LLCs are commonly confused as to landing into the same category of either a corporation or a sole proprietorship. Many people don’t realize that they are a unique blend of both. It’s important to keep in mind that an LLC and a sole proprietorship
What is a Sole Proprietorship?
A sole proprietorship is somewhat self-explanatory in terms of how it operates. It is an individual operating a business under their own name. Business profits and losses are accounted for on their individual income tax return and personal income tax is paid on profits earned from the business.
A sole proprietorship might also be referred to as a sole trader or a proprietorship. This business operates with one owner only and is not incorporated in any way. In comparison to the LLC, your individual assets are not protected from liability.
Starting a Sole-Proprietorship
Most people starting a small business do not sit back and decide whether to incorporate or take a partner. The owner usually starts the business as an offshoot of some hobby, interest, or opportunity. This is the birth of a sole proprietorship. We believe nearly every owner should at some time incorporate, for the tax, privacy and asset protection benefits. There are few if any good reasons that a small businesses should remain a sole proprietorship.
We will first list the reasons small business owners give for remaining a sole-prop. We then cover why you should always incorporate below.
Why Do People Remain As Sole-Props?
Sole proprietorships are easy to start.
All that is required to start a sole proprietorship is to start doing something that brings in money. This can be selling a product, performing a service, or renting out space for others to use to live, store belongings, or work. The possibilities and opportunities are almost limitless. Not all are hugely profitable. If it is not your only source of income, it does not have to be. As soon as you make that first craft item and someone buys it, you are in business. Frequently, people start sole proprietorships without even meaning to start a business.
You retain complete control with a sole proprietorship.
Within legal limits, you can do whatever you want as the owner of your own business. You have the right to hire and fire employees. You can change what service you offer or product you sell on a whim. In a sole proprietorship, you can rent expensive office space or work from your kitchen as long as you do not violate zoning laws. As long as you stay correct with the IRS, you can do anything you want with the profits from your business without having to answer for it. You carry the business money in your right pocket, and your money your left pocket. If you want to switch them back and forth or take a daily payday, it is your prerogative.
Setting up a bank account can be done without having to get a federal ID number unless you hire employees.
Your social security number is good enough for almost all situations. Most employers that are sole proprietors find it easier to do their taxes with a federal ID, but it can be done without it. The bookkeeping can be as simple as maintaining your personal checkbook. You can make it more difficult if you want or need to for business growth.
The size of the business can be limited so that you can manage it easier.
While most business owners are going for size, many find it just as profitable and rewarding to stay within a certain size range. It gives them a good income without the problems of growing larger. This is especially true for sole proprietorships where the owner is the only employee. Some examples are a small barbershop or beauty parlor. Having only yourself to account to keeps many of the headaches away from business ownership.
When you have earned enough money or grow tired of the business, you can just stop.
Since you are the owner and often only employee, it is your call whether the business will continue or end as long as it is solvent. Many sole proprietorships end when the owner finds a better opportunity by working for someone else. You also can have the chance of selling the business at some point for a nice profit to a competitor or someone who wants a ready made business. This is always a good option if it presents itself. You can live on the money or look to start a new company in another field or area.
Advantages and Disadvantages of a Sole Proprietorship
As with any other business structure, there are both advantages and disadvantages to using a sole proprietorship. It all depends on what your intentions are for the business. There are more disadvantages when you take everything into perspective.
Here are some of the major advantages of a sole proprietorship.
- No required annual filings or filing fees
- The only state paperwork may be licensing requirements for your industry and state
- Profits and losses are passed to and accounted for on the owner’s personal taxes. There are no business or unemployment taxes required.
- You can take advantage of self-employed retirement plans
It’s pretty simple. Everything just passes through and you handle it as an individual with a business on your personal return. You can pass through expenses and potentially even write off some personal expenses related towards your business.
Here are some of the disadvantages of a sole proprietorship, specifically when you compare it to an LLC.
- Establishing business credit can be a challenge
- You will have unlimited liability that does not protect personal assets or property
- Everything in profits becomes earned income, which could actually increase your taxes
- Establishing a savings and turning a profit to grow or sustain your business takes time and substantial effort.
- Since this is under individual ownership, it is not always viewed as a professional business
What is an LLC?
An LLC is a limited liability company. This business structure is a United States business structure in which the owners are not personally liable for the company’s debts and liabilities. An LLC operates on a pass-through basis. This means that profits and tax pass through the LLC and directly to the members of the LLC.
