Which are better Sole Proprietorships vs LLCs. Both business entities have their advantages, but which is right for you?
Identifying the appropriate business structure for a company is a key decision for almost all owners of small businesses. However, it can be very confusing settling for a structure that best suits the business model and its objectives. Without a professional mastery of legal and tax policies, it can be difficult to truly distinguish all types of business entities.
Why is the choice of your business entity important in real-life scenarios? This is because it determines the amount of taxes you pay and the time you spend doing all the necessary paperwork. Also, the type of business structure determines the best course of action when another party decided to charge your company in a court of law.
A common source of confusion among new business owners is differentiating a limited liability company (LLC) from a sole proprietorship. We have provided this informational guide to bring out the differences between LLCs and sole proprietorships in terms of their formation, tax structures, and protection by the law, among others.
Definition Of A Sole Proprietorship
A question that you are likely to encounter is what is a sole proprietorship? A sole proprietorship is a distinct business structure owned by a single person. It is the easiest and most affordable type of business structure/entity a trader can form.
For this reason, a person who runs and controls a business alone is called a sole proprietor. Unless there is a defined business structure, a store owner, a freelancer or an owner of an online business qualifies as a sole proprietor.
Usually, a business is likely to be a sole proprietorship if it bears the name of the owner i.e. the name of the business is the same as the owner’s name. However, it is important to note sole proprietorships can use a trade or a brand name and still operate successfully. The most notable feature of a sole proprietorship is there is no legal veil separating the rights and responsibilities of the business from those of the business owner.
The Definition Of A LLC
What is an LLC? An LLC is a business entity that is legally separate from the owner or shareholders and is formed under state law. An LLC brings together features of a sole proprietorship, a partnership, and a corporation, while at the same time providing extra flexibility to the shareholders.
The owners of the LLC reserve the right to adopt their preferred management structure, operating procedures, and tax treatment methods. An LLC formed and owned by a single person is called a single-member LLC, while for multiple persons is a multi-member LLC.
One can know a business is an LLC if it has the phrase “limited liability company” or “LLC” at the end of its legally-registered name. The main advantage of an LLC is that it shields the shareholders from debts and obligations of the business entity. That means, during the life and operation of the company, business creditors cannot claim the personal assets of the business owner when recovering the advanced loan amount; we will cover this point in greater detail later.
Do I need an LLC? – The complete guide.
The Formation Process Of A Sole Proprietorship And LLC
Like earlier mentioned, a sole proprietorship is the simplest and most economical entity to form and operate as far as the documentation process is concerned. Most people may be operating a sole proprietorship business without their knowledge because there is no particular requirement needed to set up a sole proprietorship and run one. For example, a retailer selling their merchandise down the local street or the mobile plumber in your area is a sole proprietor in their own right.
However, in certain regions, you may have to apply for a business license, development, or zoning approvals to be allowed to form and run a sole proprietorship business. Additionally, any business such as a sole proprietorship that operates its business under a trade name must apply for a fictitious business name. A fictitious business name is sometimes referred to as a DBA or “doing business as” certificate.
At times, an LLC may have to seek business permits and a DBA if they are carrying out business under a trade name. However, the most necessary document for the formation of an LLC is the Articles of Organization. Articles of Organization is the basis for the formation and existence of an LLC; it is filed in the state where your business is located. The cost for filing the Articles of Organization ranges from $50 to $200 depending on the state of location for your business.
The Operation And Management Of A Sole Proprietorship And LLC
The operating procedures and day-to-day management of a sole proprietorship are simplified because there is only one decision-maker. The owner of a sole proprietor does not need to consult anyone when making decisions on business operations. However, most sole proprietors prefer to hire and delegate powers and responsibilities to employees, legal, accounting experts and other professionals to help run business operations.
Noteworthy, hiring and delegating work duties ought to be a limited affair in a bid to reduce overall business operating costs; an upsurge in salaries and wages beyond a certain point may greatly attenuate business profits. It is the duty of the sole proprietor to ensure the business is operating profitably, safely and within the required legal provisions.
On the other hand, operating and managing an LLC is a bit more difficult compared to a sole proprietorship business. Usually, an LLC’s operating and management procedures are captured in an LLC’s operating agreement though not all states call for an operating agreement for LLCs. However, please note a lot of LLC operations are guided by an operating agreement, especially if you are dealing with multi-member LLCs.
But what is an operating agreement? It is a document showing the number of shares owned by each member, their voting rights and their respective share of profits. Members of an LLC may appoint a single manager or select members to run and control the operations of the LLC.
Usually, members of the LLC are accorded voting rights for decision-making based on their ownership share in the entity; ownership stake in LLC is expressed in terms of membership units. For instance, a 50% ownership stake in an LLC gives the shareholder half of the voting rights to decide on company matters. Equally, a 33% of ownership stake allows the owner to receive one-third of the LLC’s profits.
Tax Treatment For Sole Proprietorship And LCCs Business Entities
Tax treatment for sole proprietors and single-member LLC is similar as far as tax treatment is concerned. This is because, for both types of business entities, the business by and of itself does not remit any income taxes in what is called pass-through taxation. Instead, the owner pays the business’s taxes using their personal tax return, while reporting the business income on Schedule C which is attached to personal tax returns.
