Almost two years into the pandemic, Americans’ entrepreneurial spirit remains unfazed. In fact, more Americans than ever are looking to open businesses, with a staggering 5.4 million new business applications filed in 2021 alone. That’s a million more than the record set in 2020.
With normal life returning across the US, the number of business applications may hit new heights this year. One of the main decisions Americans looking to open businesses will need to make is what business structure to adopt. For the vast majority, it’s an LLC vs sole proprietorship decision.
In today’s guide, we take a closer look at each of the two business structures and how they differ from each other. This way, it’s easier for you to know whether to open an LLC or a sole proprietorship.
What Is a Sole Proprietorship?
A sole proprietorship refers to an incorporated business that has one owner. It’s the simplest type of business to form. Sole proprietorships are also the least expensive kind of business to start.
A person who operates a business on their own is automatically the sole proprietor of that business. For instance, if you operate a business as a retailer, freelancer, e-business, or sell goods and services in any other way, you’re by default a sole proprietor unless you adopt a different business structure.
One of the top distinguishing factors of sole proprietorships is that there isn’t a legal separation between the business owner and the business. The owner generally assumes responsibility for the company’s debts.
Sole proprietorships are the most common type of business in the US, with over 23 million now open.
Pros and Cons of a Sole Proprietorship
Before you decide to open a sole proprietorship, it’s smart to know what the strengths and weaknesses of this business structure are. Let’s examine each.
There are many reasons why the vast majority of small businesses in the US choose to register as sole proprietorships. These include:
One of the main advantages of starting a sole proprietorship is that you get to avoid the ton of paperwork required when opening other types of business entities. You don’t need to go through the process of registering with the state like is required with an LLC. Instead, you become a sole proprietor by the mere virtue of running a business.
That said, it’s important to note that you may need to obtain a business permit or license based on your state or local government’s requirements.
Simple Tax Setup
Compared to other business entity types, a sole proprietorship has much simpler tax requirements. As a sole proprietor, applying for an EIN isn’t a requirement. You can simply use your social security number as you do for other financial transactions that require it.
That said, sole proprietors still have the option to get and use an EIN if they choose to.
The IRS also taxes sole proprietorships as pass-through entities. That means you’ll report your entity’s income and losses on your personal tax return. Simply put, you don’t need to worry about paying taxes for your business separately.
Business Ownership Is Simplified
It’s not just starting a sole proprietorship that’s easy. Running the enterprise is also much easier compared to other business entities.
Such components as registered agents and company officers are non-existent in sole proprietorships, so you’ll never have to deal with them. Given that you’re the sole owner of the business, you have full control over the business finances and decisions, as well as anything else that affects how your enterprise functions.
Sure, the benefits of a sole proprietorship are compelling, but there are some significant drawbacks as well. Knowing these disadvantages helps you decide whether you still want to proceed with this type of business structure. Here are three cons associated with sole proprietorships.
There’s No Liability Protection
Not having to register your sole proprietorship with your state of operation comes with a disadvantage. It means that you won’t get to enjoy the benefits that a legal business entity enjoys. Because you’re self-employed as a sole proprietor, you’re on your own when it comes to the transactions you make as a business.
The biggest problem when you run a business that’s not incorporated is that you’re liable for your business’s financial, legal, and tax problems. Creditors can seize your personal assets and sue you personally for company-related issues.
Getting Financing and Business Credit Is Harder
Another major drawback of running a sole proprietorship is that it can be more difficult to secure financing and loans. That’s because most lenders opt to work with established enterprises like LLCs. That’s because established businesses are generally larger in revenue and tend to have a more substantial credit history.
As a sole proprietorship, it’s difficult to build credit in the same manner other companies do, given that these businesses rarely have their own business credit cards. Besides, all of the backing and liability in a sole proprietorship comes from one person, which makes the company as a whole dependent on the owner’s initial credit history, finances, and investments.
Selling the Business Is Harder
For many entrepreneurs, selling a business is always on the cards. The problem with sole proprietorships is that they’re harder to sell compared to other business entities. That’s because these businesses are, by nature, attached to individuals.
Because of the challenges involved in selling a sole proprietorship, many of these businesses end when the owner dies or decides that they no longer want to run the enterprise.
It’s important to note that you can still sell your sole proprietorship, but you’d have to go about it in a different way. Many people opt to sell the business’s assets instead of trying to sell the business as a whole. It’s a much simpler process than trying to sell or transfer usage rights to the new owner.
What Is an LLC?
An LLC (limited liability company) refers to a legally separate business entity created under state law. LLCs typically combine the elements of a sole proprietorship, partnership, and corporation, resulting in a business entity that’s incredibly flexible. An LLC can have one or multiple members.
Owners of an LLC decide the company’s management structure, tax treatment, and operational processes. Of course, hiring a business attorney and other professionals to help with the formation of the business and other major decisions is always a plus when you run an LLC.
The most defining feature of LLCs is that these businesses offer members liability protection from the company’s debts and obligations. Creditors who sue an LLC cannot go after the owners’ personal assets.
The choice to structure your business as an LLC has certain advantages. Here are some of them.
You Enjoy Limited Liability
It’s arguably the greatest strength of an LLC. As a member, you aren’t liable for the actions of the business. Business and personal assets are separate, which is a huge relief in case the company ever runs into trouble.
There’s pass-Through Federal Taxation on Business Profits
Unless members opt otherwise, LLCs remain pass-through entities. This essentially means that company profits go directly into the accounts of the members without being taxed. Members can then pay tax on the profits on their own income tax returns.
More Flexible Management
In most cases, LLCs are member-managed by default. Members share in the day-to-day decision-making of the company. But members can also opt to let professional managers who are either members or outsiders manage the company on their behalf.
Drawbacks of an LLC
Before you register your company as an LLC, there are certain potential drawbacks you need to be aware of. Here are three of them.
There Are Limits to Limited Liability
A judge may decide to rule that an LLC structure doesn’t protect the personal assets of its members. This especially happens when you fail to separate company transactions from personal transactions. The same may also happen if the company engages in fraudulent activities and causes losses for others.
Member Turnover Can Severely Affect the Company
In many US states, an LLC must be dissolved the moment a member dies, leaves the company, or goes bankrupt. The remaining members are then required to take responsibility for the remaining financial and legal obligations to terminate the company.
LLC vs Sole Proprietorship: Choose Wisely
When starting a business, one of the most critical decisions is to decide on an ideal business structure. In an LLC vs sole proprietorship situation, think about the pros and cons of each and make a decision based on what works best for you.
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