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.
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. Essentially, the proprietor takes on all the risks associated with the company, including those associated with both assets and liabilities. Sole proprietors are responsible for any debts or obligations the company accumulates.
Sole proprietors must keep company assets separate from personal assets. They should use different bank accounts for business income than they do for personal income.
A single-member LLC is merely a limited liability company with a single owner. Single-member LLCs are disregarded entities. A disregarded entity is ignored by the IRS, and the IRS collects the business’s taxes on the owner’s personal tax return instead of on a business tax return.
So single-member LLCs aren’t separate from the owner for tax purposes, but they are for legal purposes. The reason single-member LLCs are separate from the owner for business purposes is because of how liabilities are treated. Limited liability companies protect owner’s assets from being seized to pay for debts accumulated by the business.
If an owner wishes to operate a single-member LLC, they will need to file paperwork with the state in which they plan to conduct business.
Forming the business
There are critical differences in how single 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 elaborates that prospective owners “do not have to take any formal action to form a sole proprietorship.”
Forming a sole proprietorship is inexpensive and straightforward. The only things you need to do are choose a name, obtain proper business licenses and permits, and open business bank accounts. The sole proprietorship status refers to how many owners there are in the business. Thus, 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 can also allow 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
Whereas sole proprietorships are created by default, single-member LLCs require much more paperwork. You’ll need to file paperwork in any state where you’re going to do business. You can file paperwork with your Secretary of State’s office.
Although requirements vary from state to state, you’re likely going to need to file Articles of Organization. There is a filing fee associated with doing so. Not only will you have to indicate the chosen name for your company, you’ll also have to declare where you’ll do business.
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 place where the registered agent exists. 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. You’ll likely 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.
How do taxes work?
There are some differences in business taxes for sole proprietors and single-member limited liability companies.
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 their personal tax returns. You’ll do so on an IRS Schedule C.
You can deduct expenses for income tax purposes. By putting expenses on your Schedule C, you may lower your tax burden. You’ll need to make sure that you keep accurate records throughout the year to simplify the process of filing your income tax return.
As a sole proprietor, you’re responsible for paying the entirety of your tax burden under what’s known as “self-employment taxes.” If you work for an employer, you’re only required to pay half of the necessary contributions to Social Security and Medicare. The employer pays the other half. However, when working for yourself, you’re required to pay the full rate, which is 15.3%.
Single owners will use their Social Security Number to file federal taxes. If the sole proprietorship employs individuals, the business will need to secure an Employer Identification Number (EIN) for taxes.
Taxation as a single-member LLC
Like a traditional LLC, a single-member LLC can elect to be taxed as a C Corporation. In these instances, the company pays federal and state taxes at the corporate tax rate. However, single owners must elect for this to happen. If LLCs don’t opt to be treated as a corporation, they’re treated as a sole proprietorship for tax purposes.
In these cases, LLC funds are passed through to the owner’s personal tax returns. To pay federal income tax, single owners will complete a Schedule C for business gains and losses. Single owners are required to pay self-employment tax, just like sole proprietorships.
Like sole proprietorships, single-member LLC owners only need an EIN if they hire employees. So, the only difference between sole proprietorships and single-member LLCs is the fact that LLC owners can elect for corporate taxation.
There are key liability issues associated with both sole proprietorships and LLCs.
Sole proprietors are not protected from any business liabilities. If the business were to take on debt, file bankruptcy, or dissolve, creditors could go after the owner’s personal assets to pay the debts. Personal assets can include 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.
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.
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 maintain a formal operating agreement that governs how the LLC functions, ensuring that your 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 ownership stake to investors. A sole proprietorship doesn’t have such luxury, which could make it challenging to raise 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 or 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 since 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.