For business owners, one of the most important decisions to make is how to structure your company. The business structure you choose has a major impact on important components of your business.
The business structure determines how you pay taxes, how you are protected against judgements against the organization and how you operate. While there are many different types to choose from, the most popular are a sole proprietorship and a limited liability company (LLC).
In this post, we will define these two popular business structures and show the similarities and differences between them. We’ll also look at how you can decide which structure is right for your business.
Not choosing the right business structure may be one of the most common mistakes made by starting business owners, especially when it comes to a small business that may not have a legal back consulting at each turn. However, if you spend time learning about this topic, it may turn out to be simpler than it seems at first glance.
What Is a Sole Proprietorship?
A sole proprietorship is the simplest business type. It’s an unincorporated structure that has a single owner.
A sole proprietorship is the least expensive business structure, requiring no formal or legal paperwork to launch.
Freelancers and consultants are among the most common professions where owners use a sole proprietorship.
If you operate your business as an individual, a sole proprietorship is the default business structure. Unless you choose a different business type, the sole proprietorship is the structure you will automatically have.
A sole proprietorship, as the name implies, can only have one owner. If the owner takes on another owner or business partner, the business becomes a general partnership.
In many cases, the individual’s name is also the name of the business under a sole proprietorship. However, these business structures can also operate under a trade name or a brand name.
The main factor that defines any sole proprietorship is that there is no legal distinction between the owner and the business. That means the owner is personally liable for any debts or judgements against the business. The personal and business assets and liabilities are the same. The business owner is personally responsible.
What Is an LLC?
An LLC is a business entity that requires paperwork to be filed within a state to become a formal company. The LLC is a separate entity legally from its owners, which are known as members.
The individual members are not responsible for any liabilities or debts incurred by the business. The LLC is responsible instead.
The LLC has some elements in common with a sole proprietorship and two other common business entities – partnerships and corporations.
The LLC business structure is all about flexibility. Within an LLC framework, owners can determine the business’ management structure, operations, and tax identity.
Businesses can be started by one person as a single-member LLC or by multiple people as a multi-member LLC.
With an LLC, the business’s legal name will end either with the words “limited liability company” or its abbreviation, “LLC.”
The “limited liability” in the entity name means that members cannot be held responsible for liability from debts or other legal obligations. In other words, a creditor or someone suing the business cannot try to seize the personal assets of the business owners. If the business is sued or cannot pay its debts, the owners, in most cases, cannot be held individually financially responsible.
If the LLC goes bankrupt, that process is also handled separately from a personal bankruptcy on the part of its owners. The LLC business structure also protects owners against liability that’s due to the actions of any of its employees.
Single-member LLCs are taxed, by default, the same way sole proprietorships are. However, there are options that LLC owners have when it comes to tax structure.
It’s possible to get an LLC online using an online service, which will streamline the process, or directly through your state’s GOV website. The paperwork may seem daunting at first, but it’s actually a fairly simple process.
Differences in Legal Protection
Legal protection is perhaps the most meaningful difference between a sole proprietorship and an LLC.
In a sole proprietorship there is no legal distinction or separation between the owner and their business. If there are business debts, the owner is responsible for them.
If the business goes bankrupt, the business owner will need to file for bankruptcy protection. The owner’s personal and business assets will be considered during any bankruptcy proceedings.
Perhaps as importantly, if someone looks to sue a business that is a sole proprietorship, they can name the business owner in the lawsuit and come after their personal assets in the filing.
The owner can also be held liable personally for any acts taken by employees.
Of course, on the flip side, with a sole proprietorship, the owner is also eligible to reap all the benefits and proceeds of the business.
With an LLC, the legal protections are very different. As a separate legal business entity, the business absorbs any of the liabilities or business obligations. The owner is not personally responsible for any business debts or judgements.
That means that credits cannot come after personal assets such as the owner’s home, savings or automobiles as payment.
If a business fails, the owners do not have to pay any of the business obligations from their own assets, either. The business, not the owner, files for bankruptcy.
While there are exceptions, in most cases, if someone sues an LLC, they cannot also sue the owners. Owners of an LLC can be held personally liable for certain types of actions, including fraud and negligence. Owners can also be held liable for any debts they personally guaranteed.
Differences in Taxes
Both a sole proprietorship and single-member LLC are considered “pass-through entities” when it comes to taxes. That means the business does not pay income taxes. Instead, the owner or owners report any business income on their personal tax returns, usually the Schedule C. Any income earned from the business is taxed at the owners’ personal tax rate.
Multi-member LLCs work slightly differently but are also pass-through entities. Each owner reports their share of any business income or loss on their personal income taxes.
They also pay taxes at their personal income rate. They must also attach a Schedule K-1, which spells out their share of the business income to their tax return
One difference between single- and multi-member LLCs is that the latter must file a tax return, Form 1065, with the IRS.
LLCs have tax flexibility, meaning they can determine how they want their business to be taxed. Specifically, they can choose the default pass-through tax structure or opt to have the LLC be taxed as either an S-corporation or C-corporation.
An S-corporation is a pass-through entity while the C-corporation will pay corporate income taxes federally. Most states and some local entities also levy a corporate tax.
Why would an LLC owner choose a corporate tax status?
When a company is taxed as a corporation, business dividends are usually taxed at a lower rate than typical business income. Retained earnings in a corporation are also not subject to an income tax. Corporations are also often eligible for more tax credits and deductions.
No matter the scenario, LLC members can’t treat income as dividends. They have to pay taxes on all business profits.
Whether organized as an LLC or sole proprietorship, businesses will have other tax obligations, such as payroll taxes and state and local sales taxes. And a self-employed business owner will need to pay the full amount of self-employment taxes, which cover Social Security and Medicare.
Some states also levy special taxes on LLCs, including a franchise tax, business tax or LLC tax.
Differences in Paperwork and Compliance
Sole proprietorships require little paperwork, needing no formal filings. However, like all businesses, they may need to apply for permits, licenses and other formal documentation.
An LLC needs to file formal paperwork with the state to officially be organized as the business entity. In many states, they also need to file annual reports. If the LLC has multiple members owners, it may also need to create a legal operating agreement, which outlines how the business is managed and how disputes will be resolved. The LLC may need to issue membership units or record ownership transfers, too. To dissolve the LLC, additional paperwork is required.
Differences in Management
With a sole proprietorship, the owner is responsible for all aspects of the business. An LLC, by contrast, can be a member-managed LLC run by one or more members, or manager-managed, in which an employee is responsible for day-to-day operations.
How to Choose the Right Business Structure
Many first-time entrepreneurs start out with a sole proprietorship. It’s a simple structure and one that does not require additional expense or paperwork.
However, as a business grows or becomes more complex, a different business structure, such as an LLC, may be the smart choice.
With an LLC, you can protect your personal assets and have considerable flexibility when it comes to how your business is managed and taxed. That’s one of the main reasons many businesses launch or later file as an LLC.