How you choose to set up your business structure is an important decision. For that first starting out, the go-to may be to establish your company as a sole proprietorship. And while yes, this is the most basic business structure and the easiest to get started with, there are some disadvantages to a sole proprietorship that you need to be aware of. On the flip side, many will create an LLC when starting their business. This too has both advantages and disadvantages. In this article, we take a look at a sole proprietorship vs. llc and weigh the pros and cons of each.
Understanding Sole Proprietorships
As with any type of business structure, a sole proprietorship is going to have its pros and cons. Below are a few things you need to keep in mind when determining whether or not to set up your company as a sole proprietorship vs. llc.
Advantages of a Sole Proprietorship
- It is the easiest entity to establish as upon setting up your sole proprietorship, there is no paperwork to file. The only time you would have anything to file is if you're setting it up under a DBA.
- You also do not have to file any reports or other documents on an annual basis as you would with a corporation.
- From a taxation standpoint, the process is quite simple. You would just pass the business profitlosses through to your returns. You do not have two separate returns to file.
Disadvantages of a Sole Proprietorship
- The biggest drawback is the lack of liability protection. Essentially what this means is that as a sole proprietor you are not separate from the business. So if the company incurs debts or issued, your assets could be at risk.
- It is harder to attract investors with a sole proprietorship. Investors see this business structure as riskier than others and thus are hesitant to invest.
- A life cycle of a sole proprietorship vs. llc is generally aligned with that of the owner. That is to say when the owner passes the company will usually shut down or close its doors as the owner was the entirety of the company.
Understanding Limited Liability Corporations
Just as there are advantages and drawbacks to setting up a sole proprietorship, the same goes for an LLC. While you do get more protection with an LLC, keep in mind there are a few things that are not as favorable with this type of entity.
Advantages of an LLC
- Many, investors and lenders, in particular, look upon an LLC as more professional and therefore more credible. It will be easier to get money and/or investors by forming an LLC versus a sole proprietorship.
- The biggest advantage to an LLC is the fact that you are personally protected from the company's debts and obligations. So if the business is facing a lawsuit for whatever reason, your assets would not be on the hook in this type of business structure.
- From a taxation standpoint, you can still have the advantages of a pass-through entity. So, for instance, you can choose to be taxed just as a sole proprietor would. Your returns would include the business's profits/losses.
Disadvantages of an LLC
- There is a bit more paperwork and filing to be done versus what you find with a sole proprietorship. There are also going to be annual filings that you need to stay on top of for your LLC.
- Depending on where you're located, some LLCs may find that they are required to pay certain state business taxes beyond just the standard taxes.
Main Differences: Sole Proprietorships vs. LLC
Company Formation
As noted, it is incredibly easy to establish your company as a sole proprietorship because there is no paperwork or filing to be done. That said, keep in mind that this does not exclude you from having to take out all relevant permits and apply for any applicable state or local licensing. When forming an LLC, there is a little more involved. You will first need to ensure that your business name is not already in use. You will also have to file the appropriate paperwork with the state and in doing so select a registered agent to accept any legal documents on your behalf.
Taxation
With both of these business structures, there is the option of being taxed as a pass-through entity. A sole proprietorship would automatically be taxed in this way. An LLC on the other hand can elect to be taxed as such. This prevents you from having to file two returns and it can also save you money in the long run on your taxes. As an LLC, you are opting to have the business's profits and losses listed on your returns and you will thereby pay any taxes owed in conjunction with your income tax rate.
Personal Liability
This is perhaps the biggest difference between the two types of business structures. A sole proprietor has no protection from the business's financial obligations. That means that if the company accrues a great deal of debt, such that it cannot pay, the owner's assets are at risk. Additionally, if the company is facing legal action, again, the personal assets of the owner could be on the hook.
With a limited liability company, on the other hand, there is protection for the owner(s/) of the firm. Their assets are not intermingled with those of the business and therefore, if there are debts or legal actions, their assets cannot be taken to cover any such financial obligations or damages. This is one of the main reasons why people opt to form LLCs over sole proprietorships.
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