Llc Vs Sole Proprietorship: Legal Protection Of Personal Assets
The legal protection for personal assets is the number one reason that most people suggest forming an LLC over a sole proprietorship. When run properly, a single-member LLC will protect both a small business owner and their business in ways that a sole proprietorship cannot.
Before I continue, this is not legal advice. I suggest talking to a lawyer to help you create and run an LLC in a way that guarantees these benefits. Liability protection works in the following ways:
- When running an LLC properly, your business assets cannot be included when a court considers your personal assets, but your income and profit can be if run as a pass-through entity.
- When running an LLC properly, liability protection prevents your personal assets from being included when a court considers your business assets, as long as you were not personally responsible for the behavior that caused the court judgment.
- The debts of the business and any personal debts are separate if you follow the requirements to provide liability protection.
Legal protection is accomplished because the business structure creates liability protection, as long as certain rules are followed. Small business owners should be aware of the following practices when seeking legal protection through an LLC:
You can also run a multi-member LLC using the tax code for partnerships or as a corporation.
Looking at this section, LLC takes the win!
Lets look at the differences in the formation of an LLC vs. sole proprietorship.
Llc Vs Sole Proprietor: Operations
Sole proprietorships are tied directly to the owners personal tax return and the owner has to be involved in the operations of a business. Operations will also end when a sole proprietor dies.
Meanwhile, if your own business is an LLC, you can specify a manager in the LLC operating agreement and collect the profits. When you file articles of organization and the operating agreement, you need to specify how ownership is transferred, making it where an LLC can survive an owners death.
Which is better LLC or sole proprietorship? The benefits of LLC vs. sole proprietorship win out on this one.
Disadvantage Of Sole Proprietorship
One of the biggest downsides to sole proprietorship and ultimately the reason why a lot of people decide against it is because you have no liability protection.
There is no separation between your personal assets and your business assets. With an LLC, you do not have to worry about someone coming after your personal assets.
While being in charge of the decisions is a good thing, it can also be a bad thing. In a sole proprietorship, you are responsible for everything. There isnt someone on top of you making the decisions for you. You are the big boss that the employees may or may not like.
Some of the other disadvantages of sole proprietorship include:
- Difficulty obtaining capital
- Existence ends with owners existence no business is left to other generations
- Can only have one owner
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What Are The Main Differences Between An Llc And A Sole Proprietorship
While its perfectly suitable for an LLC to have a single owner, it could also have multiple owners. An LLC is considered a separate legal entity from its owner or owners, which are referred to as members of the LLC. The LLCs members are not held personally liable for business debts or other liabilities incurred by the business, such as lawsuits, accidents, or injuries. Instead, the LLC is responsible.
A sole proprietorship, on the other hand, is always owned and operated by only one person. The owner of the sole proprietorship is entitled to all the profits of the business but is also responsible for all of the businesss debts and liabilities.
Llc Vs Sole Proprietorship: Taxes
A single-member LLC and a sole proprietorship resemble each other in terms of tax treatment. Both are pass-through entities, which means that the business itself doesnt pay income taxes. The owner reports business income on a Schedule C thats attached to their personal tax return, and the income gets taxed at the owners personal income tax rate.
Multi-member LLCs are also pass-through entities, with each owner reporting and paying taxes on their share of the businesss income. The only difference is that a multi-member LLC must file a business tax return with the IRS, Form 1065, U.S. Return of Partnership Income. In addition, each member must attach a Schedule K-1 to their personal tax return, which shows their share of the businesss income.
In addition to income taxes, both LLCs and sole proprietorships might have additional tax responsibilities. No matter which business structure you adopt, youll need to pay payroll taxes if you have employees. Youll also need to collect state and local sales taxes if you sell taxable goods or services. And finally, as a self-employed business owner, youre responsible for paying self-employment taxes to the IRS. These taxes cover your social security and Medicare tax obligations.
