LLC vs. Sole Proprietorships in New Jersey

In New Jersey, the choice between forming an LLC and operating as a sole proprietorship involves weighing costs, benefits, and requirements. An LLC offers asset protection, separating personal assets from business liabilities—a feature not available to sole proprietors. With an LLC, taxes can be more favorable due to pass-through taxation, whereas sole proprietors report business income on personal tax returns. Additionally, an LLC requires filing an annual report and derives structural advantages from drafting an operating agreement, even for a Single-Member LLC. While sole proprietorships have fewer formalities and initial costs, they lack the asset protection and potential for anonymity like with an anonymous LLC, making LLCs a compelling option for many New Jersey entrepreneurs.

A limited liability company (LLC) is a business structure in the United States whereby the owners are not personally liable for the company's debts or liabilities. It is a hybrid business model that combines the advantages of sole proprietorships and corporations and is available in New Jersey.

LLCs have several advantages, including tax savings, liability protection, privacy (if formed anonymously), increased credibility, and improved tax flexibility. One potential drawback is the added complexity when compared to a sole proprietorship. A list of the pros and cons for LLCs is shown below.

Pros:

1. LLCs have a lot of flexibility regarding organizational and managerial decisions. LLC members can structure the company in almost any way they deem helpful.
2. LLCs can also be managed by company members or by an appointed manager.
3. In addition, LLCs can decide how they will be taxed. One option for taxation includes pass-through taxation. This taxation option is where individual members report LLC profits on their income tax returns. More information on taxation options is available below.
4. LLCs do not have to follow the same stringent corporate regulations required when operating corporations.
5. There are no limitations on how many members or who may be an LLC member.

Cons:

1. There are more tax options available for LLC companies. This can cause increased complexity and difficulty in navigating the best options.
2. Across state lines, tax and liability treatment is not the same.
3. There are some limitations on transferring LLC ownership.
4. LLCs are required to use accrual-based accounting methods. This method records revenues and expenses before payments are received or issued.

To establish an LLC in New Jersey, you must file the certificate of formation. New Jersey also refers to the documents used to create corporations with the same name, so be careful to indicate that you want to form an LLC. The cost to submit these documents to the Division of Revenue is $125.

There are several advantages to sole proprietorships, including mainly the convenience and simplicity of the business structure. Although sole proprietorships offer freedom and flexibility initially, they can also come with financial risks later down the road for the owner. Below is a detailed list of the pros and cons of running a sole proprietorship.

Pros:

1. The most straightforward and least costly form of business structure
2. Maintenance costs are minimal
3. Sole proprietorship owners have freedom and control over their business decisions within the limitations set by law.
4. Business profits go directly to the owner. Taxation is, therefore, simpler; the owner can simply file their tax return and not worry about taxation at the business level.
5. It is relatively easy to convert a sole proprietorship to a different business structure. This can be particularly advantageous once the business grows and the owner desires protection from personal liability for the business’s debts or obligations.

Cons:

1. Sole proprietorship owners have direct liability for all the debts against the business. The business and personal assets of the owner may be at risk.
2. There is also potential for higher tax rates for this business entity as everything is considered earned income.
3. Owners are at a disadvantage when it comes to raising funds. They may often be limited to using funds from their personal savings account or consumer loans.
4. It may be challenging to attract well-established employees with experience compared to larger organizations or those who desire the opportunity to become official business members.
5. As the only business owner, the demands and pressure lie only on you.
6. The business entity dissolves when the owner passes away or retires.

There are several categories to help distinguish between sole proprietorships and LLCs. These include liability, taxation, and management/ operational style.

Liability

Generally, sole proprietors own small or part-time businesses with no employees. It costs nothing to establish a sole proprietorship. Unlike a sole proprietorship, an LLC is a hybrid of the partnership and corporate forms that allows the liability protection of a corporation with the tax advantages of a partnership. As hinted above, this is a crucial difference between the two business structures. Sole proprietors are not protected from personal liability.

Taxation

Another essential difference between LLCs and sole proprietorships is tax flexibility. Only LLC members can choose how they prefer to have their business taxed. They can also elect to have corporate tax status. Dividends are taxed at a lower rate than typical business income when the company is taxed as a corporation. Corporation retained earnings are also not subject to income tax. LLC members must pay taxes on all business income, whether retained or not. A corporation has eligibility for additional tax deductions and credits.

Management and Operations

A sole proprietorship is simple in its operations and management structure. The single owner can make any business decision as they see fit. Most sole proprietors can hire employees, experts, and other individuals to help with day-to-day choices with business management. However, the owner only has to ensure that their business operates legally and that the profits cover business expenses.

An LLC's operational and management structure is more intricate. Often it is outlined in an LLC operating agreement. The operating agreement details each member's stake in the business, voting rights, and profit share. The LLC can be collectively managed by all the members or an appointed manager. New Jersey does not require you to submit the operating agreement to their Division of Revenue, but it is recommended nevertheless. It can help resolve disagreements later down the road more quickly.

Suppose you operate your business as a sole proprietor. In that case, you’ll be taxed as a self-employed person, and the income of your business is considered your personal income for tax purposes.

An LLC may make an election to be taxed as a disregarded entity, partnership, corporation, or s-corp. Note that if you elect to be taxed as an s-corporation, New Jersey taxes you at a rate of 9% of the annual profits and you have to pay additional franchise taxes. If such an election isn’t made, it’s taxed as either a disregarded entity or a partnership, depending on the number of members it has.

Business owners often start with sole proprietorships. It requires minimal paperwork and is simple in design, as shown previously. Once the business grows, transitioning to LLC may have the advantage of offering protection against personal liability for bankruptcy.

Those who want personal liability protection, tax benefits, growth potential, credibility, and consumer trust should strongly consider forming an LLC. It is recommended for businesses with more extensive customer bases, increased risk of liability and/ or loss could potentially benefit from unique tax options and have the possibility for immediate sustainable profit.

One immediate downside is the fees and more complex formation process than sole proprietorships. However, this can easily be made up for with the benefits your business can assume by establishing your company as an LLC.

Sole proprietorships work well for small-scale, low-risk, and low-profit businesses. Therefore the risk on an owner’s assets is minimal. The best business structure will depend on many factors, and it's recommended that you speak to a business lawyer before deciding. If you opt to establish a New Jersey LLC and need assistance with the setup, our knowledgeable paralegals are available to assist. Feel free to contact us through our contact form or give us a ring at +1 (307) 683-0983.