When times get tough, the tough start new businesses. Or at least that was the case in 2020 when the Census Bureau recorded a substantial uptick in business formations. And so far, the trend hasn’t slowed. In May 2021 alone, more than 500,000 new business applications were filed across the U.S. Want to join the crowd? Here’s how to get started.
Sole Proprietor vs. LLC
The first step to business ownership (after you’ve thought up your million-dollar idea, of course) is structuring your startup. By far, the simplest and least costly option is a sole proprietorship. But simple doesn’t necessarily mean it’s the right choice for your new venture. Gaining in popularity is the single-member limited liability company or LLC. Let’s break them down to help you make an informed decision.
The Sole Proprietorship
As we mentioned above, the sole proprietorship is the easiest business structure to form. Unless a business owner registers the company as a formal legal entity, the state where the business owner lives and conducts business considers the company a sole proprietorship by default.
Sole proprietors are self-employed, but all self-employed individuals are not necessarily sole proprietors. The difference is murky and lies in the operational aspects of the business. “Self-employed” could refer to an independent contractor with one or many clients. Independent contractors are paid by other companies or individuals and receive 1099s during tax season. Sole proprietors typically have a separate business name and business bank account. However, if the business owner doesn’t register the business name with the state, the business owner’s first and last name is, by default, the business’s name.
Many sole proprietors prefer to run their companies under a name that better describes what their business does. In that case, an owner must file for a “fictitious name” or a “trade name” with the Secretary of State of their state. Referred to as “Doing Business As (DBA),” its purpose is to give consumers protection against dishonest companies. For sole proprietors, DBAs help establish a separate professional business identity.
There is no legal separation between the sole proprietor and the business. Sole proprietors are not deemed employees of their companies and, therefore, do not receive W-2s. Profits and losses are passed through to the owner and filed with the owner’s taxes on a Schedule C (IRS Form 1040) “Profit or Loss From Business.” The tax deadline is the same as the personal income tax deadline.
Typically, a sole proprietor pays quarterly estimated tax payments and is also responsible for paying self-employment taxes such as Social Security and Medicare taxes. Many sole proprietors do not have employees; they file taxes and business documents with their social security numbers. However, some banking institutions do not allow a business bank account to be opened without a Federal Tax ID number, which is available from the IRS. Also, when employees are hired, the sole proprietor must obtain a Federal Tax ID number or Employer Identification Number (EIN).
Limited Liability Company (LLC)
In a sole proprietorship, the owner and the business are one legal and tax-paying entity. Not so, in an LLC. An LLC is a business structure registered in and regulated by the state. The LLC structure can be single-member (one owner) or multi-member (more than one owner). Owners are called members, and in a multi-member LLC, the entity can be member-managed or managed by a designated manager.
The main difference between an LLC and a sole proprietorship is the LLC is considered a separate legal entity from its owner/s. Like a corporation, the separation offers the owner some protection from the liabilities of the company. However, unlike a corporation, the registration fees are manageable, and the ongoing compliance requirements are less stringent.
Other key points about LLCs include:
- LLCs are recognized in all U.S. states; however, the fees and regulations vary.
- LLCs protect their members by providing a level of personal liability protection from debts and legal mishaps of the business.
- LLCs create and file formation documents, register in a state, and pay a filing fee.
- LLCs are required to keep company records and finances separate from those of the members.
- LLCs, by default, pass through the business’s profits and losses to the owner(s) unless the members choose to file as a C Corp (which taxes the company and the members on income).
As we explained, although the LLC is considered a separate entity from its members, the default tax method is pass-through. In other words, income taxes get paid at the individual member level rather than at the entity level. Profits and losses get reported on the owners’ tax returns, and salaries are subject to employment tax. LLC members do have flexibility on how they choose to be taxed, however. LLC members can determine their allocations and be taxed accordingly. If they choose to be taxed as a C Corp, they will have to pay taxes at the entity level and the member level, but they can also take advantage of the tax credits and deductions only allowed to corporations.
Which is Right for You?
The most significant advantage to the LLC over the sole proprietorship is the protection it offers the owner from the liabilities of the business, so you’ll need to carefully consider what kind of things could go wrong and what insurance won’t cover if they do.
Operating a sole proprietorship works for many startups, especially if you don’t want to deal with the compliance formalities of the LLC, you don’t plan on hiring employees, and if you sell products or services with minimal associated legal risks.
If your business has inherent risks or plans to bring on investors or additional partners, a more formal legal structure like an LLC is a better idea. Confer with an attorney and accountant before deciding, and be sure to consider every legal and tax angle.
More in: Legal Structure