Choosing the right business structure when you start a new venture is a critical decision. Many small business owners favor two popular business structures for flexibility and simplicity—limited liability companies (LLCs) and sole proprietorships.
Which one you decide on will depend on your situation, but some things you should consider when choosing your business structure are:
- Start-up costs
- Government regulation and how it could impact you
- Liability protection
- Tax implications
What's the Difference Between an LLC and a Sole Proprietorship?
A limited liability company is a legal entity formed at the state level. An LLC exists separately from its owners—known as members. However, members are not personally responsible for business debts and liabilities. Instead, the LLC is responsible.
A sole proprietorship is an unincorporated business owned and run by one person. This option is the simplest, no muss, no fuss structure out there. You are entitled to all the profits of the business.
However, unlike an LLC, you are also responsible for all of the liability.
How Does the Management Structure Differ?
In an LLC, the business can be owned by one or more members. Its members usually manage an LLC, but they can also appoint a manager to handle the day-to-day operation.
The membership of an LLC and the way it will be run are laid out in a legal document known as an operating agreement.
In a sole proprietorship, you are truly the boss and call all the shots. There are no partners or members to deal with.
What About Personal Liability Protection?
With an LLC, your personal assets are considered hands-off when it comes to business debt collection or other claims if your company is sued. In most cases, creditors can't touch your home, car, or personal bank accounts.
In a sole proprietorship, there is no separation between you and the business. You are entitled to all of the profits, along with all of the debts and obligations. You can even be held responsible for liabilities caused by your employees.
Can You Mix Business Funds and Personal Finances?
Sole proprietors don't have to worry about mixing business and personal accounts from a legal standpoint. In the eyes of the law, they're regarded as one and the same. However, the practice is still discouraged by most experts.
In an LLC, you must be careful to keep banking records and funds separate from your own personal records and funds. Violating this rule can result in the loss of your limited liability protection.
Does Your Business Name Need to Be Registered?
State regulation of LLCs include required words which must be included in an LLC name—for example, "LLC" or "limited liability company" might be required at the end of an LLC's name. Registering your LLC does give your name protection within your state.
Sole proprietors don't face the same requirements. However, if the business owner plans on operating under a company name, instead of under their own name, they will need to register for a "fictitious business name," or DBA ("doing business as"), in their home state.
What Are the Tax Implications of Each Business Structure?
By default, all profits made by an LLC are only taxed once. This is known as pass-through taxation. As the owner, the tax liability belongs to you and passes through to your personal tax return.
To file taxes, you report your operating results, including profit or loss, by submitting Profit or Loss From Business (Sole Proprietorship) (Form 1040, Schedule C) with your personal 1040 tax return. An LLC is very flexible and can also be taxed as a sole proprietorship, a partnership, or a corporation.
A sole proprietor also benefits from pass-through taxation, so you'll report your business's income or loss in the same way. The difference is that you don't have the option to file as a corporation.
You're also not required to pay taxes on the full amount of your sole proprietorship's income. Instead, you'll only pay taxes on the profit of your business.
How to Activate Each Structure for Your Business
Forming an LLC requires you to file articles of organization, sometimes called a certificate of organization, with the state. Requirements vary by state.
Typically, an LLC operating agreement is drawn up to document the members' and managers' rights and duties.
You should also expect to file certain forms with your state agency, usually the Secretary of State, and pay an initial filing fee that can range from $50 to $500. LLCs also have to file annual or periodic reports and pay a required filing fee in most states.
Unlike an LLC, no formal action is required to form your sole proprietorship if you are operating under your own name. If you want to use a different name, you will need to file for a DBA.
You may also need to acquire any mandatory licenses or permits, and these requirements vary by region, state, and industry.
Whether you're looking for the liability protection and flexibility of an LLC or the less formal, unlimited control of a sole proprietorship, now you have the tools to make a more informed decision for your business and your future.