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Table of contents
- Sole Proprietorship
- Advantages and Disadvantages of a Sole Proprietorship
- Limited Liability Company (LLC)
- Advantages and Disadvantages of Forming an LLC
- Deciding between LLCs and Sole Proprietorships
Selecting a business entity structure for your company is one of the most important decisions you can make as a small business owner. However, unless you are a lawyer or tax professional, the specific differences between each type of business entity can be difficult to grasp.
Because new business owners are frequently puzzled about the difference between these business structures, let’s take a closer look at each:
A sole proprietorship—which is an unincorporated business with one owner—is the simplest and least expensive type of business to form. Individuals who operate a business on their own are considered to be sole proprietors. For example, if you are a professional freelance writer, you are automatically a sole proprietor—unless you have adopted another business structure.
You can typically identify a business as a sole proprietorship by the fact that the owner’s name is actually the business name—although sole proprietorships can also operate under a brand or trade name, also known as a dba (doing business as). The main differentiator of a sole proprietorship is that there is no legal separation between the business and business owner. A sole proprietorship is not recognized as a legal entity. And consequently, the owner has personal liability for all of the business’s debts. Below are some things to think about when considering a sole proprietorship for your business:
- No required paperwork (except for industry-specific licenses)
- No annual state filings
- Simplified tax filing with the irs
- No liability protection
- Difficult to obtain financing in the business name
- Can be difficult to build business credit
Advantages and Disadvantages of a Sole Proprietorship
Sole proprietorships enjoy the following benefits:
- No required state paperwork, unless specific licensing is required, such as an occupational license and/or business license.
- No required annual state filings to complete, unless specific industry filings are required by your industry.
- Business income and losses are passed through to the owner’s personal tax return.
At the same time, sole proprietorships have the following negatives:
- There is no liability protection against commercial debts, lawsuits, and other obligations, so owners can be sued personally, putting all personal assets at risk.
- It can be difficult to secure equity financing because many investors do not like investing in sole proprietorships.
- Establishing business credit to obtain debt financing can be tricky because many financial institutions categorize the request as a personal loan instead of a business loan.
Limited Liability Company (LLC)
An LLC is a legally separate business entity, which is formed under state law. There can be a single-member LLC or a multi-member LLC with multiple people. LLCs combine elements of a sole proprietorship, partnership, and corporation—and offer a great deal of flexibility for owners. The LLC owners determine their management framework, operational processes, and tax structure.
LLCs end with the phrase, limited liability company, or the abbreviation, LLC. An LLC provides members with liability protection from the debts and obligations of the business. In other words, a business creditor or someone who sues the business is unable to go after the owner’s personal assets such as home, car, or personal bank account.
There are several important aspects to consider when forming an LLC, including:
- Separate legal entity
- More market credibility and financing options
- Liability protection in the case of certain lawsuits and commercial debts
- Annual state filings
- Tax advantages and disadvantages
Advantages and Disadvantages of Forming an LLC
The advantages of an LLC include the following:
- When you form your LLC, you are creating a business entity separate from yourself.
- An LLC equates to a higher level of market credibility.
- Liability protection against commercial debts, lawsuits and other obligations.
- Easier to obtain equity and debt financing.
- Instead of personal loans, you are eligible for small business loans.
- You can take advantage of the tax benefits of being self-employed.
With an LLC, business owners experience the following drawbacks:
- State-related paperwork is required, as well as specific industry licensing.
- Annual state filing fees are required
- In addition to paying federal, state, local, FICA and self-employment taxes (Medicare and Social Security), you may need to pay state business taxes and unemployment taxes.
Deciding between LLCs and Sole Proprietorships
Many business owners, such as freelancers or consultants, begin with a sole proprietorship because it’s simple. Not only is minimal paperwork required, but the formation cost is quite low, which is appealing to new business owners. In addition, taxes are simple for sole proprietors because a separate business tax return is not required.
However, it is important to keep in mind that sole proprietorships do not provide business owners with legal protection for personal assets. Consequently, business owners could end up bankrupt if their business does not succeed or experiences unexpected difficulties.
On the other hand, LLC owners are not personally liable for business debts, so business owners are protected in the event of a bankruptcy or lawsuit. In addition, LLCs provide tax flexibility as some business owners choose to elect corporate tax status for their LLC to save money.
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No. A limited liability company (LLC) cannot be a sole proprietor. Entrepreneurs often ask this question assuming that more than one person has to operate an LLC. But an individual can do business as an LLC. If you are a sole proprietor, you own and operate your own business, but it is not a corporation.
A limited liability company is a business structure that is not a corporation and not a sole proprietorship.