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 a limited liability company (LLC) vs. the sole proprietorship, to assist you with making the right choice in terms of whether or not to incorporate.
Limited Liability Corporation 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.
Creditors can go after a sole proprietor’s home, car and other personal property to satisfy debts.
A Sole Proprietorship: What to Consider
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
- You are only responsible for personal federal, state, local and FICA taxes
- There is no liability protection for you, which puts your personal assets at risk
- Difficult to obtain funding
- Tough to build business credit
Advantages of a Sole Proprietorship
When you form a 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.
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.
- 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.
Limited Liability Corporation: What to Consider
- More market credibility
- Liability protection against lawsuits, commercial debts, keeping your personal assets safe
- Slightly easier to obtain financing
- Plenty of paperwork
- Annual state filings
- Additional taxes to pay
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)
Advantages of Incorporating
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.
Disadvantages of Incorporating
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.
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 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. For legal and tax purposes, you’ll need to choose a registered agent. This could be yourself if you’re a single-member LLC, or one of your business partners if there are multiple members of the LLC. Keep in mind that the IRS considers single-member LLCs as sole proprietors when it comes to taxation.
You’ll then need to file a certificate of formation (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. Before long, you’ll want to obtain your EIN for tax purposes.
Funding 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. If you choose to register your business as a separate entity, do so as soon as possible, and set up business bank accounts. Having your business as a separate legal entity and separating your personal income and business income can provide you with legal protection and keep your personal assets safe, depending on how you do it.
Getting a startup loan can be difficult for a new business, but there are other funding opportunities available. You can go the crowdfunding route, which is becoming more popular. 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 businesses. These are structured a little differently than regular financing or microloans, so be sure to research various options before moving forward. Some may have tax advantages or more in terms of asset protection over another, so be sure to advise an accountant before moving forward.
Taxes for a Sole Proprietorship vs. LLC
If you have a sole proprietorship or LLC, there will be changes in your taxes. The most important thing when you start out is to separate your personal and business finances and get your documents in order and on hand. This includes personal tax returns and other income tax documentation, and information on any debts you may carry.
As a sole proprietor, you may qualify for filing pass-through taxation, which can save you a bit when it comes to pay self-employment tax. Your tax rate can vary depending on your business type, so keeping the proper NAICS code on hand is also vital.
For a sole proprietor, filing taxes is a bit simpler. Just as your business is a separate legal entity, you’ll want to keep the documentation and finances separate. Having receipts, mileage, 1099s, annual fees, anything tracking money coming in and going out will be vital when it comes to taxation.
The current self-employment tax rate is 15.3%. Sole proprietors are responsible for paying the balance on their own. Keep in mind that one-member LLCs are considered sole proprietors, but for an LLC with multiple members, forming an LLC could cut your tax bill. Only certain types of income qualify for the federal tax rate for C-corporations, meaning you could end up paying less than if you filed as a sole prop or single-member LLC. Check with your accountant to see exactly how much you could save.
Having the proper documentation regarding your profits and losses, payroll taxes, and any forms regarding real estate owned by your entity will be vital. Be prepared. As an LLC owner, your business will not pay taxes itself, but the profits and losses will be listed on your personal tax return, but having proper division of finances will do you well in the long run.
Personal Liability For a Sole Proprietorship vs. LLC
As a new business, legal protection is vital to your well-being and the longevity of your endeavor. Filing an LLC can do wonders to protect you personally from liability. Consider the nature of your business and what is at risk.
A limited liability corporation does just that; it limits your liability. As an owner of an LLC, you will not be personally liable for the company’s debts or liability. The same cannot be said for a sole proprietorship. As a sole prop, you would be personally responsible for the debts incurred by your business. This risk may be negligible depending on your situation, but be sure to weigh the pros and cons before moving forward.
As a rule of thumb, you should seek out liability insurance for your business for additional protection and for your peace of mind.
Managing and Operating a Sole Proprietorship vs. LLC
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.
Depending on your preference and the type of business you own, working with someone else and sharing the decision-making can be preferable. This takes a bit of the pressure off of you as an individual, but also leaves some of your sanity at risk if your business partner doesn’t always see eye-to-eye.
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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.
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 is equally difficult for both, the protections you can enjoy with an LLC can’t be understated. The additional fees, paperwork, and taxes are paid back in protection for your personal assets, something a sole prop can’t lay claim to.
The Last Word
How you run your business is important. How you incorporate or don’t incorporate it is a vital part of how things will go. Where a sole proprietorship offers freedom and autonomy, an LLC offers significant protection and benefits that are worth considering.
Keep in mind your business goals and where you want to go. Don’t be scared of asking for advice or help from seasoned professionals.