When starting a small business, one of the most important steps is deciding which business structure fits your idea the best. Although the process and amount of circulating information may be overwhelming, the legal entity of your business is crucial to your success. Two of the most common forms available for startups and small businesses are the LLC and sole proprietorship.
Limited liability company (LLC)
The limited liability company (LLC) is one of the most popular business structures. It combines elements of a corporation and partnership, while eliminating some of the negative features of each. Like a corporation, the LLC provides limited liability to its owners and shareholders; like a partnership, the LLC offers a pass-through income taxation.
- Flexibility: The management structure of the LLC is much more flexible than that of a corporation. Business owners can create an operating agreement based on their own requirements and needs.
- Limited liability: One of the most important features of an LLC protects members of the company from personal liability for business debts.
- Tax options: Income does not need to be taxed at a corporate level. Losses can be passed directly through to the individual shareholders, allowing them to claim the company’s losses on their personal tax returns. This feature is beneficial because it avoids double taxation, allowing profits to stay within the company for possible future growth.
- Pass-through taxes: Although previously stated as an advantage, pass-through taxes can also be a disadvantage. As profits and losses are reported on each shareholder’s personal tax return, the pass-through taxation may be unfavorable when the shareholders do not receive dividends.
- Investors: Because of the flexibility of the LLC business structure, investors may be hesitant to loan or invest their money.
- Additional taxes and fees: The lack of a governing structure could eventually lead to issues down the road, requiring upfront costs, such as state and attorney fees. Also, in many states, such as New York, California, Tennessee, Alabama, Kentucky, Pennsylvania and Texas, LLCs are required to pay a franchise tax or capital values tax. This tax can be based on revenue, profits, and the number of owners, the amount of capital employed in the state or any combination of these factors.
A sole proprietorship is a business structure that is owned by one individual, the sole proprietor, where there is no legal difference between the owner and the business. This structure is designed for individuals in business for themselves without associates, partners or strict state and federal regulations.
- Easy and inexpensive: A sole proprietorship does not require legal documentation, fees or filings other than the necessary license or permits. At the most, sole proprietors must register their business name with the state’s corporate filing agency.
- Few regulations: The advantage of having one business owner is complete control of any and all decisions. There are no state or federal regulations regarding shareholders or the organizational structure of a sole proprietorship.
- No business taxes: The business is not taxed separately. Company profits are filed on the business owner’s personal income tax return and can be reinvested for company growth or given directly to the owner. Tax rates for a sole proprietorship are also the lowest of the business entities.
- No liability protection: Sole proprietors are vulnerable to lawsuits and fully responsible for any damage incurred. If the company is sued, creditors can go after not only the business assets, but also the owner’s personal assets.
- Limited financing options: Due to the structure of a sole proprietorship, additional funding from an investor is not allowed. Another entity, such as a partnership or LLC, is required. According to the Small Business Administration, sole proprietors are often limited to funding their businesses through their personal savings or consumer loans.
A sole proprietorship can eventually be converted to a LLC, but conversion costs may be substantial. It is important to understand the difference between all business entities and decide which structure best fits your personal requirements as well as the needs of your business. It’s best to consult a lawyer for help with this process, but with thorough research, it’s possible to make the decision on your own.
If you’re thinking about how to raise capital, read about the 10 ways you can fund your business.