A few states and local jurisdictions levy additional taxes on LLCs. Depending on the state, this might be called a franchise tax, LLC tax, or business tax. Youll also have to pay state and local income taxes and payroll taxes.
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If You Have A Sole Proprietorship When Should You Form An Llc
It is time to go from a sole proprietorship to an LLC when you are ready to grow your business and earn a profit.
Sole proprietorships are only good for very low-profit/low-risk businesses.
Example: A sole proprietorship can be a good way to start out if you are doing business on a small scale or want to try out a low-risk venture to see how successful it will be.
Forming an LLC allows business owners to grow their businesses and take on risk. This is because LLCs provide personal liability protection.
What is personal liability protection? When a business owner has personal liability protection, they cant be held personally responsible if the business suffers a loss. This means personal assets are protected.
Visit our How to Change From a Sole Proprietorship to LLC guide to get started on making the switch.
To Improve Your Chances Of Securing Working Capital For Your Business
Lack of access to business financing might potentially limit your growth plans. Corporations have an easier time obtaining outside funding than sole proprietorships. By incorporating, you are making it easier for your business to raise capital, either by borrowing money or applying for a loan. In fact, lenders or even alternative funding programs often require businesses to incorporate before allowing them to receive funds. Funders like to see that you maintain separate business and personal finances.
Sole proprietors can only obtain funds through their personal accounts, using their personal credit or taking on partners, while corporations can sell shares of stock and secure additional funding for growth. Also, when you incorporate, it means you can open up a bank account and start building a line of credit, which for a small business owner is a necessity.
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Sole Proprietorship Vs Llc How To Choose Between Two
For entrepreneurs, it is essential to decide which kind of business they want to start. Perhaps this is why they find themselves in so much of a dilemma, especially when it comes to the sole proprietorship vs. LLC. Both these businesses are perfect for small and medium-scale businesses.
However, when we are talking about the corporate level, these two business structures are very different from each other on so many grounds. And thats the reason why its essential to know about these business entities in detail.
On this page, youll learn about the following:
When To Use A Sole Proprietorship
Sole proprietorships do offer small advantages and benefits in certain circumstances.
Example: A sole proprietorship can be a good way to start out if you are doing business on a small scale or want to try out a low-risk venture to see how successful it will be.
Sole proprietorships are best for small businesses with the following characteristics:
- They MUST be low-profit and low-risk .
- They have a smaller customer base often friends, family, and neighbors.
- They are often hobbies like photography, blogging, or video streaming.
Sole Proprietorship Advantages and Disadvantages
The only advantage to starting a sole proprietorship vs. an LLC is having to spend no money or energy up front to form a business. This advantage may seem attractive, but it can be costly in the long run.
- No Personal Liability Protection. Your personal assets are at risk in the event your business is sued or if it defaults on a debt.
- No Tax Benefits. Sole proprietors pay taxes on their profits and also pay full FICA taxes . When your business becomes profitable, taxes will be expensive.
- Limited Growth Potential. When a business becomes more profitable, risk increases. When risk and profit increase, so does the need for a legal formal business structure.
- Less Credibility and Branding Opportunities. A sole proprietor must invoice, receive payment, open a bank account, and market with their surname unless their state allows them to register and maintain a doing business as name.
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Advantages Of Forming An Llc
If you are opting to make an LLC, youre essentially making a business entity completely separate from yourself.
In simpler words, you arent your LLC, and neither is your LLC is you.
If you are opting for this, you will avail of the following benefits:
- Credibility and Liability Protection
Your market credibility will be at a higher level.
You will also get liability protection against lawsuits, commercial debts, and other obligations.
That is as long as you have set and maintained your LLC correctly and havent mingled your personal and commercial assets.
If you avoided personal guarantees, your liability protection will also remain in place.
No creditor can go after all your personal assets in case theres a lawsuit against your business.
- Easy Debt Financing and Equity
It is significantly easier to get debt financing and equity if youve got a separate business entity and a well-established credit score for your business.
