Which is right for you?
When you start a business, choosing the right structure is important. The type of business that you choose can have a significant impact on everything from your tax liability to your legal liability. You can choose between a sole proprietorship or a limited liability corporation (LLC) as the two most common business structures. Let’s look at the differences between these two business structures to help you make an informed decision that best fits your business goals and situation.
At a glance:
- Sole proprietorships are easy to set up, but LLCs offer liability protection by separating your business and personal assets.
- Each business structure has different legal and tax obligations.
- Either business entity can be a good option, depending on your situation.
Understanding a sole proprietorship
A sole proprietorship can be a good choice for entrepreneurs who are starting a new business. Setting one up is fairly straightforward, making it an easy option compared to the many formalities needed to set up other more complicated business structures.
This type of business is an unincorporated business — a sole proprietorship doesn’t separate you and your business from a legal standpoint, meaning there is no distinction between your personal assets and those of your business.
Advantages of a sole proprietorship:
- Straightforward setup: Setting up a sole proprietorship is a fairly easy process that involves minimal paperwork and is usually less expensive than other business structures.
- Control: As the owner of a sole proprietorship, you have complete control over every aspect of your business, including everything from making decisions to carrying out daily operations.
- Tax simplicity: As a sole proprietor, you’ll report business income and expenses directly on your personal income tax return (Form 1040), making tax filing and recordkeeping more straightforward as well.
Disadvantages of a sole proprietorship:
- Personal liability: The main downside of being a sole proprietor is you are personally liable for all business debts and legal obligations. This can put your personal assets at risk if your business faces financial difficulties.
- Limited access to capital: In some cases, it might be more difficult to secure business loans as a sole proprietor. This is because lenders and investors may view your business as riskier due to there being no clear distinction between your personal and business assets.
- Ownership rules: If you want to add another business owner, you’ll need to obtain an employer identification number (EIN) and change your business structure to a partnership.
Exploring the limited liability company (LLC)
If you’re looking for a balance of flexibility and protection, an LLC might be the best option for you. An LLC shields your personal assets from company debts and legal liability. To structure your business as an LLC, it’s important to also consider the laws and regulations in the state where you live. Each state has different requirements and regulations for LLCs.
Advantages of an LLC:
Limited liability:
- One key benefit of forming an LLC is the separation of personal and business assets. Your LLC is a separate legal entity, meaning that in the event of lawsuits or debts, your personal assets are typically shielded from creditors.Tax flexibility:
- LLC owners can choose how they want to be taxed, meaning you can be taxed like a sole proprietorship, partnership, or corporation, depending on how many members your LLC has. This kind of flexibility means you can optimize your tax strategy based on your business goals and circumstances.Ability to hire employees:
- LLCs have fewer restrictions on hiring employees compared to sole proprietorships, making it easier to expand your workforce as your business grows.Disadvantages of an LLC:
Administrative requirements:
- While not as burdensome as some other business structures, LLCs still have administrative requirements, such as filing articles of organization and potentially drafting an LLC operating agreement.Costs:
- Setting up and running an LLC comes with expenses, such as filing fees, yearly report fees, and possible legal fees if help is needed to create legal documents, like an operating agreement.Tax complexity:
- While LLCs offer tax flexibility, this can also introduce complexity, particularly if your LLC is taxed as a corporation. Understanding and navigating the various tax implications requires careful consideration, and it may be a good idea to consult with a tax professional, which could lead to additional costs.LLC vs. sole proprietorship: legal and tax implications
To decide between a sole proprietorship and an LLC, you’ll need to consider the legal and tax implications of each business type.
Tax considerations
For tax purposes, sole proprietors report business income and losses on their personal tax return using Schedule C. This is called pass-through taxation.
Single-member LLCs also report business income and expenses on Schedule C of their personal tax return. If you decide to expand your LLC to include more members, you can choose to be taxed either as a corporation or partnership. These business types come with their own unique business tax forms like:
Business tax returns can also have different tax filing deadlines depending on how they are structured.
Legal considerations
From a legal standpoint, one of the primary reasons for forming an LLC is the limited liability protection it offers. This protection means that, in most cases, the personal assets of LLC members are shielded from business debts and legal liabilities, giving you peace of mind and asset protection.
How to choose the right structure
If you’re stuck deciding between a sole proprietorship and an LLC, consider the following factors:
Nature of your business:
- Consider your industry, risk factors, and growth potential. If you have a business with high liability risks, or if you plan to grow significantly in the future, you may want to consider an LLC. While sole proprietorships offer simplicity, LLCs provide more flexibility in tax planning and may offer unique tax advantages, particularly for businesses with higher profits.Long-term goals:
- Based on what you’ve learned, consider your long-term business objectives and how a sole proprietorship or LLC would align with those goals. Think about scalability, succession planning, and potential exit strategies when making your decision.Costs and administrative load:
- Assess the costs of forming each business structure and the administrative requirements involved. While sole proprietorships are generally less costly and administratively burdensome, the added protection and flexibility of an LLC may justify the additional expenses and paperwork, depending on your situation.The bottom line
- Picking the right business structure is crucial for small business owners, as this decision affects your taxation, liability, and flexibility. It’s important to weigh the pros and cons of both a sole proprietorship and an LLC. By making an informed choice, you can set up your business for success and protect your assets.