This allows the LLC members to be protected and keeps their personal assets protected as well.
Advantages and Disadvantages of an LLC
The advantages of an LLC far outweigh the disadvantages but let’s take a look overall and see just what the advantages and disadvantages are.
Here are some of the advantages of an LLC.
- Tax savings, without double taxation of a corporation
- Protection against liabilities
- Privacy for members and mangers when formed anonymously
- Professional appearance and market credibility
- Tax flexibility
There are few disadvantages. LLCs are not always recommended for large corporations or large businesses simply because of the pass through piece and the burden that could place on members.
There is some additional complexity of an LLC when compared to a sole proprietorship. While it’s far more simple than a corporation, it is more complex than a sole proprietorship, which may be viewed as a disadvantage.
There are some filing fees and annual filing requirements that come alongside operating under an LLC as well.
What is the Difference Between the Two?
There are differences between sole proprietorship and LLC in several ways. The differences are related to initial setup and paperwork, taxation, and, management in a sense.
In general, sole proprietorship is kept simple. It’s operated under the individual’s name and social. These businesses typically don’t have other employees and they often are small or even just part-time operations set up by the owner.
An LLC, on the other hand, acts as a hybrid between a partnership and a corporation. This hybrid provides liability protection that a sole proprietorship does not and also has some tax benefits that are often associated with a partnership or sole proprietorship.
How Does the Startup Process Differ?
The startup and annual management are perhaps some of the most significant differences. With a sole proprietorship, there is very little required to establish your business. You might need permits or licenses, depending on your local government. An LLC may also need these, they are typically specific to your location.
A sole proprietorship typically does not require an EIN and operates under the premise of the owner’s tax ID number. For a sole proprietor, you choose a name and a business, make sure you have proper licensing or permits and you are good to go.
An LLC is a bit more involved for the startup process. It’s not overly complicated but there are some specific requirements. First, members and managers will need to be selected and assigned. You can have single or multiple members. Next, an agent will also be required.
Choose a name that is allowable within your state while also being unique to your LLC. From here, you will file a certificate of origination, which also has a fee associated with it. The fee could vary by state. Some states require business operation plans while others do not.
For an LLC, there is a bit more paperwork and groundwork to start up.
Management and operation is really not all that different. LLCs are managed by members and operated by managers. There may only be one member. Sole proprietorships are managed and operated by the owner.
Another substantial difference between the two is the liability aspect. LLCs have limited liability, as the name implies. The liability is restricted to the resources and assets specific to the business. On the other hand, sole proprietorships have unlimited liability that can strike even personal assets and resources as well.
LLC & Sole Proprietorship Taxation
Under the premise of a sole proprietor, you are taxed as a self-employed individual. This means that all business profit is added to earned income and for tax purposes, this income is listed as personal income. This could cause you to pay higher taxes, depending on the profits.
An LLC has some flexibility in how they are taxed. They can choose to be taxed like an S-Corporation, corporation, partnership, or disregarded entity. How they select to be taxed will affect their tax circumstances. If no election is made, there is a default depending on the number of members.
Should You Start an LLC or a Sole Proprietorship?
An LLC is best for a small business that makes a reasonable net profit and has its own assets and resources. The business is enough that you want to protect the owners from liability.
A sole proprietorship is best for an individual operating a small business or a side business that doesn’t have a huge liability or produce a substantial amount of profit.
Why You Should Incorporate
When a small service business is incorporated, records are more likely to be maintained by someone other than the owner. Each employee, including the business owner, draws a paycheck, tax records are controlled, and taxes are paid. Forms are filed on time and records of expenses are maintained and obligations met.
Year end tax forms are usually made out by a CPA, which is a "check and balance" for accountability. With this outside help, the owner is free to do his/her job with only a little supervision of records. In this atmosphere the small service business can grow and prosper.
A corporation or LLC is a business entity with assets completely separate from the owner. Thus, if legal suits arise, the company is liable, not the owner's assets. This is a huge advantage for incorporating a business or forming an LLC in today's "sue-happy" society.
Incorporation of a business lends itself to integrity with the business community at large. Having a Federal Identification Number (FIN) is almost a status symbol for a business. The cost of business incorporation is minimal. We charge $199.
The new tax laws offer many benefits for pass through entities. There are reduced marginal rates and new deductions. Tax savings can easily cover the cost of incorporation.