Limited Liability Company Versus Sole Proprietor. Which formation is right for you?
There are many legal ways to structure your business including S Corporations or C Corporations, but the most common two are Limited Liability Companies and Sole Proprietorships. There are advantages and disadvantages to each and a proper understanding of the legal and financial ramifications will help you decide what is best for you.
A sole proprietor is generally a small business with no employees. It is the easiest and least expensive to form. As a "passthrough" business, your income passes through to your tax return. A sole proprietor is an unincorporated business owned and run by one individual with no distinction between the business and the owner. You are entitled to all profits and are responsible for all your business's debts, losses, and liabilities.
Unlike a sole proprietorship, an LLC is a hybrid of a partnership and a corporation and it allows the liability protection of a corporation while providing the tax advantages of a partnership. An LLC is also a "passthrough" business on your taxes.
What considerations should you consider when deciding the best structure for you?
- Legal liability. To what extent do you as the owner want to be shielded from liability?
- Tax implications. Which business structure offers the best tax minimization?
- Cost of formation and ongoing record keeping.
- Future needs. Will you need financing? Do you want to create a new credit record for your business?
Understanding the key advantages and disadvantages of an LLC compared to a sole proprietor will help you to make the best decisions.
Sole Proprietor Advantages:
- No annual paperwork.
- No annual state filing.
- Quick and inexpensive to form.
- All profits/losses are passed through to the owner's tax return and you are only responsible for paying personal federal, state, local, and Federal Insurance Contributions Act (FICA) taxes. You are not required to pay any specific business taxes or unemployment taxes.
- You enjoy the tax benefits of being self-employed.
Sole Proprietor Disadvantages:
- Sole proprietor uses your social security number and this means your credit is not separate from your business credit. This can make it difficult to obtain funding and to build business credit.
- There's no liability protection against commercial debts, lawsuits, and obligations of the business.
- Legally a sole proprietor can hire employees by obtaining an EIN, however, in doing so you may put yourself at risk. If you face legal issues related to an employee, you could be putting your assets at risk if you operate as a sole proprietor.
- A member's liability is limited to the amount of their investment in the LLC. A member cannot be held personally liable for the debts or obligations of the LLC. You can have a single member or multiple members.
- Forming an LLC separates your assets from lawsuits and creditors. When you form an LLC, you are creating a business entity separate from yourself.
- You have a higher degree of market credibility with an LLC compared to a sole proprietor.
- Because your LLC has a separate and distinct Employee Identification Number (EIN) you can build business credit much easier and establish your business with a separate credit score.
- You still enjoy all the tax benefits of being self-employed.
- Increased paperwork compared to a sole proprietor including any industry-specific licensing.
- Annual state filings required
- Additional taxes such as a state business tax or unemployment taxes
- Costs for forming and completing a tax return for an LLC are higher than those of forming a sole proprietor.
If you are an entrepreneur looking to start a new business this is an exciting time for you. Knowing the proper way to legally form your business will be an important first step. The Duquesne University SBDC has knowledgeable consultants at no charge, that can assist you with your business planning needs. This includes assistance in legally forming and structuring your business. Call us today for an initial consultation.