If you are planning to start a business?
So, stepping toward one of the most important and at the same time confusing decisions!
This is a comparison guide to Sole Proprietorship vs LLC. Learn which is the best business structure for small businesses in this guide.
It is hard to realize the difference between each type of entity in real-life terms unless you are a lawyer or tax expert. There are pros and cons to each type of business and your choice of business entity affects the real-life terms, such as
- What is the amount of taxes you have to pay?
- Required time for paperwork?
- What legal risks are involved if someone sues your company?
To understand the difference between a limited liability company (LLC) and a sole proprietorship in terms of formation, taxes, and legal protection, let’s dive into the guide below to understand the best option for the business owner.
Sole Proprietorship vs LLC: A Comprehensive Guide for New Businesses in 2022
- 1 What is a sole proprietorship?
- 2 What is an LLC?
- 3 Sole Proprietorship vs LLC: What’s the Difference?
- 4 Sole Proprietorship vs LLC: Which is best?
- 5 How to Form an LLC in Six Simple Steps
- 6 How Micahguru Formation can help
What is a sole proprietorship?
A sole proprietorship is a business owned by one person. It’s the simplest and least expensive type of business to form, so most small businesses start as sole proprietorships. Typically, you can identify a sole proprietorship by the fact that the owner’s name is the business’s name, though sole proprietorships can also operate under a brand name or trade name.
The main characteristic of a sole proprietorship is that there’s no legal separation between the business and business owner, so the owner is personally responsible for the business’s debts.
What is an LLC?
A limited liability company, or LLC, is a separate legal entity created under state law. It combines elements of a sole proprietorship, partnership, and corporation and offers owners a lot of flexibility.
The owners can decide their management structure, operational processes, and tax treatment. One person can form a single-member LLC, or multiple people can form a multi-member LLC. Businesses identified as LLCs will usually have the phrase “limited liability company” or the abbreviation “LLC” at the end of their legal name.
The defining feature of an LLC is that it offers owners protection from the debts and obligations of the business. In the normal course of business, a business creditor or someone who sues the business cannot come after the personal assets of the owners.
Sole Proprietorship vs LLC: What’s the Difference?
There are five main factors to compare between a sole proprietorship and LLC:
- Limited liability
- Management structure
Sole Proprietorship vs LLC: Formation
From the formation point of view, sole proprietorships are the easiest and least expensive type of business to start. Surprisingly there is no hassle to form a sole proprietorship. You would be running a sole proprietorship without even knowing it.
By default, every person selling goods and services is a sole proprietor. You would need business licenses or zoning permits to legally run your sole proprietorship, but it depends on your business’s region. An LLC also needs a fictitious business name registration, also called a DBA or “doing business as” certificate. Several states allow individuals to register their names as trading names.
The most important formation document for an LLC is called the articles of organization. This document establishes your LLC’s existence and must be filed with the state in which you’re operating. The cost to file articles of organization varies by state.
Sole Proprietorship vs LLC: Limited Liability
A sole proprietorship is a business structure in which there’s no legal separation between the business and its owner. The owner is personally responsible for all of the business’s debts, and if the business goes bankrupt it can have serious consequences on the owner’s finances as well.
One way to protect your assets from being seized by creditors is to form an LLC: An LLC is a legally separate entity from its owners, so if the business fails or encounters legal problems, its owners don’t have to pay off its debts of their own pockets. However, since an LLC isn’t considered a separate legal entity for tax purposes (which means that it doesn’t file separate tax returns), you might want to incorporate your business instead (or form/join an S corporation).
Unlike in a sole proprietorship or an LLC, someone who sues your corporation can’t go after your assets. Of course, this protection has limits: Owners in an LLC can be held personally liable for fraud or negligence committed by them while running the business, and they can also be held personally liable for any debts they’ve specifically guaranteed.
Sole Proprietorship vs LLC: Taxation
Both sole proprietors and LLCs are taxed as pass-through entities by the US Internal Revenue Service. This means that a business’s profits will pass through to its members, who will report them on their tax returns.
In the case of multi-member LLCs, they are also considered pass-through entities. Each member reports and pays taxes on their share of income. If employees are hired both LLCs and sole proprietorships might have to pay additional tax.
So, it is obvious that the main difference between LLCs vs. sole proprietorships is tax flexibility. The LLC owners have the choice that how they want their business to be taxed.
