To Incorporate, or not to incorporate? This is the Hamletian question of every budding business owner. In this post, I shall highlight some key differences between a limited liability company (LLC) vs. a sole proprietorship.
As a sole proprietor, you will pay less for annual compliance, apart from the state licenses strictly necessary for your business to function. Sole proprietors don’t need to file formation agreements with the Secretary of state or pay anything above their self-employment tax and personal income tax.
Being your own boss also has certain disadvantages to keep in mind. or follow any formal business practices. For attorneys, a sole proprietorship is indistinguishable from its owner. This means that the owner is personally liable for all debts that their business may accumulate and for any legal claims against it. If things go sour, creditors can go after a sole proprietor’s home, motor vehicle, and other personal property to cover the debts of the business.
Single-member LLC
A single-member LLC is a business structure with a single owner. The IRS does not draw a line of distinction between the owner and the LLC for income tax purposes. The business’s profits go right onto the owner’s personal tax return.
LLC
An LLC, or Limited Liability Company, and corporation are not the same thing, although an LLC may choose to be taxed as an S corporation or a C corporation. In a single-member LLC, the owner enjoys 100% asset protection, because the business entity is considered separate from its owner.
One of the key advantages of an LLC as a business structure over a sole proprietorship is that any member’s liability cannot exceed the amount of their investment in the LLC. Therefore, no member is personally liable for any debts accumulated by the LLC.
Sole Proprietorship vs LLC: Which is easier to form?
In previous posts, I have elaborated at length on the steps you have to take to form an LLC. You have to do at least seven different things to get your LLC up and running. Unless you are an attorney, you are going to need the help of a formation service like ZenBusiness. I recommend this one because it includes free registered agent service in all of their packages.
By contrast, a sole proprietorship is the only business that doesn’t have to register with a state. you can start a sole proprietorship in three easy steps:
- Choose an available business name and pick up a location for your business
- File for a business license with your city or county
- If you want to run your business from home, you’ll need to obtain permission from the local community council.
- Open a business checking account
However, if you are planning to hire employees, you need to file for an EIN, just like an LLC.
A Sole Proprietorship: Pros and Cons
Here are some key advantages and disadvantages to keep in mind before you set up a sole proprietorship:
- The formation documents are limited to industry-specific licenses
- No annual compliance filings
- Sole proprietors only pay personal income tax, federal and state taxes, local fees, as well as self-employment tax and FICA taxes
- Sole proprietors can’t rely on liability protection
- Securing a business loan as a sole proprietor is tough
Limited Liability Company: Pros and Cons
- Obtaining a business loan as an LLC is much easier
- LLC owners can rely on personal assets protection in case of lawsuits and business debts
- Forming an LLC requires plenty of paperwork
- Mandatory annual state filings and compliance requirements
- Flexible tax rates: some LLCs are taxed as S corporations, but you can file for a C corporation as well
Benefits of a Sole Proprietorship
Minimum paperwork
When business owners set up a sole proprietorship, they enjoy the following benefits. First, as the red tape is reduced to the sanitary minimum, they can save a lot on an online business formation service. As a sole proprietor, you should only have the necessary licenses for your business.
This type of business structure is not required to maintain good standing with the state, which means sole proprietors do not have to file compliance reports every year.
Simple Taxation
Sole proprietorships can enjoy the benefits of pass-through taxation, which means that all profits and losses of the business are passed through to the owner’s personal tax return. As mentioned above, sole proprietors pay only a handful of taxes:
- Personal income tax
- Federal taxes required for your type of business
- Applicable state and local taxes
- Taxes associated with theFederal Insurance Contributions Act (FICA)
Tax Benefits and Write-offs
Sole proprietorships allow their owners to avail of all of the tax benefits that self-employed individuals enjoy. As a sole proprietor, you can turn some of your personal expenses into business expenses. You can, for example, request that your home’s mortgage be considered office space rent, or request your gas bills be deducted from your personal income tax.
Sole proprietors can also use their self-employed retirement plans like Simplified Employee Pension Individual Retirement Accounts (SEP IRAs) to page college fees, or write off recurring business expenses and business travel costs.
