Choosing a business entity for your firm is one of the most important—and sometimes perplexing—decisions you’ll make as a small business owner. Unless you’re a lawyer or a tax specialist, the distinctions between each kind of company organization may be challenging to grasp in practice. However, your choice of business entity has real-world consequences, such as how much tax you pay, how much time you have to spend on paperwork, and what happens if your firm is issued.
New business owners often misunderstand the distinction between a limited liability corporation (LLC) and a sole proprietorship. This article will compare LLCs to sole proprietorships and explain how they vary in creation, taxation, legal protection, and other factors.
What exactly is a sole proprietorship?
A sole proprietorship is an unincorporated business with one owner, and it is the most basic and least costly kind of company to establish. A sole proprietor is a person who owns and runs a company on their own. For example, whether you work as a store, freelancer, manage an internet company or sell products and services in any other capacity, you are automatically a sole owner unless you have chosen another business structure.
Sole proprietorships are identified as sole proprietorship because the owner’s name is the company name, but sole proprietorships may also operate under a brand name or trade name. The primary feature of a sole proprietorship is that there is no legal separation between the business and the business owner. Thus the owner is personally liable for the obligations of the company.
What exactly is an LLC?
An LLC is a legally distinct company organization formed under state law. An LLC combines aspects of a sole proprietorship, partnership, and corporation and provides owners with a great deal of freedom. An LLC’s management structure, operating procedures, and tax treatment are all up to the owners. A single-member LLC may be formed by one person, while many individuals can create a multi-member LLC.
You can tell whether a firm is an LLC because its legal name includes the term “limited liability company” or the abbreviation “LLC.” The distinguishing characteristic of an LLC is that it protects its members from the debts and liabilities of the company. The regular course of business. In a moment, we’ll go through what this implies in more depth.
Formation of an LLC vs. a sole proprietorship
You may be shocked to discover that there is nothing special you must do to establish a single proprietorship. You may be running a sole proprietorship without even realizing it. By definition, a sole proprietor sells products and services without the assistance of a partner. To legally run your single proprietorship, you may need to apply for business licenses or zoning permits depending on where your company is situated. Furthermore, every company, even a sole proprietorship, that operates under a trading name must file for a fake business name certificate, commonly known as a DBA or “doing business as” certificate. However, that is all there is to it regarding formation paperwork, making sole proprietorships the most straightforward and slightest costly kind of company to establish.
An LLC may also be required to get business licenses and a DBA (if operating under a trading name). The articles of organization, on the other hand, are an essential formation document for an LLC. This document confirms the establishment of your LLC and must be submitted with the state in which you operate. The cost of filing articles of incorporation varies by state, but it typically runs between $50 and $200.
Operations and management differences between an LLC and a sole proprietorship
The operational and managerial structure is straightforward because there is just one person at the helm of a sole proprietorship. That owner is free to make whatever business choices they see fit, with no influence from a third party. Of course, most single owners choose to engage workers, legal experts, accounting experts, and other professionals to assist with day-to-day company administration. But, on the other hand, a single owner has to guarantee that their company is running lawfully and adequately and enough profit to pay business obligations.
The operational and managerial structure is more complicated, and it is usually defined in an LLC operating agreement. Though only a few states need an operating agreement, most LLCs have one, especially with numerous members. The operating agreement specifies each member’s equity interest in the company, voting rights, and profit-sharing. An LLC may be administered jointly by its members or by appointed management.
Typically, LLC members vote on corporate issues in proportion to their ownership interest in the firm (referred to as membership units). A 33 percent owner, for example, would have a one-third vote on business issues, whereas a 25 percent owner would have a one-quarter voice. Profits are often distributed per ownership percentages. In the above example, the 33 percent owner would get one-third of the company earnings, while the 25% owner would receive one-quarter of the firm profits.
Taxes for a Limited Liability Company vs. a Sole Proprietorship
In terms of taxation, a single-member LLC and a sole proprietorship are similar. However, both are pass-through companies, which means the company does not pay income taxes. Instead, the owner declares company revenue on a Schedule C linked to their tax return, and the income is taxed at the owner’s tax rate.
Multi-member LLCs are also pass-through companies, with each owner reporting and paying taxes on their portion of the company’s earnings. The main distinction is that the IRS requires a multi-member LLC to submit a business tax return, Form 1065, U.S. Return of Partnership Income. In addition, each member must provide a Schedule K-1 with their tax return to indicate their portion of the business’s revenue.
