA taxes, you might also be required to pay State Business Taxes and Unemployment Taxes.
- Costs for completing the tax return of an LLC may be higher than that of a sole proprietorship.
Sole Proprietorships vs. LLC: Key Differences
Forming a Sole Proprietorship vs. LLC
Forming a sole proprietorship can be as simple as getting to work. Depending on what kind of work you do, you may have to obtain licenses, permits, zoning clearances, or other permissions from your local government. If you so desire, you can form a legal entity and file an assumed business name, and to make tax season more bearable, obtain an EIN (employer identification number).
Forming an LLC is a little more involved, but still a relatively simple process. You’ll need to choose a legal name your LLC, and be sure to check your proposed name before going to file; you’ll want to be sure you’re choosing a name unique to your business and and check with an attorney before using a name others have protected with a trademark. You’ll also need to choose a registered agent. This could be yourself if you’re a single-member LLC, or one of your business partners in the case of a multi-member LLC.
You’ll then need to file articles of incorporation (the specific name of this document can vary depending on your locale) and create an operating agreement, as well as paying a filing fee. Having a business plan in place can make aspects of this step much simpler as you form an LLC. In some states, you’ll be required to obtain your EIN for tax purposes.
Financing a Sole Proprietorship vs LLC
Whatever type of legal entity you choose to file, funding will likely be a hot topic and a challenge. Experienced small business owners will likely suggest you keep your full-time job while you get your business off the ground; this personal income can be a steady stream of capital as you get your operation moving. Either way, get a business bank account and a business credit card if possible.
Getting a startup loan can be difficult for a new business, but there are other funding opportunities available. You can consider crowdfunding where you can offer donors a gift for their contribution, make them shareholders, or just rely on the goodness of their heart. There are also a number of non-profit lenders offering microloans for new or disadvantaged businesses.
Taxes for a Sole Proprietorship vs. LLC
With both an LLC and a sole proprietorship, the profit of the business passes through to the owner’s personal tax return. But LLCs have more flexibility in how they are taxed, which may result in tax savings.
Sole proprietors typically report their business income and expenses on Schedule C. This form is filed with the owner’s personal tax return. The net profit from the business (line 31 on Schedule C) indicates the net profit of the business and it passes through to the owner’s personal tax return.
Pass through entities like LLCs and sole proprietorships may benefit from the Qualified Business Income (QBI) deduction that allows them to deduct 20% of QBI. Not all business income (and not all types of small businesses) qualify, so talk with a tax professional.
Single-member LLCs are automatically treated as sole proprietors for tax purposes, but may elect to be taxed as an S Corporation or C Corporation. This may provide tax savings but will also carry additional requirements. Check with your tax professional to choose the right filing status for your business.
Don’t forget about self-employment tax! The current self-employment tax rate (SECA, instead of FICA) is 15.3%. Normally this is split between the employer and the employee, but when you are the employer you pay the full amount yourself. (There may be ways to reduce self employment tax for LLCs that elect to be taxed as an S Corp.)
Whichever method you choose, keeping good documentation and staying on top of bookkeeping is essential. Keep good records of both income and expenses and work with an experienced bookkeeper or accountant, at least to set things up properly even if you decide to do your own bookkeeping or taxes.
When Should a Sole Proprietor Become an LLC?
The decision is ultimately yours. But keep in mind that as a new business, legal protection can be important to your well-being and the longevity of your endeavor. Forming an LLC early on can help protect you personally from business liability. It can also make your business appear more stable to lenders and vendors, as well as customers and business partners. In that sense, it can be an investment in your success.
Running a sole prop is as simple as getting to work and tracking your income and keeping it separate. You are the owner and the business, so all decisions are yours to make. That makes it easy to get started, but as your business grows you take on more risk.
Is an LLC Always the Best Choice?
Life is all about making choices and choosing to form an LLC can be a very important one. Asset protection consultants routinely market to business owners stating that an LLC is always a “good idea”, but I do not believe this to be true. Some entities are actually better suited for a sole proprietorship as the additional costs of an LLC do not provide any significant benefits over operating as a sole proprietor.
Also, understand that with the concept of an LLC providing “liability protection against commercial acts of your business”, a savvy attorney is going to try to find any loophole he can in your current setup to “pierce the corporate veil” and go after personal assets.
In addition, some courts may not look favorably upon sole member LLCs, and the question comes up in legal proceedings as to whose interests are you being protected against if technically, you are the only member of the LLC.
Which is Better: a Sole Proprietorship or LLC?
As with so many questions like this, the answer is: it depends. While obtaining funding or financing can be challenging for any business, the advantages and protections you can enjoy with an LLC can’t be understated.
Keep in mind your business goals and what you want to achieve. Don’t be scared to get advice or help from seasoned professionals.