There are a few business structures available to SMBs, with sole proprietorships and LLCs being two of the most popular. Many SMB owners are unsure as to what they are and about which one to choose, so we’ve broken down both in plain English.
“Sole proprietorship” is just finance jargon for only (sole) owner (proprietorship). Most small business owners start as sole-props. It is the default setting when you become your own boss and begin your business.
- Freedom: The beauty of SPs is that the business owner has freedom to implement any of their ideas at any time. An SP’s owner is in control of all aspects of the business, from finances to company policy and so on.
- Cheaper and Easier Management: SPs require less effort and paperwork than other business structures, including LLCs. For example, most SPs do not have to file with their state. Because very few filings are necessary, it is also likely that SP owners will have to pay less in fees than other business structures.
- Self-Employed Perks: There are many benefits in place for self-employed individuals such as self-employed retirement plans (SEP IRAs) that may result in higher deductions during tax season. If you’re founding a sole proprietorship, these perks are well worth looking into.
- Simpler Taxes: In most cases, SPs have an easier time during tax season than LLCs. For SPs, personal and business finances are not required to be seperated, unlike LLCs. While filing taxes as an SP still requires some extra steps, filing as an LLC is typically more complicated.
- No liability protection: Liability describes the legal responsibility you have for something, in this case, your business. With an SP, you as the business owner are personally responsible for all debts and damages your business incurs. Furthermore, your personal assets (e.g. car, house, savings) can be used to settle any legal disputes. If your business is sued, everything you own is at risk.
- Difficulty funding: Given the volatility that could come with a SP, it may be difficult to find investors for your business. SPs also struggle to establish business credit, since your “business” loans are technically personal loans, which might also deter potential investors.
- Missing out on tax advantages: While it’s true that filing taxes for an SP is simpler than doing so for an LLC, you might miss out on tax advantages that are only available to corporations. For example, if your business wants to save to buy new computers, you might leave money in the business. As an SP, those funds would be taxed at your individual tax rate. However, if you incorporate, those same funds would be taxed at the lower corporate rate.
Limited Liability Corporation (LLC)
“LLC” stands for limited liability corporation. This means that if a legal dispute occurs, an LLC owners’ personal property would be protected. Becoming an LLC avoids the risk of losing any personal assets (e.g. home, car) that comes with an SP.
- Liability protection: As previously stated, personal assets are walled off from potential legal outcomes and creditor actions. Instead of the owner’s personal assets, only the business’s assets are at risk of being taken to settle conflicts in court. Additionally, the member’s liability is limited to the amount of investment in the LLC, not the entire business as a whole.
- Shared responsibility: While an SP owner operates on their own, an LLC can incorporate one or more partners who can collaborate on running the LLC. This is especially useful for those who need ongoing help in certain areas of their business. More importantly, in an LLC, there is shared legal responsibility for any debts or damages the business incurs.
- Retain “pass through” entity benefits: To be clear, both SPs and LLCs are pass-through entities. This means that the income of the entity is treated as the income of the investors or owners, which avoids double taxation. However, with an LLC, partners can benefit from shared responsibility while also retaining the benefits of being a pass-through entity, whereas SPs can only have one owner.
- Additional cost: While an SP costs virtually nothing to start, an LLC is a statutory entity, meaning that it must pay filing fees to set up the entity. This process will likely cost a few hundred dollars, potentially more. Also, LLCs must continue to pay other that SPs are exempt from, such as more filing fees or other annual fees. It’s worth noting that these costs and fees vary state by state, so it may be cheaper to set an LLC in one location versus another.
- Additional filings: In a similar way to an LLC’s additional fees, LLCs require more paperwork than SPs. For example, when starting an LLC, the owner must file Articles of Organization with proper authorities. Ongoing paperwork may include annual information statements or other reports, industry licensing fees, or operating agreements. All details on how to file appropriate paperwork are usually accessible on your state’s website. Alternatively, there are filing companies that can guide you in this process but this service is another expense on top of the aforementioned fees.
- More tax work: Compared to an SP, running an LLC will likely demand more work during tax season, including handling employee tax withholdings and filing personal and business-related taxes separately. It’s also important for LLC owners to be diligent in keeping personal records and funds separate from the LLC’s. Crossover of personal and LLC funds could result in loss of protection or other legal repercussions
Generally speaking, SPs will transition to LLCs when the owner decides the business has reached a point of development that warrants liability protection, despite the extra costs and complications that come with owning an LLC. What that point of development looks like for your business is up to you to decide. There are also other business structures out there that may fit your business better than a SP or LLC. If you’re struggling with navigating your options, it may be useful to connect with other small business owners and learn from their experiences, or consult business and financial specialists.
NOTE: All information above is state and industry specific. Always check with your local and state governments before making any decisions for your business.
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