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November 23, 2020
Limited Liability Company vs Sole Proprietorship
You are about the begin your new journey by starting a new venture. But which business type is best for a startup? One of the first things you need to address is deciding on your business structure. Will you have partners or will you be the 100% owner of the startup? Although there are many legal ways to structure your business, the most common two are Limited Liability Companies (LLC) and Sole Proprietorships. There are advantages and disadvantages to each and a proper understanding of the legal and financial ramifications will help you decide what is best for you.
A sole proprietor is generally a small business with no employees. It is the easiest and least expensive to form. As a "passthrough" business, your income passes through to your tax return. A sole proprietor is an unincorporated business owned and run by one individual with no distinction between the business and the owner. You are entitled to all profits and are responsible for all your business's debts, losses, and liabilities.
Unlike a sole proprietorship, an LLC is a hybrid of a partnership and a corporation and it allows the liability protection of a corporation while providing the tax advantages of a partnership. An LLC is also a "passthrough" business on your taxes.
Four things to consider when choosing your business structure
When you are forming your business entity, there are four key things to consider: legal liability (personal protection), tax implications, operational costs and fees, and your financing needs.- Legal liability. To what extent do you as the owner want to be shielded from liability?
- Tax implications. Which business structure offers the best tax minimization?
- Cost of formation and ongoing record keeping.
- Future needs. Will you need financing? Do you want to create a new credit record for your business?
Which business structure is right for your small business?
Understanding the key advantages and disadvantages of an LLC compared to a sole proprietor will help you to make the best decisions.
Sole Proprietor Advantages:
A sole proprietorship offers several benefits. If you are just starting and testing the waters, you are the only owner (U.S. citizen), you are not looking to bring in a partner and you do not need significant capital or your business has a low chance to be sued and you are not in a high growth industry then sole proprietorship would be a good fit for you. Some examples of a sole proprietorship include a single-person artist, small grocery store, plumber, carpenter, electrician, web designer, farmer, boutique owner, floral shop, barbershop, or restaurant.- No annual paperwork
- No annual state filing
- Quick and inexpensive to form
- All profits/losses are passed through to the owner's tax return and you are only responsible for paying personal federal, state, local, and Federal Insurance Contributions Act (FICA) taxes. You are not required to pay any specific business taxes or unemployment taxes.
Sole Proprietor Disadvantages:
- The sole proprietor uses your social security number and this means your credit is not separate from your business credit. This can make it difficult to obtain funding and build business credit.
- There's no liability protection against commercial debts, lawsuits, and obligations of the business.
- Legally a sole proprietor can hire employees by obtaining an EIN, however, in doing so you may put yourself at risk. If you face legal issues related to an employee, you could be putting your assets at risk if you operate as a sole proprietor.
LLC Advantages:
LLC is a separate legal entity. Thus, the main advantage of an LLC is that your personal assets are protected. Creditors cannot claim assets that are not owned by the company. Also, you as a partner or owner cannot be sued because of the actions of your employees or your partners. However, you may still be sued due to your negligence (Tip: Get business insurance!).- A member's liability is limited to the amount of their investment in the LLC. A member cannot be held personally liable for the debts or obligations of the LLC.
- You can have a single member or multiple members.
- You have a higher degree of market credibility with an LLC compared to a sole proprietor.
- You can build business credit much easier and establish your business with a separate credit score.
- You still enjoy all the tax benefits of being self-employed
LLC Disadvantages:
- Increased paperwork compared to a sole proprietor including any industry-specific licensing.
- Annual state filings required
- Additional taxes such as a state business tax or unemployment taxes
- Costs for forming and completing a tax return for an LLC are higher than those of forming a sole proprietor.
As you can see, although sole proprietorship is easier to start and operate, LLC is a separate entity and offers protection in terms of liabilities. However, you can always start a sole proprietorship and then convert your business to an LLC in the future.
Next Steps
If you are an entrepreneur looking to start a new business this is an exciting time for you. Knowing the proper way to legally form your business will be an important first step. The Duquesne University SBDC has knowledgeable consultants at no charge, that can assist you with your business planning needs. This includes assistance in legally forming and structuring your business. Call us today at 412-396-1633 for a no-cost consultation. We are here to help you start, grow, and prosper!
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