If you’re ready to start your journey as an entrepreneur, one of the first roadblocks you’ll hit is deciding whether to operate as a sole proprietorship or form an LLC.
Each type of business structure has its strengths and weaknesses, and which one you choose will largely depend on your own situation. However, being flexible with your business structure can be the key to success, so always be ready to adapt as your enterprise grows and your business activities change.
What Is a Sole Proprietorship?
A sole proprietorship is a business that operates under a sole owner and is not a separate legal entity. Any debts or profits incurred by the business transfer directly onto the owner — you can treat business income as personal income, and any losses or debts are in the owner’s name.
Most small businesses start as a sole proprietorship because it has the most straightforward business structure and several other benefits, making it a great choice for individuals who want to focus on running their business and getting it off the ground. Other benefits include:
- Simplified tax filing, as you’ll file all profits and losses in your personal tax return
- Tax benefits such as deducting the costs of running the business as deductibles, including travel costs, marketing costs, home office costs, and self-employed retirement plans
- No requirements to register your business with the state unless your business has specific licensing requirements
- No annual state filings, except for industry-specific requirements
While sole proprietorships are the simplest way of organizing a business structure, they are also among the riskiest. The lack of legal distinction between the owner and business opens up a wide range of drawbacks that often become apparent as your business grows. They include:
- You have no protection against commercial debts, lawsuits, and other financial obligations that your business incurs. While you can, and should, take out business insurance to help cover any potential liability costs, running a sole proprietorship can put your personal assets and finances at risk.
- Securing financing for a sole proprietorship is almost impossible, as many investors view an unincorporated business as an inherently risky venture.
- Establishing business credit can be incredibly difficult, as banks will categorize any financing as a personal loan instead of a business loan. This categorization can limit your ability to finance your business, and you may have to pay a higher interest rate than necessary.
- Trying to establish a strong brand can be difficult, as working under your own name can make your business seem less credible than a formal, incorporated company. While you can create a “Doing Business As” name in your state, you’ll need to pay ongoing fees for as long as you want to keep the commercial name.
What Is an LLC?
A Limited Liability Company, or LLC, is the simplest formal business structure for operating a company. It’s often the first step away from a sole proprietorship as it’s relatively easy to set up and cost-effective, especially when compared to larger corporations.
When you form an LLC, you legally distinguish your individual identity from the business entity. While an LLC can protect you from various liabilities, it requires more work to set up and maintain.
Setting up an LLC has several advantages that make it appealing to companies, even if you’re the sole owner. These include:
- You will have protection against commercial debts, lawsuits, and other financial obligations you incur during business operations. This protection means that business creditors cannot go after your personal assets if you cannot pay them, as long as you maintain a clear separation between personal and business assets.
- Establishing a business credit score is much easier, as the business is now a separate entity with its own business bank account. It also allows you to apply for business loans, which often have higher caps and more favorable terms than personal loans.
- You will be benefiting from the tax benefits of being self-employed while also reaping the tax benefits of being an established business. It’s worthwhile to work with a tax consultant to optimize your benefits and reduce your tax burden as much as possible.
LLCs have some drawbacks, especially if you’re used to working as a sole proprietorship. These disadvantages include:
- Having to file state-related paperwork as well as industry-specific licensing requirements
- Higher taxes, including state business taxes, unemployment taxes, and personal FICA taxes
- More complex tax returns, which may necessitate working with an accountant or tax specialist
Key Differences Between a Sole Proprietorship and LLC
The major difference between running a sole prop and LLC is how the law views your business. In the case of a sole proprietorship, no legal distinction exists between you and your business, which gives you plenty of freedom to focus on your business instead of administration. However, it also comes with the risk of potentially putting up personal assets to clear off business debts if your business fails.
LLCs have more legal protection, as the business is a separate entity from you, the individual person. While the paperwork, taxes, and administration are more involved and complex, many sole proprietors will eventually transition to a more formal business structure, and an LLC is a perfect place to start.
Most small businesses start out as sole proprietorships as owners find their feet. The lack of paperwork and complicated taxes allows owners to focus on growing their business. However, the lack of distinction between the business and owner will eventually limit the organization’s growth and potential.
The decision to move to an LLC is not simple, but it’s a transition that most successful businesses make. Not only will it make your company seem more reputable and stable, but it will also let you reap the benefits of business-focused financing. The limited liability also provides an extra layer of security that can encourage business owners to take risks necessary for faster business growth.
That said, not all businesses need to switch to an LLC, especially if you don’t need the protection of an LLC or alternative funding streams. In some cases, the costs of registering an LLC and hiring accountants to manage your finances may outweigh the benefits of the transition.