The two most popular ways of organizing a small business are LLCs and sole proprietorships. They are less costly and complicated compared to the alternatives of corporations and partnerships. There are key differences between these two widely used structures, including the owner’s liability, expense and ease of creation. The advantages of a sole proprietorship are simplicity and low cost; the advantage of LLCs are their flexibility for tax purposes and their liability protections for owners. Consider working with a financial advisor as you chose a legal structure for your business.
Sole Proprietorships and LLCs
The owner of a sole proprietorship is not legally distinguished from the business. They are one and the same. That means the business income is the owner’s income, and it’s reported that way for tax purposes. Similarly, the business’s obligations are the owner’s obligations.
LLCs are a blend of corporations and partnerships. The LLC is a legally separate entity. That means the business’s obligations are not the same as the owner’s. LLC income generally flows directly to the owner, but it can be treated as a corporation for tax purposes as well.
Sole proprietor or single-member LLC are options for one-person companies. And there are significant similarities between the two types of entity. Each will report income to the IRS on a Schedule C filed as part of the owner’s federal tax return. If there are any employees, each will need an Employer Identification Number and have to withhold taxes.
There are also significant differences between the two. These differences guide business owners making this choice.
Sole Proprietor Pros
The sole proprietorship is by far the easiest type of business entity to set up. It is the default entity for one-person businesses.
There are no special filing fees or paperwork for sole proprietorships. They may still need to register them the authorities for tax purposes or if operating under a name different from the owner’s first and last names, however.
Sole proprietor taxes are simple, too. The business revenues and expenses are reported on a Schedule C as part of the owner’s tax return and the profits are treated as individual income.
Sole Proprietor Cons
Liability is the biggest negative to a sole proprietorship. The owner is completely liable for any obligations of the business. If the business incurs debts, creditors can come after the owner’s personal assets, including home and vehicle.
It is difficult to get equity investors in a sole proprietorship. And it can be hard to establish business credit. Without a distinction between owner and business, any loans are likely to be considered personal loans by a lender.
The business income is also subject to self-employment taxes. Self-employed earners pay both the employee’s and the employer’s share of Social Security and Medicare taxes, which comes to 14.3%.
Limited liability is the biggest advantage an LLC holds over a sole proprietorship. If the business incurs a commercial debt or has to pay damages from a lawsuit, the owner’s assets are protected. Entrepreneurs who choose the LLC structure typically do so for the legal protection it affords them.
For tax purposes, LLC income usually flows directly to the owner and is reported on the owner’s tax return and taxed at the owner’s personal rate. This avoids double taxation, business and personal, that corporations must pay.
It’s generally somewhat easier for an LLC to get equity investors and also to take out business loans. And there is no need to submit a “doing business as” or D.B.A. notice with the state as sole proprietors must do if conducting business under something other than the owner’s first and last names.
LLCs involve more paperwork, and not all businesses can use the LLC structure. Business owners must file articles of organization with the state when creating an LLC. The associated legal work and filing fees mean it can cost $1,000 or more to set up an LLC. They also have to file annual reports with the state. Changing the LLC requires filing articles of amendment with the state.
If they choose to be taxed as corporations, LLCs file separate tax returns from the owner’s return. This adds to the complexity and cost at filing time.
Also, the liability protection afforded by an LLC is not absolute. If a creditor seeks to “pierce the corporate veil” and is successful, a single-member LLC may be considered essentially as a sole proprietor. Then the owner can be held personally liable for the business’s obligations.
The Bottom Line
The ease, simplicity and low cost of setting up and administering a sole proprietorship has to be balanced carefully against the liability protection offered by the LLC. Unlike a sole proprietorship, an LLC is a hybrid of the corporate and partnership structures that allows the liability protection of a corporation with the tax advantages of a partnership The other differences between sole proprietorships and LLCs generally are of less importance for single-owner companies, but should be kept in mind and may influence the decision in some cases.
Tips for Small Business Owners
- Consider working with a financial advisor experienced in business tax issues. If you don’t have a financial advisor yet, finding one doesn’t have to be hard. SmartAsset’s free tool matches you with up to three vetted financial advisors who serve your area, and you can interview your advisor matches at no cost to decide which one is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
- financial advisors in your area in five minutes. If you’re ready to be matched with local advisors who will help you achieve your financial goals, get started now.
- Another popular structure for a small business is an S corp. Understanding the similarities and differences between an S corp and an LLC will help you decide which one may be the most appropriate for your enterprise.
Photo credit: ©iStock.com/sturti, ©iStock.com/Maica, ©iStock.com/imaginima