When you start your small business, one decision you have to make is how to form your entity. Many entrepreneurs find it difficult to decide between the LLC or sole proprietor business structure. The best way to make that decision is to take a few minutes to really understand the differences between the two. Let’s dive in and break the question down one issue at a time:
What is a Sole Proprietor?
A sole proprietor is a business owned and operated by one person. You don’t even have to do anything in order to create one. If you are self-employed (or even have a second job that is actually a business) and haven’t set up any other business formation, you have a sole proprietor business by default. You may have to register to get a business license but not much else. You don’t have a special tax form to file each year. If you operate your shop under a name other than your own, you’ll have to file a DBA too, but that’s about it. This is the simplest business form there is to start and maintain.
What is an LLC?
LLC is short for Limited Liability Company. An LLC can have one or many owners. Each owner is a member. An LLC is also fairly easy to set up. You can actually do it yourself using a company like LegalZoom. To form an LLC, you usually have to draft an operating agreement. Also you’ll have to draft Articles of Organization and file them with the Secretary of State. This is a fairly easy and inexpensive process.
The LLC entity provides some liability protection for the members. That means creditors and disgruntled customers will find it difficult to attach your personal assets.
Interestingly, the IRS doesn’t recognize the LLC entity. That means if you have an LLC, you must decide if you want to be taxed as a corporation, partnership or (you guessed it) sole proprietor.
Sole Proprietor Taxes vs. LLC Taxes
All the net taxable income from your sole proprietor business flows to you. That means you report it on your 1040 using a Schedule C. Of course, you’ll have to make sure to take care of withholding and self-employment tax too. If you have employees, you’ll have to pay payroll taxes as well.
Let’s consider the issue of tax from the standpoint of an LLC. If you don’t make another election and you operate a single owner LLC, the entity will be taxed as sole proprietorship. That means the income is reported on Schedule C of the 1040. If your LLC has more than one member, the income must be reported on a partnership return if a corporate election is not made.
If the LLC is owned by a corporation or partnership, the income from the LLC is reported as part of the corporation or partnership income.
Sole Proprietor Advantages
The big advantage of having a sole proprietor business is that it’s easy to set up and just about free to do so. Also, it’s super simple to maintain. You don’t have to do anything really. It’s actually more of a default than anything else. What I’m saying is that unless you take other action, your business already is a sole proprietorship. It doesn’t get much easier than that.
A big benefit to doing business this way is that the owner has complete control over what he or she does with the business at all times. There are no other people to consult with.
Sole Proprietor Disadvantages
The disadvantage of the sole proprietor is that it provides no protection or tax benefits. If you operate your business as a sole proprietor you are personally liable for the business debts and you will be held personally responsible for any act or failure to act. Worse, you have unlimited liability. That means creditors and lawsuit-happy customers can (and will) come after you and your personal assets if they want to.
The LLC provides members with limited liability. The only time that this protection is jeopardized (and the courts pierce the LLC protection) is if the LLC conducts fraud or misrepresentation.
The owners have a great deal of flexibility as to how they want to file their tax return, as detailed above. And income can flow unevenly as well, with some members receiving more than others. Like a sole proprietor, the LLC is easy and inexpensive to set up and maintain (but a bit more cumbersome than the sole proprietor). But unlike the sole proprietor, the LLC can have more than one member and only one of those members has to be a real person. The other members can be partnerships, corporations, etc.
First, there is a bit more paperwork involved in setting up the LLC and maintaining it, as I mentioned above. Next, if you have multiple members and one member dies or no longer wishes to be part of the LLC, the entity must be dissolved. Also, since the LLC has limited liability, it may be more difficult to borrow money. That’s because creditors know they can’t come after you personally, so they may not want to make the loan in the first place.
And last, there is the issue of liability. Typically, members aren’t personally responsible for the debts of the business or the other members. A good thing. However, there are some exceptions to this.
If any member (as a member of the LLC) acts negligently, fraudulently or illegally, and that act results in damage to someone else, each member can be held responsible. Also, if you as a member personally guarantee a loan, you will be responsible if the LLC is unable to repay the debt. Finally, if the LLC distributes assets in a way that is prohibited by the operating agreement, the members receiving those distributions are liable.
Which is the best choice for you?
Most business owners start off as sole proprietors and then quickly adopt either the LLC or corporation form. That’s because the unlimited liability of a sole proprietor is simply too great a disadvantage. Which election do you make for your small business? Why?