Disadvantages of a Sole Proprietorship
When you set up a sole proprietorship, you should keep in mind some drawbacks as well. There’s zero liability protection against debt collectors, private enforcement officers, legal claims, and other liabilities. In other words, your nest egg is always on the line.
Sole proprietorships always pay sales tax
Sole proprietors must always pay state sales taxes on thier products and services. In some states, sole proprietors also have to pay excise taxes.
Investors distrust sole proprietorships
Sole proprietorships find it hard to generate equity financing because investors avoid putting their money into such business structures. This negative tendency could limit the amount of free capital that your business needs to sustainably grow and develop.
Sole proprietorships can’t access cheap business loans
Business lenders are very careful when working with sole proprietorships. Even if the business owner manages to secure a loan, the conditions will be far from favorable. Many small business owners find themselves compelled to take out personal loans to finance their small businesses. As a rule, the average amount of a personal loan is a fraction of a business loan’s, so your business will often be cash-strapped.
Sole proprietorships have a low market credibility rating
Because a sole proprietorship does not have its own trade name but operates under its owner’s legal name, its market credibility rating is never high. One option is to file for a fictitious business name (DBA) with a popular business formation service provider like ZenBusiness. Filing for a DBA with your state’s department of revenue or the secretary of state means that you will have to pay an initial filing fee and annual compliance fees.
Advantages of Forming an LLC
As soon as you see that your sole proprietorship is really taking off, I strongly advise you to restructure it as an LLC. Here are some of the biggest advantages.
LLCs offer 100% liability protection
As I have already mentioned on multiple occasions above, a limited liability company is regarded as a business entity separate from its owner. This means that your personal assets will not be at stake when a customer files a claim against the company or the business runs into debt.
Great branding flexibility
An LLC owner can use the business’s legal name as its brand name. This gives them the privacy of not putting their own name behind their brand. A law firm may not have a problem with it, but a company that holds multiple brands would rather distance its brand name from that of its owner.
Higher market credibility
an LLC provides liability protection against commercial debts, legal claims, and insurance claims. As long an LLC has been properly formed by a reliable formation service like ZenBusiness, the owner’s personal assets will never be at stake.
This type of business structure also eliminates the risk of co-mingling of personal and business assets, which facilitates the company’s access to working capital. The high level of liability protection remains in place for as long as the LLC maintains commercial activities.
LLCs can access cheaper business financing
LLC owners find it much easier to access equity and debt financing due to operating as a separate business entity. Furthermore, LLCs can quickly build a positive business credit score. This is because their potential equity partners and lenders do not categorize their applications as personal loan requests.
As an LLC owner, you can access proper business loans that bring a larger amount of capital at preferential interest rates and long payoff terms. LLCs also get easier access to business credit lines and cards, small business loans, motor vehicle leases, factoring equipment loans, and much more.
LLCs can enjoy considerable tax advantages
An LLC does much more than just protecting its owner or members from lawsuits, creditors, etc. When you form an LLC, your business entity enjoys great taxation flexibility. In other words, you can choose to pay taxes as a C-Corporation or an S-Corporation. Single-member LLCs protect its owner from potential double taxation.
LLCs are exempt from sales tax on some transactions
As an LLC member or owner, you may not have to pay sales taxes on certain transactions. For example, retailers who buy wholesale items don’t have to pay sales taxes on these items, because their customers will pay it.
If your LLC sells raw materials and other supplies to manufacturers, you are usually exempt from paying sales taxes. Finally, when your LLC sells products or services to non-profit companies, your business may not have to collect or submit sales taxes.
LLC taxation options
Many single-member LLCs elect to be taxed as Sole Proprietorships. However, they can also choose to be taxed as an S-Corporation or a C-Corporation. Electing to be taxed as a sole proprietorship means that all profits and losses are written into the owner’s individual tax return.
If the owner of a single-member limited liability company elects to be taxed as an S-Corporation, the company’s profits or losses flow to the owner’s individual tax return, but they can reduce FICA taxes by setting up a “reasonable salary” and receiving the remaining profit amounts as dividends.
