Unless you’re a tax professional, the differences between each type of business entity can feel like a foreign language. However, it’s essential you do your research and talk to an attorney or CPA because your choice of business entity DOES have an impact on how much you pay in taxes and what happens if your company gets in trouble.
(Btw… I’ll be dropping infographic gems on Instagram on this subject all week long. Make sure you are following so you can drop your questions and interact with me! )
What is a sole proprietorship?
A sole proprietorship is an unincorporated business with one owner. It is the simplest and least expensive business entity. You don’t need to file any paperwork with your state. And thus, you have no liability protection. Simply selling your service or product without any legal setup would qualify you as a sole proprietor.
What is an LLC?
LLC stands for “limited liability company”. Owners of an LLC are called members. Just like the name implies, an LLC offers members liability protection. An LLC is a legally separate business entity that is created under state law; it is separate from your personal being. It combines elements of a sole proprietorship, partnership, and corporation. The flexibility offered with an LLC means business owners can decide on management structure, operational processes, and tax treatment.
So, how do you know which one is right for you and your business? Let’s think about a story… It might even sound familiar:
Claire is an entrepreneur. She is in her second year of business. During her first year, she made $50k and operated as a sole proprietorship. Now, in her second year, she’s made some serious gains and doubled her revenue. She’s wondering, is this the right time to form an LLC? Is it even necessary?
Some things Claire should consider…
- Ease of formation
Sole proprietorships are the simplest way to go. They are less complex and less expensive (and they demand less paperwork). All you need to do to start your sole proprietorship is… start your business!
To establish an LLC, you must do so through your state, often the secretary of state’s office. This entails drafting and filing articles of organization and paying a filing fee (which can get real pricey in some states). Setting up an LLC requires more upfront time, money, and effort. - Raising capital for your start-up
In any business, you’ll need to fund your business using personal resources, equity, or loans. Keep in mind, establishing a line of credit and loan approval may be tricky as a beginner entrepreneur. The same holds true for sole proprietors; banks may be more strict about lending to sole proprietors compared to a legally formed entity such as an LLC. - Taxes
A sole proprietor’s net business income is taxed on their individual tax return at the proprietor’s individual tax rates. Single-member LLCs and sole proprietorships are taxed the same. They both may claim an array of business tax deductions.
(If you’re curious about the 12 business deductions you SHOULD be taking, I have a Maximize feature on that! Read it here.
A key difference in taxes between LLCs and sole proprietorships is flexibility. Only LLC owners can choose how they want their business to be taxed. They may choose to stick with the default (pass-through taxation) OR elect the LLC to be taxed as an S-corporation or C-corporation. LLCs have the opportunity to save money by electing corporate tax status.
The benefit to this is…tax savings! This is a tax strategy. You select the method that will garner the least amount of taxes. One size does not fit all; it differs for each business depending on your current situation and your future goals. Work with a CPA or Business Attorney if you are at a level where multi 5 and 6 figure tax bills is your (new) norm. - Legal protection
You are most vulnerable legally in a sole proprietorship. There is no legal separation between the business and the owner. As a sole proprietor, YOU are personally responsible for the business’s debts. If the business goes bankrupt, both personal and business debts will be included in the bankruptcy proceedings. To that same end, if someone sues a sole proprietorship, they can also go after the owner’s personal assets; you and your proprietorship are one-in-the-same.
LLCs offer more protection. An LLC is a legally separate entity. The owner is not personally liable for business happenings. This protects you from the previously mentioned vulnerabilities of a sole proprietorship. The bottom line: one of the best ways to protect your personal assets is to form an LLC.
So, which one should Claire choose?
The turning point in Claire’s story is when she starts making that money! Sole proprietorship was a great route for the first year of business. Minimal paperwork, no big cost. It’s simple for the new entrepreneur.
Now, Claire is all-in on her business. Now is the time to form an LLC! An LLC will ensure she is not personally liable for business obligations. Additionally, LLCs offer more tax flexibility, presenting more opportunities for her to save thousands. This is also a time where it makes sense for Claire to build a working relationship with a proactive CPA who can lead the way for Claire to easily, regularly and strategically save 5 figures in taxes year after year as her business continues to grow.
When deciding when the time is right to form an LLC, a major key to consider is business growth. A sole proprietorship is just fine for those beginning stages or if your business is really a part-time hobby where you aren’t generating much revenue. But as your money and business grows… So does your vulnerability! And that’s when it’s time to level up.
8 Easy & Effective Tax Write-Offs for Creatives & Service Providers
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