When starting a business there are many important decisions you’ll need to make. The structure of your business is one of the first things you will need to decide, and it will impact many things from the protection you have for your personal assets to how many and what types of taxes you'll pay. Two of the most common structures for new businesses are sole proprietorships and limited liability corporations (LLCs).
What is a sole proprietorship?
According to the Small Business Administration, a sole proprietorship is an easy-to-form business structure that gives you complete control of your business. “You're automatically considered to be a sole proprietorship if you do business activities but don't register as any other kind of business. Sole proprietorships do not produce a separate business entity. This means your business assets and liabilities are not separate from your personal assets and liabilities.”
What is an LLC?
An LLC is a business structure that lets you enjoy some of the benefits of both a partnership and a corporation. This structure provides protection from personal liability in most cases. For example, if the business is bankrupt or you get sued, your house, car or other personal assets are protected.
Can a sole proprietorship become an LLC?
A sole proprietor can be converted to an LLC. In order to do this, you would need to file to become an LLC. A lawyer can help you with this and make sure you’re set up correctly. You may also want to consult with and hire an accountant to ensure that you are paying taxes correctly. No one wants to get hit with back taxes or penalties because they didn’t file or pay correctly. It is smart to have a professional set you up from the beginning.
Advantages and disadvantages of a sole proprietorship.
• It's a low-risk way to test out owning a business.
Since you are automatically a sole proprietor, this is the easiest way to test out your business. You can get started and make sure you like being self-employed and can support yourself from your business. Since you don’t have to file any paperwork, there are no time-consuming or formal startup procedures.
• It's easy to form.
Since your business is not separated from your personal assets, it's easy to form a sole proprietorship. You don’t even have to register with the city or state!
• There's no cost associated with forming a sole proprietorship.
Since you don’t have to pay any fees to get started and there's no “cost” to form a sole proprietorship, it's a great first step to building your own business. Don’t forget you’ll still need to pay taxes on your profit and comply with all local and state taxes laws — so its not actually free to run the business.
• You can be held personally liable for business debts.
Should you be sued, bankrupt or in debt to another individual or business, your home, car or other assets could be seized as a sole proprietor. You will have no legal protection for your personal assets.
• Banks may be hesitant to lend to you.
If you know you may need to raise or borrow some capital to run or start your business a sole proprietorship may not be the ideal business structure for you. Banks are less likely to lend money to sole proprietors and other investors or lenders may also shy away. Make sure to take this into consideration when building out your business plan. If you don’t plan to borrow or raise money, you might be good to go!
Advantages and disadvantages of an LLC.
• Profits and losses can be passed through your personal income and are not subject to corporate taxes.
This could save you some money on your taxes, which is always a good thing! You will still want to have a finance professional who is knowledgeable about local, state and federal tax laws work with you to ensure you are complying with all laws and paying the appropriate taxes on time to avoid penalties.
• Your personal assets are protected should your business go bankrupt or face a lawsuit.
An LLC separates your business assets from your personal so if you are protected. Hopefully, your business is so successful you never have to worry about this, but it’s nice to have the peace of mind.
• You can file taxes using another business structure such as an S-Corp.
There are multiple ways an LLC can file taxes. Filing as an S-Corp may allow you to file taxes only as an owner of the business and not an employee. Consult with your accountant to determine which structure is the best for your specific business in your city and state.
• LLCs are considered self-employment, and members must pay a self-employment tax and contribute to Medicare & Social Security.
If your business is consulting or another service-based business (coaching, social media management etc.) make sure you factor in the additional taxes you’ll need to pay when you set your hourly or project rates. You’ll need to charge more for your time to pay the additional taxes.
• It's more expensive to form then a Sole Proprietorship.
In order to form an LLC, you will need to file paperwork. The cost of forming the LLC and registering it is only a few hundred dollars. You may also want to pay a lawyer to draw up and file the paperwork for you, which will add to the costs of getting started. It could be intimidating to have to spend the additional dollars before you’re able to start selling your products or services, but it may be well worth it for the peace of mind you’ll have knowing everything is filed correctly.
With an understanding of the advantages and disadvantages of a sole proprietorship and Limited Liability Corporation, you can work with your lawyer and accountant to set up your business in the way that works best for your needs and goals.