In this case, only the “reasonable salary” component will be subject to FICA taxation. Single-member LLC owners enjoy all of the abovementioned tax benefits of being self-employed.
Disadvantages of Forming an LLC
LLC profit is subject to social security and medicare taxes. In some cases, LLC owners may end up paying more taxes than owners of a corporation, for example. This is because salaries and profits of an LLC are subject to self-employment taxes. With a corporation, only salaries (and not profits) are subject to social security taxes.
Owners must immediately recognize profits. Because LLCs do not subject to double-taxation, their profits are automatically included in their members’ income. To avoid this, the owners can elect to be taxed as a C 0corporation. C corps are not obliged to immediately distribute their profits to the shareholders as a dividend. Consequently, shareholders in a C corp are not always taxed on the corporation’s profits.
As soon as you form an LLC, you need to sign up for a registered agent service. New business owners usually purchase the registered agent service separately from the LLC formation service. However, the registered agent service of ZenBusiness is included in all of their LLC formation packages. The filing fee depends on your formation state.
LLC vs Sole Proprietorship: Business taxes explained
For tax purposes, the IRS does not differentiate between a single-member LLC and a sole proprietorship. Although an LLC is a separate legal entity from its owner, they are considered the same for tax purposes by the Internal Revenue Service (IRS). For the IRS, a single-member LLC is a disregarded entity, which means equal to a sole proprietorship at tax time.
Regarding the payment of federal income taxes, both business structures are considered “pass-through” entities. In pass-through taxation, all business profits pass-through to the owner of the business who reports them as personal income.
Tax rates can fluctuate depending on the owner’s individual tax bracket. In addition to federal income tax, owners of sole proprietorships and single-member LLCs must pay self-employment tax. This tax covers both the employer’s and employee’s share of the Social Security and Medicare taxes. The current self-employment tax rate is 15.3% (12.4% for Social Security and 2.9% for Medicare).
Multi-Member LLC Taxes
Partnership
In a partnership, the business’s profits are split among the partners. This is the default tax structure of all multi-member LLCs. Owners in a partnership must also pay employment taxes.
Form 1065
Form 1065 is the standard form used to calculate a partnership’s profit or loss. The revenues and the expenses of the business are listed on the first page. The total expenses are subtracted from the total revenues.
Schedule K and Schedule K-1
On the fourth page of Form 1065, you’ll find Schedule K. It is used to break down the partnership’s income into different categories. For example, standard business income goes on line 1, rental income goes on line 2, etc.
After a Schedule K has been filed for the partnership, each partner fills out a separate Schedule K-1, depending on the management structure. Each partner’s Schedule K-1 shows their share of the partnership’s income
S Corporation
An S corporation is a pass-through tax classification rather than a legal entity. As such, it is not subject to corporate taxation. Unlike sole proprietors and partnership members, S corp owners can save money on employment taxes by distributing their earnings to members and passive shareholders.
Owners of an S corp that play an active role must become employees and be paid a salary based on their position in the company. On this earned income, they owe both personal income tax and employment tax, while the remaining business profits (retained earnings) are only subject to personal income tax.
C Corporation
C corporations’ tax status differs significantly from other business structures. C corps are the only business entities subject to corporate taxation. Currently, the corporate tax rate is 21%. In addition, shareholders are also obliged to pay taxes on any dividends that they receive. Consequently, there is double taxation of at least a portion of the business income. When electing C corp status, business owners are exempt from paying a self-employment tax.
Sole Proprietorships File Schedule C
IRS Schedule C (Profit or Loss from Business) is a tax form that sole proprietors fill in to report their revenue and profit. The owners of a single-member limited liability corporation also file Schedule C. This form is filed together with the business owner’s Form 1040.
Although Schedule C is not the same as a 1099 form, sole proprietors may need IRS Form 1099-NEC to fill out a Schedule C. This form is also mandatory for freelancers who work 9 to five but also run a small business on the side.