LLC VS Sole Proprietorship: What's Your Best Choice
Widely maintained across the US, small businesses are booming now. And on the verge of opening a small private firm or initiating a promising startup project, many entrepreneurs wonder about which legal structure to choose for their enterprise.
A sole proprietorship or LLC? Which entrepreneurial model will best suit your entrepreneurial needs and plans? Let’s try to figure it out together.
What Is a Sole Proprietorship?
It is an unincorporated business form or disregarded entity that requires no state registration. Unless you establish a formal legal entity, you’ll be automatically considered a sole proprietor once you get into entrepreneurial activities.
This informal entity is owned and operated by a single individual. Directly associated with its enterprise, the owner is held liable for all business commitments and indebtednesses.
Sole Proprietorship Pluses and Minuses
To understand what this business form offers in practice and how it performs, take a look at its major fortes and drawbacks.
| Pluses | Minuses |
|---|---|
| Simplicity | No personal asset protection |
| Straightforward management | Lack of tax benefits |
| No profit distribution requirements | No investment potential |
| No-frills taxation | Restricted growth opportunities |
| Self-employment benefit | Low credibility |
Pluses
- Simplicity: There is nearly no paperwork to file, and there are only a few formalities to follow;
- Straightforward management: A business owner is a business manager by default, with no third parties involved;
- No profit distribution requirements: It’s the owner who automatically receives all business incomes;
- No-frills taxation: Income taxes are payable under the owner’s personal tax return, with no added forms to be filed;
- Self-employment benefit: Sole proprietors are considered self-employed and can make use of deductible business costs to minimize taxes.
Minuses
- No personal asset protection: In case of a lawsuit or overdue financial commitments, sole proprietors will be held liable against those with their own funds and property;
- Lack of tax benefits: The higher your business revenues, the higher your tax burden. And there are no specific tax benefits to optimize increasing levies;
- No investment potential: Unincorporated entities are not favored by independent investors. It feels like lending money to an individual;
- Restricted growth opportunities: Increasing incomes entail more risks and call for investments to further upscale your business. At this point, you outgrow the sole proprietorship model;
- Low credibility: Sharing a name and funds with their owners, sole proprietorships don’t look credible and reliable to creditors, vendors, suppliers, and partners.
What Is an LLC?
A limited liability company (LLC) is an incorporated entity that requires state filing. It can be owned by a single individual or multiple co-owners called company members.
Once filed with the state, an LLC becomes an independent legal person with its own rights, authorities, duties, and commitments. As such, the company is legally separated from its members. And the entity and member assets are split up.
LLCs legally protect their owners from financial and regulatory liabilities of the enterprise. Likewise, an LLC structure holds stockholders non-liable for the actions of the company employees if there are any.
LLC Pluses and Minuses
What makes LLCs so popular? And where do they lag? LLC pros and cons enlisted side by side will demonstrate the strong and weak points of this business model you should be aware of.
| Pluses | Minuses |
|---|---|
| Liability shield | Legalities to observe |
| Customizable | Added taxes |
| Flexible management | Higher running costs |
| Strong credibility | |
| Consistent enterprise growth |
Pluses
- Liability shield: Should your enterprise be sued or fail on its financial commitments, your own assets stay intact;
- Customizable: LLCs can make use of different tax options to implement a tax strategy that will best work for their business scenarios;
- Flexible management: Company owners can entrust ongoing business management to hired directors fully or partially;
- Strong credibility: Functioning as an independent entity, an LLC gains more trust and loyalty both from customers and from banks and credit agencies;
- Consistent enterprise growth: Good for different types of business activities, an LLC structure will easily keep up with step-by-step and rapid business growth. It won’t limit your opportunities.
Minuses
- Legalities to observe: LLC formation is not difficult yet does entail a number of formalities. Likewise, further business maintenance also drags in some compliance requirements;
- Added taxes: depending on the type of LLC, industry, and activity, your company might be exposed to additional charges at state and local levels;
- Higher running costs: Unlike sole proprietorships, LLCs have to pay annual fees in most states. That’s not to mention initial filing fees.
LLC vs Sole Proprietorship: How They Compare
When comparing these two business forms to decide which one is better for your business situation, you should take into account the following key factors:
- Regulatory implications;
- Related costs;
- Taxation;
- Liability protection;
- Credibility.
Regulatory Implications
To establish an LLC, you’ll have to prepare an LLC statute and file it with the Secretary of State. LLCs are state-specific entities and registration requirements vary by jurisdiction.
Besides, there are certain state rules you’ll have to observe afterward to keep your entity compliant and legitimate.
By way of contrast, there are no formalities to match opening a sole proprietorship unless you plan to run it under a DBA (doing business as) name that requires state registration.
Related Costs
There is a compulsory filing fee you should pay to the state to form an LLC. The rate varies by jurisdiction and ranges from $40 in Kentucky to $500 in Massachusetts.
Further on, you’ll have to add an annual reporting fee ($100 - $200 on average) to your running costs to maintain your LLC in good standing with the state.
Meanwhile, sole proprietorships are free from those expenses.
Taxation
Sole proprietorships use pass-through taxation and pay taxes on business profits on individual tax reports of their owners under their personal tax rates.
LLCs, on the other hand, are entitled to be taxed as:
- Pass-through entities to avoid paying corporate income taxes;
- S-Corps to minimize charges on growing revenues;
- C-Corps to engage big investors.
Liability Protection
This is by far the biggest difference between the two entrepreneurial models since an LLC safeguards your personal funds and property from company commitments.
And for sole proprietorships, business and owner assets are considered to be the same in the eyes of the law.
Credibility
The fact of state registration alone gives LLCs more customer trust from the start. Legal entities also feel more reliable to creditors, sponsors, vendors, and suppliers and are overall more competitive on the market.
When to Choose a Sole Proprietorship?
Being the simplest organizational model, this entrepreneurial form is a great choice for the following businesses:
- Local private firms with smaller customer bases;
- Home-run ventures that mostly serve locally and have lower profits;
- Smaller businesses with low financial and lawsuit risks;
- Freelance projects created around hobbies or personal services.
When to Form an LLC?
An LLC structure has a lot going for it, so no wonder it’s on the rise. Consider opening an LLC over a sole proprietorship if:
- You have ambitious business plans and seek to grow your company over time;
- You want more legal flexibility and better financial security for your enterprise;
- You seel to minimize a tax burden over a growing business income;
- You need secure protection for your individual assets;
- You are about to set up a venture with high risks of lawsuits, customer claims, and financial issues.
Final Thoughts
Many startuppers and businessmen-to-be still choose a sole proprietorship structure for its simplicity and no-frills formation and maintenance. At the same time, though, our recommendation is to launch your business with an LLC.
With a formal legal structure in place, you‘ll protect yourself from business risks from the start and get a solid base for future business growth and expansion.