LLCs with multiple members are also subjected to pass-through taxation where individual shareholders pay and report taxes based on their stake in the business’s profits. However, the difference with a multi-member LLC is that business tax returns must be filed with the Internal Revenue Service (IRS), Form 1065, and U.S.A Return of Partnership Income. Simultaneously, all members must individually attach a Schedule K-1 to their personal tax return, indicating their share of the business’s profits.
Apart from income taxes, other tax duties may be levied on both LLCs and sole proprietorship businesses. For instance, you may have to pay payroll taxes if you have employed staff in your business, regardless of the entity you opt to go for. Also, the business entity must aggregate and remit state and local sales taxes if it is dealing in taxable goods or services. Finally, self-employed business owners must pay self-employment taxes to the IRS; these payments cater to the business owner’s social security and Medicare tax.
Only a few states and local governments impose extra charges on LLCs. Depending on the state the business is located in, this extra tax may be referred to as LLC tax, franchise tax, or business tax. Also, the LLC must pay state and local income taxes and payroll taxes.
Electing Corporate Tax Status Is Limited To LLCs Only
One major difference between LLC businesses and sole proprietorships is flexibility for tax remittances. This is because LLC owners can decide how they want to be taxed, that is, elect to have the LLC entity taxed as a C-corporation or S-corporation or opt for pass-through taxation.
An S-corporation is taxed as a pass-through entity. However, if the LLC is taxed as a C-corporation, the business entity must pay corporate income tax at the corporate level and a flat rate of 21%. Note: many states and other local jurisdictions also impose corporate taxes.
In some instances, an LLC can save money by electing corporate tax status. When your business is taxed like a corporation, dividends paid by the company are usually taxed at a lower rate compared to the ordinary income generated by the business. Additionally, income tax will be levied on the company’s retained earnings.
On the other hand, stakeholders in an LLC cannot consider income as dividends; the LLC must remit taxes for gross business profits, and it does not matter if the earning were retained in the LLC or paid out to the owners. Additionally, a corporation may pay more from extra tax deductions and credits.
Comparing Legal Protection Between Sole Proprietorship And An LLC
For a sole proprietorship business, there is no legal separation between the entity itself and the owner. For this reason, the owner is personally liable for the debts incurred by the business. Also, if the business runs bankrupt, the business owner must likewise file for personal bankruptcy; both personal and business loans are incorporated in the bankruptcy case. Creditors of a sole proprietorship may personally sue the business owner and claim the personal assets of the sole proprietor.
The establishment of an LLC is one of the most effective ways to safeguard personal assets. The personal assets of the LLC owner/s are exempt from claims originating from the LLC’s obligations. In the event the business goes broke and fails to pay its creditors, the LLC owners need not use their personal assets to settle outstanding business debts. At the same time, parties that sue an LLC cannot also personally sue the LLC owners, but with some exemptions.
However, the LLC owners can be charged in court if they are personally liable for professional negligence, fraud, or loans secured by personal assets. Worthy to note, there is no single business entity structure that fully exonerates LLC owners from their business’s liabilities and obligations or wrongdoings.
Difference In Paperwork And Compliance Requirements Between An LLC And Sole Proprietorship
The last difference between a sole proprietorship business and an LLC is in the documentation and compliance required for each of the two entities. A sole proprietorship business needs the lowest number of paper documents to set up and operate. Thereafter, the sole proprietor will only require to pay federal, state, and local taxes, and renew their business permit.
However, an LLC has more compliance requirements. Apart from preparation and filing of the articles of organization at the onset of the formation process, an LLC must file a report every year and in numerous states. If the LLC has multiple stakeholders, the responsibilities are more. Some of them include the issuance of membership units, accounting for transfers of ownership rights, and organizing regular member meetings.
These responsibilities are not legally mandatory but are important for LLCs to safeguard their members from their LLC entity’s liabilities. Also, because LLC is a legally-registered business, its dissolution process is more complex and requires extra documentation.
Should I Choose A Sole Proprietorship Or An LLC For My Business?
Since it is easy to set up a sole proprietorship business, many freelance workers and consultants usually begin as sole proprietors. There is less money and paperwork needed to form a sole proprietorship which tends to attract many budding entrepreneurs, especially traders looking to test the market with their business propositions. There are fewer taxes levied on sole proprietorship businesses, because the business owner does not have to file a distinct business tax report.
Circumstances are likely to change as your business expands and stabilizes its foothold on the market. There is no legal separation between the personal assets of the business owner and those of the business.
This is to means, the sole proprietor may go bankrupt if the business finances significantly dwindle due to unforeseen encounters, and the business fails to meet its financial obligations. On the other hand, owners of an LLC and are protected from the business’s liabilities. In case of business bankruptcy, your personal assets are protected.
Also, an LLC provides the owners with tax payment flexibility. A majority of LLC owners opt for pass-through taxation, similar to how taxes for sole proprietorships are levied. Nonetheless, the owners of the LLC may opt to elect corporate tax status for their LLC, thereby saving money for the business. The LLC business structure has gained traction in all 50 states due to its support for the growth of small businesses.
There are many factors to consider when evaluating the most ideal business structure. The best way forward is to talk to a business lawyer before making your selection. Nonetheless, due to the benefits from tax flexibility and protection from liability, an LLC is often befitting for a majority of small businesses.