Small business is the heart of the American Dream, providing a pathway to economic mobility. Yet while all businesses are made from hard work and grit, one of the biggest mistakes made by business entrepreneurs is thinking that they are all the same. Each different business or venture has different needs, and one of the most critical decisions is the structure of that venture. The structure will define the business’s ability to meet its needs, obligations, risks, and ability to change and grow. The options for ownership structure for entrepreneurs usually come down to two options—sole proprietorship and limited liability companies (LLC).
It’s important to understand the differences between these structures in the context of your business’s needs.
A sole proprietorship has only one owner who is responsible for and in control of all company profits and debts. This means that since you and your business are a single entity, you may be eligible for certain business tax deductions, such as health insurance deductions. This also means that if you so desire, you can easily dissolve your business at any time with no formal paperwork.
However, as a sole proprietorship, you are left vulnerable to unlimited personal liability, meaning that there is no separation between personal or business assets. Being personally liable also limits your potential growth and your ability to take on business debt.
However, individual members of an LLC are considered self-employed and must pay taxes to government programs including Medicare and Social Security. Requirements of setting up an LLC do vary by state.
Each business form is appropriate for a different type of business. Here’s a guide to know which might be best suited to your needs.
Since a sole proprietorship is the simplest business to set up, it is popular among independent contractors, consultants, and small home-based businesses. Many small businesses start as sole proprietorships and change legal structures as they grow. A sole proprietorship can easily be dissolved, unlike an LLC.
Ultimately, when you’re choosing a business structure, sole proprietorship offers the value of simplicity, but there are many potential risks. Among them, higher taxes, more legal exposure, and a more limited ability to gain new business or incur debt.
The LLC business structure can have as few as one member (single-member LLC) but can also include multiple members. This form of business combines the pass-through taxation of a sole proprietorship with the limited liability protection of a corporation. An LLC is the most common type of business in California for these reasons.
These advantages are beneficial when it comes to the ease of paying taxes and business write-offs, tracking income, and lawsuits.
LLCs do not pay taxes as entities, but as pass-through structures. This means that taxes are put on the owner(s) to pay all the taxes the LLC garners and can claim losses on their individual tax returns instead of a separate corporate tax return. Certain tax advantages can be achieved if the LLC also acts as an S Corporation (S Corp). An LLC can be owned by just one person, two or more people, a corporation, or another LLC. An LLC can also write off many expenses that an individual cannot themselves. However, LLC members are considered self-employed by the IRS and therefore are required to pay self-employment taxes toward Medicare and Social Security.
LLCs make it easy to track income, as they are their separate from personal accounts. As such, all debts, payments, and incoming revenue should be made to the LLC’s account. The owner may pay themselves or other LLC members, but this tracking method provides strong business accounting as the ledger tracks all business revenue and expenses.
The LLC members have no personal liability, which means that they are not legally responsible for LLC debts. However, there are some exceptions to liability if a member is found to treat the LLC as an extension of their personal affairs instead of as a separate business structure. LLC members can be held liable under certain circumstances including if:
Again, it should be noted that requirements for setting up an LLC vary by state. It is strongly advised that an attorney prepare legal documents to set up the framework of an LLC including operating agreements, buy-sell and dissolution provisions, and business succession planning.
When setting up a new business or venture, there are many considerations to take into account when it comes to deciding between to file as a sole proprietor or as an LLC. When choosing, it’s critical that you consider not only the current state of your business but also its future. For example, while an LLC provides personal risk protection, it can lack flexibility when removing members. Therefore, if entering into an LLC, you should hire a business attorney to oversee operating agreements and buy-sell dissolution provisions. Additionally, while a sole proprietorship may seem more straightforward, it can come with high personal risk and limited capacity to raise funds.
At the end of the day, if you’re unsure of which business structure is best for you, you’ll want to consult a business attorney for advice. Laws around business structures can change from state to state. For example, in California both a sole proprietorship and single-member LLC pay taxes on income. In contrast, a single-member LLC in California must register with the Secretary of State, file biennial reports, maintain a registered agent, list a California business address, and pay the annual $800 Franchise Tax. However, the serious advantage that comes with all of that paperwork and cost with a California LLC is the liability protection and ability to raise capital funds.
It is critical to remember that what affects one type of business will not necessarily have equal or any impact for another. So understanding your aspirations in context is critical. Steinberg Law can help examine current needs and future business aspirations, help you weigh your options, make the most informed decision, and create a customized plan for your business.