Do you run a business? Are you a freelancer looking to form a new company? If so, you may be confused about the different types of entities available.
If you’re the sole owner of a business, there are two different types of business entities that you’ll choose from: a sole proprietorship and a single-member limited liability company (LLC).
Each entity has unique advantages and disadvantages. Curious about which structure is best for your new small business? We’ve put together everything you need to know.
Before we go into the pros and cons of sole proprietorships and single-member LLCs, here are the essential components of each.
Sole proprietorships are the most basic form of business structure. Once you begin conducting business, you operate as a sole proprietor by default. Sole proprietorships are not a separate legal entity from the owner.
The sole proprietor takes on all the legal liabilities associated with the business, including any debts or obligations the company accumulates.
Sole proprietors must keep company assets separate from personal assets. Owners should use a business bank account, and not conduct personal transactions in the business account. The same is true for credit cards. Open a business credit card account and don’t include personal transactions.
A single-member LLC is a limited liability company with a single owner, and LLCs refer to owners as members.
Single-member LLCs are disregarded entities. A disregarded entity is ignored by the IRS for tax purposes, and the IRS collects the business’s taxes through the owner’s personal tax return. Single-member LLCs do not file a separate business tax return.
Single-member LLCs are considered a separate legal entity, because of how liabilities are treated. LLCs protect the owner’s personal assets from being seized to pay for business debts.
If an owner wishes to operate a single-member LLC, they need to file paperwork with the state in which they plan to conduct business.
Forming the business
There are critical differences in how owners go about forming sole proprietorships and single-member LLCs.
Starting a sole proprietorship
According to the United States Small Business Administration, “A sole proprietorship is the simplest and most common structure chosen to start a business.” The site explains that prospective owners “do not have to take any formal action to form a sole proprietorship.”
Forming a sole proprietorship is inexpensive and straightforward. You need to choose a name, obtain proper business licenses and permits, and open business bank accounts. Once you’ve completed these few steps, you can begin:
- Hiring employees
- Opening a brick-and-mortar location
- Marketing your company
When operating as a sole proprietorship, you may want to select a “Doing Business As” (DBA) name. This is the name under which your business operates. For instance, “John Doe” may elect to do business as “JD Marketing.” Registering a DBA can protect your identity. It also allows you to create a name that’s more appropriate for branding. If your company operates under a name other than your own, you’ll need a DBA to file for licenses, permits and a business bank account.
Creating a single-member LLC
Single-member LLCs require much more paperwork. You’ll need to file paperwork with your state’s Secretary of State office.
Although requirements vary from state to state, you typically file Articles of Organization, pay a filing fee and indicate the chosen name for your company.
One of the other requirements for forming a single-member LLC is choosing a registered agent.
The registered agent is responsible for accepting legal correspondence on behalf of your company. Owners also need to list a registered address, which is the physical location for the agent. The registered address can be different from your company address, but it cannot be a P.O. Box.
Some states will allow you to serve as your own registered agent. However, know that you must be physically present at your registered address during regular business hours.
There are also maintenance and compliance requirements associated with a single-member LLC, and you’ll need to file an annual report with the Secretary of State’s office. Failing to file an annual report could cause the state to shut down your business.
Once you set up your business, you need to understand how the taxes are filed and paid.
How do taxes work?
When it comes to taxes, sole proprietors and single-member limited liability companies are treated differently.
Taxation as a sole proprietor
Taxation as a sole proprietor is straightforward. The IRS allows sole proprietors to “pass-through” business income and losses to the personal tax returns (Form 1040). You’ll do so on IRS Schedule C.
You post business income and expenses on Schedule C, and your business profit is added to other sources of income on your personal tax return. Make sure that you keep accurate records throughout the year to simplify the process of filing your income tax return.
FICA taxes, which fund Social Security and Medicare, are paid by both the worker and the employer.
