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 relatively new type of hybrid business structure that is available in most states, including Washington.
LLCs offer several advantages, including, but not limited to, tax savings, liability protection, privacy (if formed anonymously), increased credibility, and more tax flexibility. One potential drawback is the added complexity when compared to a sole proprietorship. A list of the pros and cons of LLCs is shown below.
A sole proprietorship, also referred to as a sole trader or a proprietorship, is an unincorporated business with just one owner who pays personal income tax on profits earned from the business. Most small businesses start off as sole proprietorships. It is the most straightforward type of structure to run your business.
The business is treated as an extension of the owner. In other words, unlike LLCs, there is no legal distinction made between the owner and the business. There are no necessary steps or paperwork you need to submit when operating a sole proprietorship. However, many people submit a “doing business as” request with their local county clerk’s office and obtain a Certificate of Assumed Name to take on an assumed name such as “Sprinkles and Cakes.” Without this certificate, the sole proprietorship must operate under the owner’s name, for instance, “Jackie’s Cupcakes.”
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.
There are several categories to help distinguish between sole proprietorships and LLCs. These include liability, taxation, and management/ operational style.
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.
Another important difference between LLCs and sole proprietorships is tax flexibility. Only LLC members can choose how they prefer to have their business taxed. 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.
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A sole proprietorship is simple in its operations and management structure. It is the single owner that 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 in 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.
If you operate your business as a sole proprietor, 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. 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.
When considering either option, we highly recommend collaborating with Bench's proficient professionals. As your dependable partner, Bench stands prepared to help you organize financial records, optimize deductions, and ensure a seamless and efficient filing process for the current year.
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 an 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 that 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 personal 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.