December 12, 2019 Structuring en_US Your business’s structure affects your legal and tax liabilities. Learn the pros and cons of LLCs vs. sole proprietorships and other structures. https://quickbooks.intuit.com/cas/dam/IMAGE/A9caqS8ph/7fd0d8efa2483f57662d616e78f87487.png https://quickbooks.intuit.com/r/structuring/sole-proprietorship-partnership-llc-or-corporation-whats-right-for-your-business/ LLCs vs. sole proprietorships vs. other business entities
Structuring

LLCs vs. sole proprietorships vs. other business entities

By Chris Scott December 12, 2019

If you’re an entrepreneur ready to open a new business, one of the first decisions you’re going to need to make is the type of business structure you’ll create. Although limited liability companies (LLCs) have become very popular, they may not be the best option for you when doing business.

In this article, we’ll compare LLCs to other business structures. We’ll start by looking at LLCs vs. sole proprietorships. Then we’ll discuss the differences between an LLC and a corporation, as well as the differences between an LLC and a partnership. By the end of this article, you’ll have a much better idea of which structure is best for your new business.

LLCs vs. sole proprietorships

sole prop

Looking at LLCs vs. sole proprietorships is only relevant for owners operating individually. A sole proprietorship is only an option for single owners. If you have more than one owner in your company, you’ll want to skip to one of the sections below. Note that this only references owners of the company — both single-member LLCs and sole proprietors can have employees. This breakdown will primarily compare single-member LLCs and sole proprietorships.

Single-member LLCs

Single-member LLCs are LLCs that have only one owner. According to the IRS, “a limited liability company (LLC) is an entity created by state statute. Depending on elections made by the LLC and the number of members, the IRS will treat an LLC as a corporation, partnership, or as part of the owner’s tax return (a “disregarded entity”).

By default, the IRS treats an LLC as a “disregarded entity” unless the owner files Form 8832 declaring that he or she wishes for the institution to be treated as a corporation. If the owner does not file this form, then the owner should reflect business activities on his or her personal tax return.

As a single-member LLC, the owner does not receive a salary, nor is the owner considered an employee. Instead, the owner takes funds and puts money back into the company as needed. The owner reports business income on their personal tax return to pay taxes, which include:

  • Federal income tax
  • State income tax
  • Social Security
  • Medicare

Owners are responsible for paying the entirety of Social Security and Medicare taxes, much like for those who pay self-employment taxes. Employers typically pay half of these taxes, while employees pay the other half. But because a single-member LLC doesn’t have any other workers, and the owner reports income on their personal tax return, he or she must pay self-employment taxes on the earnings.

The two primary benefits of single-member LLCs are pass-through taxation and liability protection. By passing business income through to their tax returns and treating it as personal income, owners only have to pay tax on it once. Granted, they’ll need to pay self-employment taxes. But they avoid having to pay taxes at the corporate tax rate and then again at the personal tax rate. Single-member LLCs do not pay business taxes at either the federal or state levels.

As we’ll detail below, some businesses must first pay taxes at the corporate tax rate, which is 21% at the national level. Then, after that, business owners receive a salary, which is then taxed again on personal income tax returns. Pass-through taxation allows businesses to skip this “corporate tax rate” step and report everything on personal returns.

The other benefit to a single-member LLC is that the business is considered a separate legal entity for liability purposes. This means that the owner is not held responsible for any debts or obligations accrued by the company. So if the business were to rack up debt, creditors could not come after the owner’s personal assets, like their bank accounts or cars.

To start an LLC, you’re going to register with your local Secretary of State’s office. This likely requires a filing fee. Additionally, you’ll probably need to submit annual reports every year. Lastly, if you were to pass away, you could give ownership of the LLC to someone else.

Sole Proprietorships

A sole proprietorship is similar to a single-member LLC in the sense that the organization only consists of one person. That person is responsible for all of the assets and liabilities of the business.

Sole proprietorships are the most common and easiest business structure to form. There is no legal distinction between the owner and the business in a sole proprietorship.

If you work as a freelancer, you actually operate as a sole proprietor without having to file anything. When you report self-employment income on your IRS Schedule C, you automatically classify yourself as a sole proprietor.

The only time you’ll need to file paperwork as a sole proprietorship is if you would like a “Doing Business As” (DBA) name. A DBA informs your local Secretary of State’s office that you’re operating under a name different from your own.

Other than that, you don’t need to file any paperwork. There are no annual reporting requirements with a sole proprietorship — a key benefit over single-member LLCs.

