Choosing the right entity type for your new small business is critical, but it can be challenging to know which one to pick if you’re not a lawyer or an experienced business professional.
Unfortunately, choosing the wrong business structure can have significant consequences for the success of your new venture.
The choice you make today affects how you pay taxes, whether you have legal protection if someone sues your business, and paperwork requirements.
The designations of sole proprietor and limited liability company (LLC) are popular choices for new and smaller businesses.
Like all business entity types, each of these has pros and cons to consider. This guide provides you with detailed descriptions of each type of business entity along with some of the top pros and cons of each.
What Is A Sole Proprietor?
The simplest and least expensive of the business types, working as a sole proprietor means that your business is unincorporated, and you are the only owner.
The IRS considers any individual who operates a business on their own with or without employees a sole proprietor by default.
If you prefer to operate as an LLC, you need to file paperwork with your state government to do so. People who work primarily as independent contractors also fit this category.
The name of your business defaults to your own name unless you choose to use something else.
In that case, you need to file paperwork called Doing Business As to legally operate your business under a fictitious name.
The main thing to remember about working as a sole proprietor is that no legal separation exists between you and your business.
You are responsible for all business debts, which means that a client or creditor could collect your personal assets in a lawsuit.
Pros Of Sole Proprietorship
The designation of sole proprietor is the simplest of all business structures.
As the owner and only employee of your business, you’re already the sole proprietor by virtue of your business activities.
You have no paperwork requirements unless you choose to use something other than your legal name as the name of your new business or you need a permit to operate.
Selling merchandise to customers, whether online or in a physical location, is a common example of a time when you would need a permit as a sole proprietor.
You Only Have to File One Income Tax Return
Since the IRS views you and your business as one in the same, it only taxes your income once at the personal level. You report your profits, losses, and expenses on your individual income tax return, which is a simpler process than preparing a corporate tax return. You also have this advantage if you choose to operate as a single-member LLC.
Not As Many Guidelines To Follow
Other than filing a Doing Business As if applicable and obtaining a permit if required, you don’t have any other guidelines imposed on you by the IRS, federal government, or state government when operating as a sole proprietor.
Another thing to consider is that all profits left over after paying your expenses belong to you.
LLCs, on the other hand, must go through a formal registration process, create a business name separate from their own name, and appoint a registered agent to receive legal correspondence. Each of these requirements costs money.
Cons Of Sole Proprietorship
As simple and cost-effective as it can be to operate as a sole proprietor, it isn’t the right choice for everyone.
One of the biggest reasons new business owners decide against this type of entity is that they have no protection against losing their personal assets in case of a lawsuit.
The person or company suing you can go after everything from your savings account to IRA to your personal vehicle.
When someone sues an LLC, they can only recover the company’s assets and not those of the owners.
Raising Capital Can Be Difficult
As a sole proprietor, you only need an employer identification number from the IRS if you decide to hire employees.
Without an EIN, it’s impossible to obtain a business loan from a bank or credit union.
Lenders and creditors also tend to view sole proprietorship as a more informal business structure than an LLC.
You Make All the Decisions
While some people see this as a positive thing, being responsible for every facet of running your company can become quite stressful and isolating.
Business owners often appreciate having someone else’s perspective when facing big decisions.
What Is An LLC?
The structure combines the benefits of sole proprietorship and a corporation with fewer of the downsides of each.
You can operate an LLC as a single member or with one or more business partners.
Single-member LLCs control every aspect of the business just as sole proprietors do, but they have the benefit of the limited liability protection, meaning legal separation and financial protection.
Launching a new business as a sole proprietor and then switching to a single or multi-member LLC is a common business move.
LLCs operated by just one person use a flow-through taxation method, which means they report their income, losses, and expenses on a personal income tax return just as sole proprietors do.
If you choose to form an LLC, you must do it in the state where you live and operate the business.
Pros Of An LLC
Protection of personal assets tops the list for most people when they consider the benefits of forming an LLC.
Creditors and clients who might sue your company cannot hold you personally responsible for business debts.
Flexibility With Tax Filing
Operating as an LLC gives you more choices when it comes to filing your tax return.
You can opt for the pass-through system described above, or you can voluntarily select to have the IRS tax your business as an S-corporation or C-corporation.
However, you should know that choosing the second option is more complicated as it requires you to follow strict and specific guidelines.
If you’re uncertain of the best way to pay your taxes as an LLC owner, consult with your accountant or tax advisor.
Simplicity In Setup
Although no setup is as simple as the sole proprietorship, registering as an LLC is a straightforward process.
The main thing you need to do is file articles of incorporation with your Secretary of State.
The paperwork requirements for an LLC are more than a sole proprietorship but less than a corporation. You don’t even have to file an annual report in some states.
Even if you initially launch your business as a single-member LLC, you always have the option of bringing in more members later.
This isn’t possible as a sole proprietor, since the structure limits ownership to a single individual.
Easier To Obtain Funding
LLCs have an easier time raising capital from outside sources than sole proprietors do.
Lenders and creditors view this business entity as more professional and stable than sole proprietorship since it’s a separate entity from its owner.
You may also have an easier time attracting investors, although investors tend to prefer corporations.
Cons Of An LLC
Since it’s a more formal business structure, LLCs are on the hook for annual renewal fees, and some must file an annual report with their state.
The startup costs of an LLC can be a deterrent for new business owners who are on a tight budget.
Regular Requirements To Deal With The Government
You should expect more bureaucracy if you choose to operate your business as an LLC, especially within your own state.
Depending on your industry and type of business, you could have frequent interactions with federal and local governments as well, such as filing an annual report with the state, for example.
LLC business owners often find the licensing process to be a hassle, but fortunately, it’s a one-and-done deal.
Inflexibility With Member Turnover
Membership and ownership of an LLC is typically quite flexible, but not always.
Some states require LLCs to dissolve and form a new LLC when a member leaves or a new member joins. At the very least, you will need to refile paperwork with your state.
Changes in LLC membership also require you to amend your company’s articles of incorporation, operating agreement, and amend paperwork with the IRS.
Confusion over what you need to do could necessitate taking on the expense of hiring an attorney.
LLCs Have Been The Most Popular Business Structure For 16 Consecutive Years
Nearly three out of four business owners choose to operate as an LLC over all other business entities.
While that doesn’t necessarily mean it’s the right choice for your business, you might consider setting a goal to become an LLC within a certain amount of time if you start out as a sole proprietor.
The best way to decide is to look at your risk of losing personal assets, along with the paperwork requirements, tax options, and membership structure of each, and decide how well they would work for your new company.