Importance of Choosing the Best Business Structure
There’s probably not a single person that worked a day in their life and didn’t dream about becoming their own boss.
You have nobody to report to, and all the profits come your way. While that’s true, advocates of this dream usually fail to mention that there’s also nobody to rely on to handle your business for you—you become your own business.
If you’re planning to start a business (assuming you already have a business idea) before you start making any deals, there are crucial decisions to be made. As a newcomer to the being-your-own-boss world, you’ll need some help—that’s where we come in.
In this article, we’ll explain the differences between the two most common business structures—sole proprietorships and LLCs—and show you which one you should choose.
What Is a Sole Proprietorship?
A sole proprietorship is an unincorporated business of a single person, meaning that you’re the sole owner.
The law doesn’t consider a sole proprietorship as a separate entity from its founder. In other words, you will be responsible for your business’s debts, liabilities, and obligations. You also report business profits as personal income.
This type of business structure is the go-to for most contractual workers (freelancers, personal trainers, independent contractors, etc.) and small businesses with limited profits. You’re automatically considered a sole proprietor if you don’t form a different business entity.
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What Is a Limited Liability Company (LLC)?
A limited liability company is a business entity for which you need to file paperwork to open up. Since they are formed at the state level, each state has different regulations you need to be aware of.
Check out our comprehensive guide on how to start an LLC and learn about the nuances of opening up an LLC in each state.
The main difference between the two structures is that an LLC is legally viewed as a separate business entity from its founder. An LLC allows you to have multiple owners. Bear in mind that this is not a necessity—you can still operate as a single-member LLC.
The most common reasons people opt for an LLC instead of a sole proprietorship are as follows:
- Being able to scale their business and get business loans,
- Making use of tax benefits,
- Reducing risk and separating business debt and/or obligations from personal assets.
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Sole Proprietorships vs. LLC—Business Structure Differences
Having to file paperwork is not the only difference between being a sole proprietor and running an LLC. Both come with their pros and cons, and which one will work better depends on your business model and goals.
While you can change your structure later on, making the right choice from the start can have a massive impact on the success of your business.
Running a Limited Liability Company vs. Being a Sole Proprietor
Any person that sells goods or services without a partner or formal employment is a sole proprietor by default. This means that you don’t need to worry about any formation paperwork and the costs that come with it. Note that this excludes business licenses and other permits that might be necessary for your business.
With an LLC, you need to form a separate business entity with a DBA and business permit. The process can be complicated, especially if you’re unfamiliar with the legal jargon, which is why many people use LLC services to have a helping hand.
As a sole proprietor, you have to ensure you make enough money to cover all business debts and that everything you do is legal. With an LLC, things get more complex.
You need to document your company operations and have legal records of the way you run your business. For example, an LLC operating agreement outlines the management structure in terms of profit share and voting rights.
An LLC makes it easier to build up your credit score and secure business loans if needs be.
Handling Personal and Business Assets
As a sole proprietor, your personal and business assets are one and the same. This means that you have no protection when it comes to potential debts and lawsuits.
If your business gets sued for commercial activities, it’s filed as a personal lawsuit, and your personal assets can come at risk.
An LLC offers personal liability protection. Since the law considers the owner and the LLC as separate entities, you’re not personally responsible for your business’s shortcomings. Creditors can’t go after your personal assets (e.g., seizing your home) unless you’ve given a personal guarantee or you’re found guilty of negligence or fraud.
There is a downside to this as well. Sole proprietors can use business funds for personal reasons and can infuse money into the business as they see fit.
LLC owners must keep the two separate and have banking records for proof. If you fail to do so, you will lose your personal liability protection.
Both LLCs and sole proprietorships have what is called pass-through taxation. This means that you don’t have to pay any corporate taxes, and only your personal income gets taxed once a year.
If you have a multiple-owner LLC, your tax gets reduced to the percentage of ownership you hold.
The difference between the two is that you can choose how you get taxed when you have an LLC. This includes getting taxed as a:
- Sole proprietorship—Personal income tax once a year
- Partnership—Individual members pay taxes based on their share of ownership
- C corporation—The company pays corporate tax, and shareholders pay taxes on the dividends they hold
- S corporation—Corporate tax varies at the state level. The limit of S-corps is having no more than 100 shareholders
Limited Liability Company and Sole Proprietorship—Overview
Check out the table below for a brief recap of the significant differences between a sole proprietorship and an LLC:
|Pros||– No state paperwork.|
– Personal tax only.
– Self-employed tax benefits.
– No annual filings and paperwork.
– Ability to mix personal and business assets
|– Flexible taxation.|
– Higher market credibility.
– Separate credit score.
– Personal liability protection.
– Self-employed tax benefits
|Cons||– No personal liability protection.|
– Hard to secure financing.
– Low market credibility.
|– State-level paperwork and formation costs.|
– Inability to mix business and personal assets freely.
– Annual filings and paperwork.
– Corporate tax in some cases.
|When to use it||– Low-profit and low-cost businesses.|
– Secondary source of income.
– Small customer base.
– Small ecommerce business.
|– Potential for sustainable profit.|
– Higher risk of profit loss.
– Multiple founders.
– Larger customer base.
The good news is, both sole proprietorships and LLCs are completely viable options. The bad news is, that doesn’t mean you can’t get it wrong.
In 2022, there were over 30,000 bankruptcy filings. Making the right business (and personal) decisions is crucial for your success, and it starts with choosing your business structure.
Most entrepreneurs start off as sole proprietors and then form a business entity to sustain their growth. Still, if you foresee an immediate profit with a high risk of loss should things go awry, consider opening an LLC from the start.