If you’re running a business solo and have yet to form a business entity with your state, you’re operating as a sole proprietorship. However, if your business is doing well, you may wonder if it’s time to choose a specific business entity type, such as a limited liability company (LLC).
There’s no particular profit level or stage in the life cycle of a business at which it’s time to form an LLC. You can make your business an LLC any time, from the day you start doing business to 10 or 20 years later or beyond.
An LLC offers many benefits, but that doesn’t mean it’s right for you and your business. This guide lays out the differences between a sole proprietorship and an LLC to help you make an informed decision.
What Is a Sole Proprietorship?
If you’ve started your business without forming a business entity, you default operating as a sole proprietorship, assuming you’re the only owner. Sole proprietorships do not require registration with the state.
In the case of a sole proprietorship, the business’s income passes through to the owner, just like in an LLC, and income is reported on the owner’s tax return. However, the key difference is that a sole proprietorship does not provide the owner with personal liability protection.
If you’re a sole proprietor, you and the business are legally considered the same. This means that if your business has debt or is sued, you’re personally liable for the obligations of the business. This puts your assets, including your home, at risk.
What Is an LLC?
An LLC is a popular business structure for small businesses that offer personal liability protection so that your assets are not at risk if your business is sued or cannot pay its debts.
In addition, an LLC is a “pass-through entity” in taxes, meaning that the LLC itself is not taxed. Instead, income passes through the company to the LLC owners or members, who report it on their tax returns.
LLCs also offer flexibility in management, as there are few requirements regarding organizational structure.
Benefits of an LLC
Let’s discuss the specific benefits of an LLC.
1. Simplicity of Administration
LLCs are easier and less expensive to form than a corporation. Unlike corporations, LLCs are not required to have a board of directors or hold annual meetings. LLCs do, in most states, have to file annual reports. Corporations are more complex.
In an LLC, the members do not have to answer to anyone. They ultimately control the company and can structure the management in any way they choose. In a corporation, on the other hand, managers answer to the board of directors, which has overriding decision-making power.
3. Limited Personal Liability
In LLCs and corporations, owners are considered separate entities from the business, so both structures offer personal liability protection. However, in a few instances, owners do have personal liability. For example, if an owner personally guarantees a bank loan, which is common, they’re liable for that debt.
In a sole proprietorship, again, the business owner and the business are legally the same, so the owner is personally responsible for the obligations of the business.
As mentioned above, LLCs are pass-through entities, which means income passes through to the member or members. If the LLC has only one member, it’s taxed as a sole proprietorship. If the LLC has more than one member, it’s taxed as a partnership.
However, LLCs are unique because they can elect to be taxed as a corporation if the members decide it makes financial sense. This is done by filing an election form with the IRS. In addition, you can choose to be taxed as a C-Corp or an S-Corp.
For corporations, the business income is taxed at the current rate for corporations (21% as of late 2022), which is lower than the usual individual taxpayer rate. But remember that corporation shareholders must also pay taxes on their distributions.
However, members are subject to self-employment tax in an LLC taxed by default as a sole proprietorship or partnership. Once such LLC switches to being taxed as a corporation, self-employment taxes no longer apply.
Similarly, self-employment taxes do not apply to members with S-Corp status, which is the main advantage of electing S-Corp status.
With S-Corp status, members are generally paid as company employees, which means more accounting and payroll expenses. Therefore, S-Corp status is only beneficial when the self-employment tax savings exceed those additional expenses.
5. Profit Sharing Flexibility
Most businesses split profits based on owners’ capital contributions, regardless of the entity type. For instance, corporations pay dividends based on the shareholders’ ownership percentage.
But with an LLC, owners can specify in the operating agreement any profit-sharing plan they choose. As a result, one member can take a share of profits greater than their ownership interest, while other owners take less. This may be based on the fact that one member is more involved in day-to-day operations.
If you have a sole proprietorship, your name is the legal business name. However, an LLC allows you to choose your business name, lending greater legitimacy.
Entrepreneurs choose to form an LLC for a wide variety of reasons. It’s much simpler to form and manage than a corporation and offers liability protection and flexibility about management, taxation, and profit sharing.
If you’re unsure If it’s the right time to form an LLC, consult with an attorney and tax advisor. It’s best to take your time and choose the option that gives your business the best chance of success.