Sole Proprietorship vs LLC: Management Structure
A sole proprietorship or a single-member LLC can be defined as “Boss of yourself”. You can take the decisions related to the market, finance, policies, and goals of business all by yourself without any interference.
No approval nor consultation is required from any third party.
But if we talk about the multi-member LLCs, owners can share decision making or appoint a manager to make decisions for the LLC.
Sole Proprietorship vs LLC: Paperwork
If we compare the difference related to paperwork, a sole proprietorship needs a very less amount of paperwork before launch. A sole proprietor is only required to stay in touch with federal, state, and local taxes, after launching.
Now moving towards an LLC, they have more responsibilities. Firstly, they have to file initial articles of organization and then an annual report in many states. An LLC with multiple members has to bear more responsibilities, for example: drafting an operating agreement, issuing membership units, to hold members’ meetings.
These steps are not legally important but are still highly recommended for LLCs to ensure liability protection for members.
Sole Proprietorship vs LLC: Which is best?
Most people prefer to start the business as a sole proprietor as it seems easy due to
- Minimal paperwork
- Simple tax procedure
- No major investment is required
But once the business starts establishing and growing, the owner realizes that
- No protection of personal assets is available
- If failed in running a business (due to plan fault or any unexpected challenge) then chances of being bankrupt are possible.
On the other hand, LLC owners get
- More protection in case of a business bankruptcy or business lawsuit (as they are not liable for business debts)
- Tax flexibility
Which business structure is best for you? It depends on several factors and it’s important to research well before starting a business. However due to these two reasons, liability protection and flexibility of tax, an LLC is suggested for the small business owners.
How to Form an LLC in Six Simple Steps
There are two ways to form an LLC for your business: Do it yourself or get a professional formation service to do it for you.
To form an LLC yourself, you have to follow these steps:
- Pick a Name for your LLC
- Appoint a registered agent
- File your Article of Organization (Certificate of Formation)
- Decide on member vs manager management
- Draft your Operating Agreement
- Apply for Business Tax ID
Pick a Name for your LLC
The first step to forming an LLC is to select a name for your LLC. Generally, you will need to follow this naming instruction:
- You must include the word limited liability company or LLC in your company name.
- You have to avoid restricted words such as a bank, trust, Law, Attorney, etc.
- You should not include such words in your company name that confuse your LLC with a government agency.
- I also recommend registering your LLC name’s web domain even if you do not want to create your business website today.
Appoint a Registered Agent
The next step in forming an LLC is to appoint a registered agent. A registered agent is also known as a statutory agent or resident agent.
A registered agent is a person or a company who sends and receives legal papers on behalf of your LLC.
These legal papers include official correspondence like legal summons and filing documents.
Your registered agent must be a state resident where you want to start your LLC. If your registered agent is an individual, he will be a member of your LLC and you.
File your Article of Organization (Certificate of Formation)
The next step you have to do is to file the formation documents with your Secretary of State. These documents are known by various names, most commonly this document known as Certificate of Formation. It describes the organizational structure of your business.
Decide on Member vs Manager Management
The next thing you have to do is decide how your company will be managed.
A Limited Liability Company can have one or more owners. If you are a single owner, you don’t have to select between member management or manager management. You are automatically in control of all management decisions.
But if your LLC has multiple owners or investors, your group will need to collectively manage the company or elect a manager.
Learn More: Member vs Manager Managed LLC
Draft your Operating Agreement
An LLC operating agreement is a legally binding business document that entails the ownership of its members, how the company is managed, and the structure of the LLC or limited liability company.
It can provide details such as one meeting naming a registered agent, selecting managers, and adding and dropping members.
An operating agreement is not required in every state, but it is highly recommended to have an operating agreement to avoid internal disagreements between LLC members.
Apply for Business Tax ID
The final step is to apply for your Business Tax ID, also known as Employer Identification Number (EIN) and Federal Tax Identification Number.
What are the Purposes of EIN?
- An EIN is necessary for your business tax purposes.
- It is also required to open a business bank account in the United States.
- It is also needed when you want to hire employees legally.
Applying for an EIN is quite simple and free of cost. You can quickly obtain this by visiting the IRS.gov website.
How Micahguru Formation can help
You’ve come to the right place if you’re thinking about forming an LLC with the help of a professional incorporation service.
Micahguru Formation is a U.S. incorporation company that helps founders and entrepreneurs globally to launch and manage their U.S. businesses remotely.
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