Sole proprietorships and LLCs are two of the more common and straightforward structures for new businesses. And yet, for the first-time founder, choosing the more suitable option can throw them into an overwhelming state.
So, what are the main differences between sole proprietorships and LLCs? And how do they impact your business in the short and long term? There are several fundamental differences between the two options.
Sole proprietorship
A sole proprietorship is a business structure in which there is no legal differentiation between the entity and its single owner.
Sole proprietorships are also the easiest business structures to form. An owner can establish a trade name by registering a fictitious name or a DBA (Doing Business As) with the commonwealth, open a business banking account and have the business up and running relatively quickly.
Sole proprietorships are taxed as pass-through entities, meaning that taxes flow from the business directly to the owner to pay. All the profits go to the owner.
The benefit of a sole proprietorship is how easy it is to set up and manage. The owner is in complete control. But what you gain in ease, you give up in terms of risk. That’s because a sole proprietorship structure does not protect an owner from personal liability should the business face financial or legal challenges. As the owner, all business liabilities and debts rest on your shoulders. There is unlimited liability.
Some other issues that one might consider in a sole proprietorship: the individual normally provides the capital, and the owner is subject to self-employment taxes
Limited Liability Corporation (LLC)
LLCs are companies with at least two owners, known as members. However, it can be organized as a single member LLC. Unlike sole proprietorships, however, each member’s personal assets are separate from the business’ liabilities, which offers much more personal protection to the owners. Unlike using a fictitious name, forming an LLC also registers your business with your commonwealth, Secretary of State, preserving its name there and preventing other entities from using it. This is very helpful in protecting your brand and the products or services you sell.
Another big difference between the two options is the flexibility LLCs have when it comes to taxation. An LLC can operate like a C Corporation (C Corp) and pay a corporate tax rate, or the business can opt to pay taxes as an S Corporation (S Corp) and operate as a pass-through tax entity for its members.
There is also what’s called a Single-Member LLC, in which the sole owner of a business registers the organization as an LLC to take advantage of its protections. Single-member LLCs separate an owner’s personal assets from the business’ liabilities. The owner can also opt to be taxed as a C Corp as an S Corp, just like an LLC.
To set up either type of LLC, owners must file Articles of Organization with the commonwealth. While the form is relatively simple, it’s always a good idea to consult a business attorney prior to filing.
Other elements to consider: the LLC members may sell interests to raise capital, depending on the restrictions in the operating agreement, the interests may be transferrable. If organized as a single member, taxes are reported on Schedule C 1040. If a partnership, the IRS 1065 and members get a K-1. The salary of a single member LLC is subject to self-employment taxes. The timeframe is perpetual, and the members can set up a management framework that suits them.
What to consider when choosing your business structure
Before you decide to structure your business as either a sole proprietorship or an LLC, ask yourself these two important questions and/or seek out a small business attorney’s opinion.
1. Am I willing to take on personal risk for my business?
Although sole proprietorships require owners to take on more personal risk than LLCs, they are easier to set up and manage. Are you willing to accept the risk to keep things simple?
2. How do I want to pay taxes?
Sole proprietorships and LLCs offer different tax structures and owners must decide which taxing method works best for their needs.
The good news is that whichever structure you choose, you can always change it as your business grows. Suppose you begin as a sole proprietorship and then later decide that personal liability protection or a corporate tax rate is better for you and your business. In that case, you can form an LLC and keep your business moving forward.
As you review your structure and try to determine the right formation for your business entity contact SCORE Cape Cod & the Islands for a Mentor to guide you along with a business attorney.