As a sole proprietor, you pay self-employment taxes. You’re responsible for paying the worker and the employer share of FICA taxes, which is currently a 15.3% tax rate. The sole proprietor deducts the employer half of FICA taxes as a business expense.
Sole proprietors use their Social Security Number to file federal taxes using Form 1040. If the sole proprietorship employs individuals, the business must obtain an IRS Employer Identification Number (EIN) for payroll tax purposes.
Taxation as a single-member LLC
Like a traditional LLC, a single-member LLC can elect to be taxed as a C Corporation. In this case, the company files a tax return and pay federal and state taxes at the corporate tax rate.
If an LLC doesn’t elect to be taxed as a corporation, it’s treated as a sole proprietorship for tax purposes. The LLC’s profit is posted to the personal tax return through Schedule C.
Single-member LLCs are required to pay self-employment tax, just like sole proprietors, and LLC owners need an EIN if they hire employees.
Sole proprietors and single-member LLCs have different exposure to business liability.
Sole proprietors are not protected from any business liabilities. If the business were to take on debt, file bankruptcy, or dissolve, creditors can go after the owner’s personal assets, including bank accounts, houses, cars and other property.
Single-member LLCs are attractive because they can shield owners from the liabilities associated with the business. However, the limited liability protection isn’t as robust as it is for traditional LLCs (those with multiple members).
A court may overturn any business owner’s liability protection. Limited liability is based on the idea that the company and the individual are two separate entities. Since a single-member LLC is a disregarded entity, owners are less likely to keep personal and business affairs separate, and a court may be more likely to pierce the corporate veil.
If the corporate veil is pierced, the court may allow a creditor to go after the personal assets of the LLC member.
To keep your liability protection intact, you need to make sure that you cross your T’s and dot your I’s. Single-member LLC owners should maintain a formal operating agreement that governs how the LLC functions, ensuring that the business complies with both federal and state law. Owners should also keep all business and personal financials separate from one another.
Benefits and disadvantages of each business structure
Both sole proprietorships and single-member LLCs have unique advantages and disadvantages. Consider the following when deciding which organizational structure is right for your new company.
Advantages of sole proprietorships include that they:
- Are easy to form: Once you begin conducting business, you run a sole proprietorship by default. You don’t need to file complicated forms.
- Are easy to dissolve: When business operations come to a close, it’s easy to dissolve the company. Owners can dissolve the company whenever they choose to do so.
- Provide pass-through taxation: Filing tax forms is easy. All you need to do is complete IRS Schedule C.
Disadvantages of sole proprietorships can include:
- No protection from liability: Single owners are responsible for all tax liabilities, even if they hire employees.
- A limited lifespan for the business: Were something to happen to the owner, business operations would cease immediately. This could be unanticipated and untimely, and could negatively affect any employees involved.
- Challenges raising capital: Other entity types, like LLCs and C Corporations, can offer an ownership stake to investors. A sole proprietorship doesn’t offer that option, which can make it challenging to raise additional capital.
Advantages of a single-member LLC include:
- Liability protection: So long as owners protect the corporate veil, they won’t be held accountable for the liabilities of the business.
- Passing on ownership: Because the LLC exists as a separate entity, it’s easy to give ownership to another individual.
- Flexibility with taxation: Owners can elect pass-through taxation (using the personal tax return), or select corporate tax treatment.
- Easy to expand ownership: You can change from a single-member LLC to a multi-member LLC by filing an amendment with your respective state.
Disadvantages of single-member LLCs include:
- Complex formation: You’ll need extensive paperwork to form an LLC, because you’re creating a separate entity.
- Necessary compliance: You’re required to complete various compliance forms to remain in good standing. You’ll also need to make sure you protect the corporate veil to keep your liability protection intact.
Which is best for you?
If you’re operating as a single owner, you’ll need to choose between a sole proprietorship and a single-member LLC. Each has its perks. If you have basic business operations without any liabilities, a sole proprietorship is likely in your best interest. If you’re looking to put more credibility behind your business’s name, a limited liability company could be the better choice.