Choosing the right business entity involves all sorts of tax considerations. Even though a sole proprietorship is the easiest business type to start, it might not be the best type of business for you. Too many business owners are operating with entities that may have been appropriate when they were established, but aren’t working as effectively now. Let’s go over Sole Proprietorship vs LLC and see which business type is best for you and best for your business.
Sole Proprietorship vs LLC: What’s Best for Me?
One of the most expensive mistakes businesses make is choosing the wrong business entity. The majority of business owners start as sole proprietors. More than C corporations, S corporations, and partnerships, a sole proprietorship is the most common form of business organization in the United States. It helps that a sole proprietor business is the easiest business type to start and operate. With over 23 million people who have sole proprietorships, this classification of business represents over 70 percent of all businesses in the United States today. As a business grows, many owners establish a limited liability company or corporation to help protect them from business liability. So what are the differences between sold proprietorship vs LLC, and which type fits your business?
As a sole proprietor, you don’t need to formally register your business with a state. This makes it unique from corporations and LLCs. A sole proprietorship is the easiest type of business to run, with no regulations about having a board of directors, meeting minutes or annual meetings. All a sole proprietor needs for a startup is a business name and a business checking account. While you don’t need to register your business with your state, you might need to get a business license with your locality, apply to the state for sales tax permits, and get any specific licenses and permits for your type of business. As the owner, you are in complete control of the business, and you don’t have to answer to anyone. You also get all of the profits from the business.
While you get all of the profits, being in complete control also means you must take all of the losses for the business as well. Beyond being personally responsible for business losses, the biggest disadvantage of the sole proprietorship is that legally and financially your personal and business futures are tied together. That means if your business declares bankruptcy it would affect your personal finances. Additionally, any lawsuits against the business would affect you as an individual, or your family.
When you run a sole proprietorship, you must pay income taxes and self-employment tax, that means Social Security and Medicare tax, on the entire income of the business. Just like other businesses, taxes for sole proprietorship businesses must be reported and paid at specific times and amounts. A sole proprietorship pays income taxes by completing a Schedule C and including this income on the owner’s personal tax return. If your business is profitable, which you hope that it will be, that can be a big bill to pay. With those considerations in mind, a sole proprietorship is generally best for startups and small businesses with no employees in industries with little legal liability.
Limited Liability Company (LLC)
The limited liability company (LLC) is a relatively new type of business legal entity in the United States, but it is a fast-growing form of business. An LLC is a legal form of business organization with limited liability for the owners, similar to a corporation. The liability of LLC members is limited to their investment in the business.
An LLC is formed in the state in which it operates, and is formed by filing Articles of Organization with the state in which you will be doing business. If your LLC does business in several states, you will need to set up a separate LLC registration in each state. Along with the required state formation application, an LLC should also have an operating agreement. This agreement defines the purpose of the LLC, how its members work together, and other details that describe what happens in certain circumstances.
While an LLC is a type of business entity, it is not a tax classification. LLCs can actually choose to be taxed as whatever entity they want. While a single-member LLC, with just one owner, is assumed to be “disregarded,” and taxed as a sole proprietorship, that same single-member LLC can elect to be treated as an S corporation or a C corporation. Similarly, a multiple-member LLC, with two or more owners, will be taxed as a partnership, but can also elect to be taxed as an S corporation or a C corporation.
If you operate your single-member LLC as a sole proprietorship, you may pay as much in self-employment tax as you do in income tax. If that’s the case, you might consider setting up an S corporation to reduce that tax. LLCs offer the strongest asset protection of any entity, and their flexibility makes them the entity of choice for many startup businesses.
When it comes to deciding between a Sole Proprietorship vs LLC, it’s important to consider all of the tax ramifications. Financial Gravity can help you discover why your tax filing status may be costing you thousands of dollars annually in overpaid taxes. Download your free eBook to learn how to bust the 10 tax myths that are sabotaging your small business growth.