There’s a famous quote that says: “Life is all about making choices. Always do your best to make the right ones and always do your best to learn from the wrong ones”.
The decision to incorporate or not incorporate your business can be a very important choice, so for this article I wanted to hone in on the Limited Liability Company (LLC) vs. the Sole Proprietorship, to assist you with making the right choice in terms of whether or not to incorporate.
A Sole Proprietorship: What to Consider
Choosing to forgo incorporation is actually choosing to remain a sole proprietor, which is what you are considered the moment you leave the kitchen table full of “hope” and “vision”, with your business idea written on a napkin. With the Sole Proprietorship, you have the following benefits:
- There is no required state paperwork to fill out, unless there’s specific licensing paperwork that’s required on behalf of your industry.
- There is 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 and you are only responsible for paying personal federal, state, local and Federal Insurance Contributions Act (FICA) taxes. You are not required to pay any specific business taxes or unemployment taxes.
- You can still enjoy just about all of the same tax benefits of being self-employed, from turning some of your personal expenses into 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) for higher deductions, writing off regular business expenses such as marketing costs, writing off business travel costs, writing off costs to entertain clients and more.
However, with the 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.
- It’s hard to generate equity financing for a Sole Proprietorship, as many investors choose not to invest in said entities. 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.
The Pros & Cons of Incorporating
Choosing to incorporate brings both advantages and additional costs. It will be up to you to determine if those advantages are worth the additional costs that you will have to pay. Incorporation entity choices include the following:
- Limited Liability Company (LLC)
Incorporating as an LLC separates your personal assets from lawsuits, creditors, etc. It also avoids the potential double taxation that occurs with C-Corporations. 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 your LLC properly without any co-mingling of personal/commercial assets and properly fund your LLC with working capital, your corporate veil should remain in place and you can’t be sued personally for commercial activities.
- It’s much easier to generate equity and debt financing due to having an actual incorporated business as well as an established business credit score. This will avoid many potential equity partners and financial institutions from categorizing your request as a personal loan rather than a business loan, which brings all sorts of caps in terms of approval amount potential. It also opens you up to all sorts of commercial debt financing options including loans, leases, factoring, trade credit and more.
- You can combine the “best” of the incorporation worlds, by electing your LLC to be taxed as a Sole Proprietor (which is the standard election), an S-Corporation or a C-Corporation. Electing to be taxed as a sole proprietor just means all profits/losses flow to the owner’s individual tax return like normal. 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 taxed under FICA.
- And of course, you will enjoy all of tax benefits of being self-employed.
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 FICA taxes, you might also be required to pay State Business Taxes and Unemployment Taxes.
- Costs for completing the tax return of an LLC is much higher than that of a Sole Proprietorship.
Is Incorporation Always the Best Choice?
Life is all about making choices and choosing to incorporate or not incorporate your business can be a very important one. Asset protection consultants routinely market to business owners stating that incorporation 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 and taxes 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 break the corporate veil. This could be your lack of providing funding to your business, this could be your co-mingling of personal/business affairs, or more.
In addition, some states don’t look too favorably on sole member LLCs, as often 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? So it gets tricky, make sure to sit down with your trusted CPA and business attorney to map out the right route for your business.