Small business startup owners have a big choice to make in structuring their companies.
The options for ownership structure for entrepreneurs usually come down to two choices - sole proprietorship or limited liability companies (LLCs).
Each structure has its upsides and its downsides, and no new business owner should sign any legal agreement on his or her new company until proper due diligence has been done on sole proprietorships versus LLCs.
Before getting into the details on both business structure models, it's important to get all the help you can in making the right decision for you, and for your company. That should mean consulting with a trusted tax attorney, business consultant and/or financial planner.
What Is a Sole Proprietorship?
A sole proprietorship is likely the easiest business structure to implement, but it is not considered to be a legally binding entity.
In effect, a sole proprietorship can be created with any name the business owner wants. In legal terms, the company name in a sole proprietorship is just a name - it doesn't split the business owner away from his or her company, like an LLC does.
To establish a sole proprietorship, a business owner simply files the necessary legal documents, including name and any local licenses required by the town, city, or state where the business is located. Do that and the company is up and running as a sole proprietorship.
On the downside, any financial legal or liability is the responsibility of the sole proprietor, who is now vulnerable to lawsuits, fines, debts and other obligations, which all are the personal responsibility of the business owner.
What Is a Limited Liability Company?
A limited liability company offers new business owners something of a win-win from a tax and legal standpoint - the pass-through taxation benefits of a business partnership or sole proprietorship along with the limited liability protection that comes with being a corporation.
By structuring a new business as a limited liability company, that business starts out as its own separate and legal entity, with separate debts and assets that remain apart from the owner's personal financial picture, with the exception of the owner's personal taxes.
Think of an LLC as a blend of a business partnership and a corporation.
The term "limited liability" means exactly that - unlike a sole proprietor, a limited liability business owner is protected against lawsuits, debts, and other financial obligations related to the operation of the LLC. By and large, a limited liability company owner has largely protected himself or herself from creditors and legal trouble.
Advantages and Disadvantages of a Sole Proprietorship
There are "pros and cons" in having your business structures as a sole proprietorship or a limited liability, but that's not the complete picture.
The real issue is how best to select a business model depending on a company's internal factors, like the number of owners, the unique goals of the company, and how the founder (or founders) wants the company to operate.
You also need to weigh the more logistical elements of structuring a company - how you'll do it, what it costs, what the tax picture looks like, and how the day-to-day side of the business will be run. Let's take a look at all of those issues, and see where the upside and downside fall for sole proprietorships and limited liability companies:
Forming Your Company
A sole proprietorship is much easier to form than an LLC.
- With a sole proprietorship, all a business owner has to do is hang a shingle on the door and run the company under the proper rules and regulations of local governing bodies (meaning you'd need to get the proper licenses and permits and pay any fees associated in running your company.) In general, though, it costs very little - even nothing - to file as a sole proprietorship.
- With a limited liability company, the paperwork starts to pile up. First, you must form your company and register it with the proper authorities (usually the town, city or state the business operates in.)
You'll need to complete and file articles of incorporation, which spell out exactly how the business will be run and who'll be making the decisions. You'll also need to pay a filing fee of $100 or more (it depends on the state you're located in) and file it with your state's secretary of state's office. In all, expect to pay about $1,000 or so to properly file your business as an LLC.
Filing a company as a sole proprietorship is much easier and less expensive than filing as an LLC. With the latter, you're paying more upfront cash, filling our more paperwork, and takes up way more time than with a sole proprietorship.
Capital Funding Realities
The stark reality is that any company needs cash flow to sustain itself, and both a sole proprietorship and an LLC seek business funding in different ways.
- With a sole proprietorship, the business owner needs to raise money through traditional means, like getting a loan or a line of credit from a bank or seeking help from angel capitalists. That's not always easy to do and often requires the business owner to put up her or her own capital to obtain loans and financing.
- With an LLC, funding a business is basically the same as a sole proprietorship, with a big caveat. Under an LLC, debts and other financial obligations aren't necessarily held against the business owner - they're usually held against the company, which is treated differently from a legal point of view when loans go unpaid and creditors demand payments on loans and credit.
Business funding is basically the same under a sole proprietorship and an LLC. The main difference is that a limited liability company owner has more upside financial and legal protection than a sole proprietor.
Taxes also come into play when choosing between a sole proprietorship and an LLC.
- With a sole proprietorship, federal taxes are based on the company owner's net business income, yet the taxes must be filled out on the business owner's individual tax return, and at the business owner's tax bracket.
- With a limited liability company, taxes are viewed differently by Uncle Sam. Under U.S. law, LLC's are deemed as disregarded entities, meaning they are taxed similarly to a sole proprietor (or, the IRS disregards the differences between an LLC and a sole proprietorship for tax purposes. With an LLC, you'll also have more tax paperwork (like handling employee tax withholdings) than would a sole proprietor.
In general, there aren't substantial tax differences between the two business structures.
For 2019 tax purposes, both an LLC and a sole proprietorship can take advantage of new federal tax laws that allow for a pass-through deduction of up to 20% of all business income (for both LLCs and sole proprietorships), which represents a substantial tax break for U.S. small business owners.
Logistics and Operational Standpoint
Here's where a sole proprietorship and an LLC can really differ.
- With a sole proprietorship, you as the business owner make all the decisions and are the go-to person for business partners, customers and financial professional specialists like an accountant, a banker, or a financial planner.
- With an LLC, there can be a single decision-maker, as designated by the article of incorporation, or decision-making responsibilities can be shared among company executives. Sharing the responsibilities of running a business is much more prevalent - and even desired - in an LLC business structure.
If you like the responsibility of giving orders and making big decisions, you can structure your company as an LLC or a sole proprietorship as a single-source run company. But with an LLC, it's much more likely that the company is run and managed in a shared responsibility model.
This another area where a sole proprietorship and an LLC can vary significantly.
- With a sole proprietorship, the owner of the company absorbs all the responsibility - good or bad - in running the business. There is no protection against lawsuits, debt filings, bank actions, and other potential downside business liabilities. That means the company owner's personal finances are at risk, and can at great risk of being taken by creditors or courts.
- With a limited liability company, the business is regarded as a separate entity from the business owner, whose personal assets are walled off from potential legal outcomes and creditor actions (unless the business owner made a personal guarantee against a business loan.)
It's much more likely to see a sole proprietor take out substantial business insurance to protect against financial liabilities that might befall a company. LLCs may (and should) take out business insurance, too, but an LLC owner isn't as worried about financial liability.
LLCs vs. Sole Proprietorships: An Important Decision for Business Owners
There's no doubt that business owners face a unique and important choice in selecting a business structure - specifically a sole proprietorship versus a limited liability company.
The key in making the right decision is to do your due diligence, consult with other small business owners and learn from their experiences, and consult business and financial specialists who can guide you through the myriad issues that matter to a small business owner - issues like logistics, regulatory filings, taxes, and personal liability.
Do all that and you're well on your way to making the business structure decision that works best for you.