However, if the owner passes away, the business immediately ceases operation. While you can give an LLC along to another owner, you cannot do so with a sole proprietorship.

LLCs vs. partnerships

If you have two or more people in your organization, you’ll need to decide between an LLC and a partnership.

LLCs

All of the information that applies to single-member LLCs also applies to dual-member LLCs. Secretary of State offices will likely require you to file articles of organization, and potentially an operating agreement to define how the two LLC members will run the organization.

Owners report income on their individual tax return via pass-through taxation. So imagine a dual-member LLC earns $50,000 in taxable income. Each owner’s individual tax return must account for $25,000 of the profit. Note that while owners have an equal share in the company in this example, this doesn’t necessarily need to be the case.

Partnerships

partnership

Partnerships are the other form of business available to multi-member organizations. Unlike a sole proprietorship, which does not require state filings, owners must register partnership status with their local Secretary of State’s office.
The two partners directly share in the profits and losses of the business. They don’t need to have equal partnership in the company. For instance, one owner can own 75% of the company, while the other owns the other 25%. If the firm makes $50,000, one owner would receive $37,500 in profit while the other would earn $12,500.

Partnerships are very similar to sole proprietorships in that owners are responsible for the liabilities of the company, including those of other partners. Unlike LLCs, there is no additional liability protection offered by this business structure.

Partnerships are pass-through entities. Owners report business earnings and losses on their personal income tax returns.

LLCs vs. corporations

If you have more than two members in your ownership group, you’ll want to compare the differences between an LLC and a corporation. Corporations may also commonly go by “Incorporated” or “Inc.”

LLCs

Everything that we’ve mentioned regarding dual-member LLCs is applicable to multi-member LLCs. Owners still report income on their tax returns. They are also awarded personal liability protection. LLCs can have an unlimited number of owners.

Corporations

Ccorp

Corporations, otherwise known as C Corporations or C Corps, are a more formal type of business structure. The most significant difference you’ll notice when looking at LLC vs. Inc. structures is that a C corp can have ownership shares.
While LLCs can divide ownership amongst their members, C corps have shares that members can purchase. If you’ve ever bought shares of a company on the stock market, you’re technically purchasing an ownership stake in the company.

This can be an advantage over LLCs, as LLCs are not authorized to issue shares. Many investors find the ability to issue shares an attractive benefit to C Corps.

The other significant difference between LLCs and C Corps is that the latter is responsible for paying taxes at the corporate level. This means that owners must pay taxes twice, under what’s known as double taxation. The business pays corporate taxes. Owners then receive a salary, which they must report and pay taxes on with their personal tax returns.

Unlike LLCs, C Corp owners don’t report income on their personal taxes. They report salary or wages, but any business earnings or losses are kept separate from the owner’s personal returns.

C Corps are afforded the same liability protection as LLCs. Owners are protected from the business’s debts and obligations. Like an LLC, C Corps can have an unlimited number of owners.

The last thing to note in an LLC vs. corporation comparison is that C corps have a board of directors. The shareholders elect the board at shareholder meetings. Members do not choose owners of an LLC, and an LLC is not required to set up annual meetings.

The small business alternative: S corps

Scorp

Another recent incarnation, S corporations are not a business structure. Instead, S corp status refers to the tax treatment that the organization receives. Corporations and other businesses can elect to file as an S corp, which provides them with pass-through taxation and liability protection.
Not all businesses are eligible for S corporation election, however. If you have more than 100 shareholders or have shareholders that are not U.S. citizens or resident aliens, your company will not be suitable for S corporation election. Additionally, shareholders can lose their limited liability protection if they don’t follow corporate formalities.

Your first decision must be whether you should elect an LLC or sole proprietorship, partnerships, or C corporation. Then you can decide whether you’d like to be taxed as an S corp for federal tax purposes.

Take your time and consider your options

As you can see, selecting a business entity is not as easy as it seems. It’s imperative that you take your time and do your research before choosing the business entity that’s right for you.

Selecting the right business entity is an important decision that could spell the difference between success and failure, and personal asset protection and tax obligations. There isn’t one business entity that’s ideal for every single business. Your ideal entity depends on several factors, including your industry, location, number of owners, and exit strategy.

As a business owner, you should conduct due diligence by impartially considering the benefits and disadvantages of each business entity. Also, consider consulting with a trusted accountant or attorney to help figure out which option is best for your situation.

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Chris Scott is a digital marketing consultant and freelance writer. He enjoys writing about personal finance and saving. He graduated from the University of Maryland with a degree in Finance and currently resides in Boston, MA. Read more