When you launch a new business, there are any number of strategic decisions you have to make. Few are more foundational than the decision about your company’s legal structure. Though there are several options to consider, including multiple types of Corporation, most startups wind up in one of two categories: Sole proprietorship or limited liability company (LLC).
Both of these business structures come with their own unique pros and cons, and implications for taxation, management, legal liability, and more. Before you formally launch your company, it’s important to know what distinguishes each of these business structures.
Sole Proprietorships and LLCS: Defining the Terms
Let’s begin with quick definitions.
What is a Sole Proprietorship?
The Sole Proprietorship is the simplest, most basic legal structure, and it’s only available for businesses that are run by one person. (If you want to run a company with a friend or a team of colleagues, look into a Partnership, which works in much the same way as a Sole Proprietorship but allows you to divide responsibilities and liabilities.)
Sole Proprietorships are famously uncomplicated, and in fact, this structure does not even create a separate business entity. For all intents and purposes you are the business: You get to claim all of the business’ profits but you’re also on the hook for all of the business’ losses and liabilities.
What is an LLC?
An LLC is a legal entity formed at the state level. This is the most popular structure for small and mid-sized businesses. The LLC exists as a separate entity from its owners, which means that you are not personally responsible for the LLC’s losses or liabilities.
When you establish an LLC, you have to choose someone to serve as your registered agent. Basically, this is someone who can receive legal and tax documents on the LLC’s behalf. Some states allow you or an employee to serve as the registered agent, but most require you to hire an outsider. Northwest Registered Agent is one of the most popular services here. (Is Northwest Registered Agent legit? Reviews overwhelmingly say yes.)
Sole Proprietorship vs. LLC: Key Distinctions
There are a number of categories in which these two business structures can be compared. Here are a few of the main points of distinction.
When you have a Sole Proprietorship, you are not just the business owner, but also the manager for all day-to-day operations.
An LLC allows a member, or multiple members, to serve as managers, or else to hire a manager who can handle daily administration. Every LLC has a legal document called the operating agreement, which outlines the management structure and basic responsibilities.
One of the primary points of distinction is in legal liability.
When you have a Sole Proprietorship, there is no legal separation between you and your business. You get to claim all the assets and profits, but you’re also held responsible for all debts and obligations. If a creditor or a lawsuit comes after you, you can potentially lose personal assets such as your home, car, or personal bank account. You may even be held liable for the actions of your employees.
LLCs create a separate legal entity, and maintain a clear demarcation between personal and business assets. As such, creditors and lawsuits are usually not permitted to claim any of your personal assets. (Exceptions can be made, typically if you have engaged in fraudulent or illegal behavior.)
In other words, the LLC structure provides a kind of safety net that the Sole Proprietorship does not.
When you have an LLC, it’s important that you avoid mixing personal and business funds, or using the LLC’s assets to pay off personal debts. Violating this rule may shatter your personal liability protections.
Sole Proprietors do not have to worry about mixing business and personal funds because, in the eyes of the law, there’s really no distinction. All of the assets brought in by your company are considered to be your personal assets.
Another important consideration is how you report taxable income to the IRS.
Sole Proprietors are taxed on a pass-through basis, which essentially means that you report all of your business income on your personal tax returns. If you owe the government anything, you’re simply taxed at your normal, personal tax rate. You avoid the corporate tax rate.
LLCs also get to be taxed on a pass-through basis. The difference is that an LLC also has the option of opting into corporate taxation. This flexibility can sometimes come in handy, and a tax expert can provide a recommendation for the most advantageous way for your LLC to report its income.
If you do business as an LLC, you must register your business name with the state. You’ll need to ensure you don’t pick a name already in use, and you’ll typically need to include either “LLC” or “limited liability company” in your official, legal name.
Sole Proprietors do not have to register a business name in this way, but if they plan on doing business under a name other than their own, they will need to register a fictitious name or a DBA (doing business as) name.
There are no filing fees associated with Sole Proprietorships, though depending on the state and the industry that you’re in you there is the chance that you may need to pay for a business license or permit.
LLCs do have to pay annual fees, which vary from state to state. LLC annual fees can range from a couple dozen to a couple hundred dollars.
Choosing the Structure That’s Right for You
Both business structures offer benefits, with the Sole Proprietorship being a bit less fuss on the front-end, and the LLC excelling when it comes to personal liability protection. Talk with a business coach, attorney, or trusted advisor if you have remaining questions about the structure that’s right for your business.