In addition to income taxes, LLCs and sole proprietorships may be subject to extra tax obligations. If you have workers, you must pay payroll taxes regardless of the company form you choose. If you sell taxable products or services, you must additionally collect state and local sales taxes. Finally, as a self-employed company owner, you must pay self-employment taxes to the IRS. These taxes cover your social security and Medicare taxes.
A few states and municipalities impose extra taxes on LLCs. Those taxes may be a franchise tax, an LLC tax, or a company tax, depending on the state. You will also be required to pay state and local income taxes, as well as payroll taxes.
Only LLCs have the option of selecting corporate tax status.
Tax flexibility is a significant distinction between LLCs and sole proprietorships. Only LLC owners can select how their company is taxed. They have the option of sticking with the default—pass-through taxation—or electing to have the LLC taxed as an S-corporation or C-corporation. A pass-through entity is an S-corporation. If the LLC is taxed as a C-corporation, it will be subject to a flat 21 percent corporate income tax at the federal level (most states and some localities also levy corporate taxes).
By choosing corporation tax status, LLCs may occasionally save money. Dividends from a corporation are typically taxed at a lower rate than regular business income when the firm is taxed as a corporation. Furthermore, retained profits in a company are not taxed. In contrast, LLC members cannot classify income as dividends and must pay taxes on all business earnings, whether or not they are kept in the firm. A company is also entitled to additional tax breaks and credits.
Legal protection of an LLC vs. a single proprietorship
There is no legal distinction between the company and the owner is a single proprietorship. The proprietor is personally liable for the company’s obligations. If the company goes bankrupt, the single owner must apply for personal bankruptcy, including personal and commercial commitments. Furthermore, a person who sues a sole proprietorship may identify the owner personally in the case and seek their assets.
Creating an LLC is one of the most excellent methods to safeguard your assets. Because an LLC is a legally distinct entity from its owner, the owner is not personally responsible for its liabilities. As a result, if the company collapses, the proprietors may declare bankruptcy and avoid paying business creditors out of their wallets.
With a few exceptions, someone who sues an LLC cannot sue the owners personally. Of course, owners of an LLC may be held personally responsible for fraud, carelessness, or personally guaranteed obligations. No business structure provides complete protection for owners from company obligations.
Paperwork and compliance differences between an LLC and a sole proprietorship
The last distinction between an LLC and a sole proprietorship is in the paperwork and compliance obligations. As previously stated, a single proprietorship requires the least amount of documentation before start. However, a single owner has to worry about federal, state, and local taxes after that. Furthermore, a single owner may need to renew company licenses.
An LLC is subject to additional regulatory requirements. In many states, LLCs must submit an annual report after filing the first articles of incorporation. An LLC with numerous members is responsible for even more tasks, such as writing an operating agreement, issuing membership units, documenting ownership transfers, and conducting member meetings. None of these procedures are legally necessary, but they are strongly recommended for LLCs to maintain member liability protection. Furthermore, since an LLC is a recognized business organization, dissolving an LLC requires extra documentation.
Which is better: an LLC or a single proprietorship?
Because it is simple, many company owners, especially freelancers or consultants, begin as single proprietors. There is little documentation needed at the start, and there is no significant expenditure of funds, which is appealing to young entrepreneurs, especially those exploring a company concept. Taxes are further simplified for lone owners since no separate business tax return is required.
When your company begins to expand, the rubber meets the road. Because a sole proprietorship form provides no legal protection for your assets, you may go bankrupt if your company does not thrive as anticipated or encounters an unforeseen obstacle. On the other hand, LLC owners are not personally responsible for company obligations, providing you with more protection in a business bankruptcy or litigation.
Furthermore, LLCs provide tax flexibility. The majority of LLC owners adhere to pass-through taxes, which is how sole proprietors are taxed. You may, however, choose corporation tax status for your LLC if it would save you more money. The LLC structure is recognized in all 50 states as a way to promote small company development.
Many variables will influence the ideal company structure for you. Therefore it is advisable to contact a business lawyer before making this crucial choice. On the other hand, an LLC is frequently a perfect match for a small company owner owing to the combination of liability protection and tax flexibility.