New entrepreneurs have a long list of to-dos when starting their businesses. Among the tasks to check off that list is deciding their business structure. For small businesses with a sole owner and no (or very few) employees, the two most popular options are:
- Sole proprietorship
- Single-member LLC (Limited Liability Company)
So, which one might be the best choice for your business?
I advise you to consider talking with an attorney and accountant to dig into the advantages and disadvantages of each for your specific situation.
In the meantime, let’s take a look at some of the basic characteristics of each so that you’ll have some fundamental information as you start your research.
How a Sole Proprietor and Single-member LLC Are Alike—And Different
Establishing the Business
By default, a business owned by a solo individual will be regarded as a sole proprietorship. When entrepreneurs include their first and last names in the business name (for example, Jillian Suko Career Coaching), they don’t have to register their name with the state. If they choose to use a fictitious name (such as “Catalyst Career Coaching,” they will likely need to file a fictitious name registration form with the state where they wish to operate. (You might also see the term “DBA” or “Doing Business As” used instead of fictitious name.) Some states also require that business owners run advertisements in a local and/or a legal newspaper to inform the public of the person who is responsible for the business operating under the fictitious name.
Documentation called Articles of Organization are required by the state when forming an LLC. In most states, the form is relatively simple, but to make sure you’re completing it accurately, you can gain peace of mind by talking with an attorney or asking an online document filing service to assist you. When registering an LLC, the business name is automatically registered, as well, so there’s no need to file for a fictitious name.
Regardless of the business structure, certain requirements are the same for sole proprietors and single-member LLCs. For example:
- Obtaining an EIN to open a business bank account (and to hire employees if needed)
- Applying for any necessary licenses and permits
- Withholding payroll taxes from employees’ wages or salaries (if the business has employees)
A business run as a sole proprietorship does not have any legal separation between the company and the business owner. They are considered the same legal entity, and therefore, the business owner is personally responsible for all debts and legal obligations of the business. This is arguably what many people consider the biggest drawback to operating as a sole proprietor. If the business gets sued or cannot pay its bills or loans, the owner’s personal assets might be taken as restitution or payment.
When a business is formed as a single-member LLC, the company becomes its own legal entity. That means its owner (member) is typically not held personally responsible for debts or if legal action is taken against the business. (Note, however, that an LLC owner might be held accountable if that individual is found to have ignored compliance rules or willfully engaged in wrongful business activities.)
Income Tax Treatment
In a sole proprietorship, the owner and the business are considered the same tax-paying entity. Therefore, the income tax obligations of the business flow through to the owner's personal tax return (with IRS Schedule C accompanying it). This is called pass-through taxation, and business profits are taxable according to the applicable tax rates for individuals. Business income is also subject to self-employment taxes (Social Security and Medicare).
By default, a single-member LLC is considered a disregarded entity. Therefore, as with a sole proprietorship, business tax obligations flow through to the LLC owner. However, by electing for corporate tax treatment, an LLC (if it meets all eligibility requirements) can choose to be taxed as either a C Corporation or S Corporation. These options can help business owners minimize their self-employment tax burden because only the owner's wages or salary are subject to self-employment tax. With C Corp tax treatment, business income gets taxed at the corporate tax rate and the business files a separate income tax return. With S Corp tax treatment, income tax gets reported on the business owner's personal income tax return (with IRS Form 1120-S accompanying it). Generally, LLC owners find the S Corp option more attractive than the C Corp because, with C Corp tax treatment, profits are taxed at the corporate level, and then the distributions made to the owner are taxed on the individual level, as well.
Ongoing Business Compliance
From an ease of administration standpoint, you can’t beat a sole proprietorship. Because the state doesn’t recognize it as a separate legal entity, there are no required corporate compliance formalities to abide by.
The single-member LLC business entity type stands as the next best thing when considering simplicity. Compliance requirements vary from state to state, but generally, they are far less extensive than what a corporation must do to stay in good standing. A few of the typical compliance obligations that an LLC must fulfill include:
- Filing an annual report with the state (in some states, these are every two years or on some other schedule)
- Maintaining a separate business bank account and keeping all business transactions separate from the owner’s personal affairs
- Recording major changes to the LLC by filing an Articles of Amendment
The Skinny on Selecting to Operate as a Sole Proprietor or Single-member LLC
Although it costs a little bit more to establish and maintain an LLC than a sole proprietorship, I encourage you to consider the big picture and think about what will serve your interests best for the long term.
The type of entity you choose for your business will have financial and legal ramifications, so make sure you learn as much as possible about your options. Also, realize that you don't know what you don't know! Seek professional guidance from an attorney and accountant or tax advisor to fully explore the pros and cons before you make a decision.