You have worked hard to get your new business to the point where you are ready to launch it. While you are understandably anxious to get things started, you still have an important task to complete before you start serving customers. You need to decide whether you should work as a sole proprietor or register your business as a limited liability company (LLC) with the state.
What is a Sole Proprietor?
Sole proprietorship is the simplest type of business structure. The term refers to one person who works for themselves, with or without employees. Freelance graphic artists and a person who operates a small online shop are just two common examples of sole proprietors. Most people who choose sole proprietorship operate their business under their own name, but they do have the option of registering a trade or brand name.
When you work as a sole proprietor, there is no legal distinction between yourself and the business. You file taxes under your own name and include your business income there rather than file a separate return for your company. You are also personally responsible for the debt you incur to operate your business.
To illustrate how this works, assume that you buy wholesale merchandise on credit and then cannot repay the debt because you didn’t sell the items. The creditor can initiate collection activities against you personally, and any action taken by the creditor would appear on your individual credit file.
Sole proprietorship is a popular choice among self-employed individuals due to its simplicity. Unless you state otherwise, federal and state taxing authorities consider anyone who makes a profit working on their own as a sole proprietor. Choosing to operate as a sole proprietor makes sense for independent contractors who work in a low-risk industry. According to the Small Business Administration (SBA), 87 percent of self-employed people with no employees choose to operate as a sole proprietor.
What is a Limited Liability Company?
As the owner of an LLC, your business and personal finances remain separate under state laws. People like this business structure because it offers them flexibility while offering the best features of sole proprietorships, partnerships, and corporations. Creditors cannot sue you personally for debts you took on for your business.
A common misconception among new business owners is that you cannot register as an LLC if you have no employees. The reality is that a single-person LLC is the most common type of registration under this business structure. You own 100 percent of the business in this instance, which means you are free to spend profits however you would like.
When it comes time to file your annual income tax return, you report your business income and expenses on your personal tax return just as sole proprietors do. Once you add employees, you may find that the LLC structure works best for you.
Knowing the expenses of each type of business formation is essential to help you make the best decision for your new company. For example, you do not pay any fees to start working as a sole proprietor unless you choose to register a Doing Business As (DBA) name with your Secretary of State. If you do not register a DBA, your name and the business name are the same by default.
LLC registration fees vary considerably by state and can be as high as $800 and or as low as $50 as of December 2022. For people who choose to form an LLC, registration fees will be their biggest expense. Below are several other costs that are unique to the LLC business structure.
● Operating Agreement: LLC members typically write an operating agreement that outlines the responsibilities of each member, the division of profits and debts, and the process to follow when a member leaves the LLC or a new member joins. Your LLC has the option of preparing its own Operating Agreement, but most people who choose this structure prefer to pay up to a few hundred dollars for an LLC formation service to do it for them.
● Publication: Some states require new LLC owners to publish a notice of the formation in the local newspaper, and costs vary by jurisdiction and how many days or weeks you must publish the same information.
● Registered Agent: LLC owners can appoint a registered agent to receive correspondence on behalf of the business, including legal documents. You can either appoint your own Registered Agent or hire registered agent service to act in this role for a few hundred dollars a year.
As you can see, operating your business as an LLC increases your start-up fees compared to working as a sole proprietor. However, business formation fees are just one aspect to consider. Paying the start-up costs in exchange for legal protection and the other benefits of an LLC are worth it for many business owners.
The default tax reporting status for both sole proprietors and LLC owners is pass-through taxation. The term pass-through taxation means that business professionals pay individual income taxes, rather than the company itself paying corporate taxes. The Internal Revenue Service (IRS) requires people involved with each type of entity to report their income and expenses on Schedule C and then taxes them at an individual level.
LLC members can choose to pay taxes as a corporation, and multi-member LLCs must include Form 1065, U.S. Return of Partnership Income with their individual tax return. The IRS also requires those involved in a multi-member LLC to include Schedule K-1, which shows how much of the company’s income went to each member.
Compliance and Paperwork Requirements
Sole proprietors only have a few compliance and paperwork requirements they must meet, such as keeping up with taxes and renewing any necessary permits. Most states require LLC owners to file an annual report indicating profit or loss and major business activities.
Multi-member LLCs usually hold membership meetings, record ownership transfers, and issue membership units. State governments require additional paperwork when an LLC dissolves.
Only LLC members receive legal protection when it comes to business debts, which is one of its biggest advantages. Creditors and customers can sue you as a sole proprietor, and you cannot prevent them from going after your personal assets. Should your business fail, and you need to declare bankruptcy, your petition will include both business and personal debts.
Because LLC members are separate legal entities from their business, creditors and others who might sue cannot try to obtain personal assets from them. In the case of business failure, the LLC members only need to file bankruptcy on behalf of the business while their personal assets and credit score remain unaffected.
Suing individual members of an LLC is possible when one or more of them has committed fraud, negligence, or gave a personal guarantee of repayment as a condition of business financing.
Sole proprietors operate under a simple management structure, since they make all decisions for the company even after they hire employees. The primary responsibilities of a sole proprietor are to operate the business legally and turn enough of a profit to cover business debt.
LLC members typically choose to outline the company’s management structure in an Operating Agreement because it is much more complex. Members earn profits and share expenses based on the percentage of the company that they own.
The business structure you choose ultimately depends on the size of your company, whether you plan to expand, and your business model. People who start out working as a self-employed consultant or freelancer usually choose the sole proprietor status. The structure is simple and does not require much in terms of start-up costs.
Once a business starts growing, continuing to operate as a sole proprietor is often not practical. The legal protection from personal lawsuits the LLC status grants, along with greater flexibility in paying taxes, appeal to people who want to expand their operations.
The governments of all 50 states recognize LLCs and encourage entrepreneurs to form them because these businesses generate more taxable revenue. If you still cannot decide which company structure is right for you, consider hiring a business lawyer to help you better understand the pros and cons of operating as a sole proprietor or forming an LLC.