Deciding whether or not to incorporate your business is a very important step. The decision you make will affect your business from here on out. As such, you want to be sure that you are well informed on this matter before choosing one over the other.
In this guide, we will address the key differences between a limited liability corporation (LLC) and a sole proprietorship. Our goal is to help you decide whether to operate as an LLC or sole proprietor.LLC Vs. Sole Proprietorship
One of the biggest benefits of choosing an LLC over sole proprietorship is that member liability is limited to how much they’ve invested in the LLC. As such, a member isn’t personally responsible for the debts of the LLC (see also how to remove an LLC member here).
A sole proprietor, on the other hand, would be liable for any debts that are incurred by the business. That said, this liability is dependent upon the rules that govern an LLC. Moreover, if you operate the LLC the same way as you would a sole proprietorship, the liability protections are lost.
For instance, let’s say you incurred debts as a sole proprietor. Creditors are allowed to go after your house, vehicle, and other personal properties to satisfy those debts. This isn’t the case with an LLC, as you are protected from having your personal assets collected.
Let’s now turn our attention to some other factors you’ll want to consider in your decision to choose either an LLC or a sole proprietorship.
Sole Proprietorship
If you ultimately go with a sole proprietorship, you can look forward to avoiding filling out and filing a lot of paperwork. The only documentation you really need to worry about is industry-specific licenses. Furthermore, there are no yearly state filings to concern yourself with.
A sole proprietor is only responsible for the following taxes:
Local self-employment
Personal federal
State
A lack of paperwork and filings is great, but you also must keep in mind that you aren’t protected from liability, which puts you at risk of having your personal assets taken if debt is incurred.
As a sole proprietor, you are likely to find that it is difficult to secure funding. What’s more, it is also rather challenging trying to build business credit. It’s not all dark, though. You still have plenty of positives going for you as a sole proprietor.
Pros of Sole Proprietorship
In forming a sole proprietorship, the following benefits come with it:
You don’t have to fill out any required state paperwork. Other than required industry-specific licensing documents, paperwork is remarkably minimal.
The same is true for annual state filings. Unless there is a required industry-specific filing, you can enjoy being responsible only for the taxes mentioned below.
All profits and losses get passed through directly to the owner’s personal tax return. As such, you are responsible for only paying your state, personal federal, local, and FICA (Federal Insurance Contributions Act) taxes.
That means you do not have to pay on any unemployment taxes or specific business taxes. What’s more, you can still get most of the same tax benefits as being self-employed. This includes turning certain personal expenses into business expenses, such as using your personal vehicle for business use.
Under a sole proprietorship, you can write off regular business expenses, including marketing costs, business travel costs, entertaining clients, and much more. Furthermore, self-employed retirement plans such as Simplified Employee Pension Individual Retirement Accounts (SEP IRAs) come with higher deductions.
Cons of Sole Proprietorship
Like anything, sole proprietorship has its downsides. For starters, lawsuits, commercial debts, and other obligations aren’t protected against, meaning you can be directly and personally sued for any commercial activities that result in you going to court.
Moreover, this puts your personal properties and other assets at risk of being taken. And as a sole proprietorship, you may have a hard time generating equity financing. This is because investors prefer not to invest in sole proprietors.
Due to this, you could run into trouble funding your business, especially if you are struggling to sustain your operations. Additionally, because it’s tough to establish business credit for debt financing, you could face challenges when trying to secure a business loan. This is also because many banks categorize such requests as personal loans, limiting how much you can borrow.
And since you won’t be operating under a trade name, you will have far less market credibility. You can get around this by creating a DBA name. Just keep in mind that this will cost you additional and ongoing fees through the secretary of state or your state’s department of revenue (see Doing Business As).
Limited Liability Corporation
As an LLC, you will have far more market credibility, including liability protection against commercial debts and lawsuits. As such, you can rest easy knowing that your personal assets remain safe.
Whereas it is difficult to get financing as a sole proprietorship, it’s the opposite operating as an LLC, if only slightly. You will also have a lot of paperwork to fill out, which can be time-consuming and bothersome when you’re trying to get a business off the ground and running.
Furthermore, you will be responsible for annual state filings, as well as having additional taxes to pay each year.
Pros of LLC
Perhaps the most appealing aspect of forming an LLC - check out the best LLC formation - is that it separates your personal assets from potential lawsuits, thus preventing creditors from coming after your personal assets (see also the best registered agents here).
When you choose to form an LLC, you are creating a separate business entity from yourself. As such, the LLC is not you, and you are not the LLC.
Although there are indeed some common traits, LLCs don’t have to worry about the potential double taxation that can occur when operating as a corporation. What’s more, functioning as an LLC will benefit you in the following ways:
Better market credibility. This can play a big role in the success of your business going forward. An LLC gives you the notoriety of an established, legitimate organization that you can’t get operating as a sole proprietorship.
Having liability protection gives you the assurance that your personal assets can’t be taken from you in the event that your business runs into legal troubles. Whereas a sole proprietorship is responsible for such problems and can have their assets taken to resolve debts, you are considered entirely separate from your business dealings.
What’s more, you get to enjoy all of the tax benefits that come with being self-employed. This can have a big payoff come tax season. Finally, we suggest services like Nolo (look here), Rocket Lawyer (read more), Zen Business (see the review), or Incfile (see here), which provide various legal assistance when setting up a LLC.
Cons of LLC
With an LLC, you have to fill out a lot of state-related paperwork, including any industry-specific licensing.
Annual state filings and their associated fees are your responsibility, as well. This also includes any industry-specific licensing requirements.
You’ll not only have to pay your state, personal federal, local, and FICA taxes but potentially even Unemployment Taxes and State Business Taxes.
Compared to a sole proprietorship, the costs for completing an LLC’s tax return is much higher. Of course, you get the benefit of operating as self-employed, which can pay off in the end.
Which is Better?
Many business owners opt for an LLC because they are concerned with being held personally liable for their business’s actions. You should, however, understand that any attorney worth their salt will look for any possible way to get around this level of protection.
Oftentimes, when there are legal matters involving an LLC, the courts question whether the legal proceedings at hand are based on the business owner’s belief that they can’t be touched. This raises all kinds of questions and often causes more challenges for the business owner.
Still, this doesn’t mean that you will face the same scrutiny. The protection that LLCs provide cannot be dismissed. If you enjoy the peace of mind that such protection provides, an LLC may very well be your best option.
So, what’s the bottom line? In the end, you have to take into consideration things like raising capital, growing your business, and even sustaining it. LLCs are often the easiest option for business owners, regardless of how much paperwork is involved.
Summary
Sole proprietorship might provide freedom and autonomy, but an LLC gives you protection and significant benefits that need to be considered. Let's take daycare centers for example - though you can still be held personally liable if your personal conduct resulted in a child's injury while they are under your care, establishing your daycare as an LLC can protect your personal assets in a lawsuit against the daycare in certain circumstances. Now, with your business goals in mind, weigh the pros and cons of each. And don’t be afraid to ask for guidance and direction from those who have gone before you.
If there is anything that we can help you with in your journey to starting your own business, feel free to reach out to us. Our small business specialists will be more than happy to help you get your business going.
Be sure to check out our extensive articles catalog for more information on small businesses. We cover a wide range of topics that will help you in your decision-making.