Instead of a personal loan, you can pick from small business loans which include leases, trade credit, and factoring.
- Multiple Tax Benefits
You have the option to combine some of the best of the incorporation worlds.
That is by electing your single-member LLC either to get taxed as a sole proprietor, which will be the standard election or an S-corporation.
When you elect your tax treatment as a sole proprietor, it means that all your losses and profits will flow to your personal tax return.
This way only your salary is subjected to FICA withholding.
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Taxes: Which Is Better
The difference in taxes between an LLC and a sole proprietorship will depend on where you live, how many members are in your LLC, and how you want your LLC to be taxed.
While the federal taxes paid should be the same for a sole proprietorship and an LLC being taxed as a pass-through entity, some states have additional taxes for LLCs. As we mentioned in the LLC section, some states levy a gross receipts tax or a franchise tax that applies to LLCs but usually not to sole proprietorships.
Differences Between Llcs And Sole Proprietorships
Now its time to compare the differences between LLCs and sole proprietorships. There are more differences between these business structures than similarities. Rather than just listing bullet points, well take a closer look at various categories you should evaluate. This will make it much easier for you to decide which one is right for your business.
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Llc Vs Sole Proprietorship: Legal Protection
In a sole proprietorship, theres no legal separation between the business and the owner. The owner is personally responsible for the businesss debts. If the business goes bankrupt, the sole proprietor has to file for personal bankruptcy, and both personal and business debts will be included in the bankruptcy proceedings. In addition, someone who sues a sole proprietorship can name the owner personally in the lawsuit and come after their personal assets.
One of the best ways to protect your personal assets is to form an LLC. Since an LLC is a legally separate entity from the owner, the owner isnt personally liable for the businesss obligations. If the business fails, the owners can file for business bankruptcy, and they dont have to pay business creditors out of their own pockets. And with some exceptions, someone who sues an LLC cant personally sue the owners. Of course, owners in an LLC can be held personally liable for fraud, negligence, or personally guaranteed debts. Theres no business structure that offers absolute protection for owners for liabilities connected to the business.
Running Your Business As A Sole Proprietorship Vs Llc
There are a few distinctions in operating a business as a sole proprietorship vs. an LLC. As a sole proprietor, theres no separation between you and your business. Youre not obligated to separate your personal and business bank accounts and credit cards. However, opening up a different checking account for your business will make it easier to identify business expenses when it comes time to file your taxes.
With an LLC, its important to keep your business finances completely separate from your personal ones. Youll need a business bank account, and youll sign documents and contracts on behalf of the business, not as yourself personally. Keeping things separate preserves your liability protection because it shows that the LLC truly has its own separate identity.
Taxwise, an LLC offers more options than a sole proprietorship. All sole proprietors are self-employed. Youll list your business income and expenses on Schedule C of your personal tax return and youll pay personal income tax on your profits. Youll also be responsible for paying your own Social Security and Medicare taxes, otherwise known as self-employment taxes.
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Core Differences Between Sole Proprietorship And Llc
Here are the highlights of a sole proprietorship vs. LLC comparison:
- Taxes. From an income tax standpoint, sole proprietorships and single-member LLCs are generally taxed the same unless certain elections are made with respect to the single-member LLC.
- Liability. LLCs grant more protections in terms of personal liability.
- Costs. Sole proprietorships are free to start. LLCs require registration and ongoing fees.
- Funding. Its generally easier to get external financing for an LLC than for a sole prop.
- Management and control. Sole proprietorships offer more control than LLCs, but with that comes more responsibility.
When Should You Open An Llc
There are a few reasons to open up an LLC instead of operating as a sole proprietorship:
- You want to expand the company to more than one owner in the future, which is easy with an LLC
- You want to protect your personal assets from potential financial and legal liability
- You want to take advantage of any applicable local, state or federal tax benefits that come with forming an LLC
In summary, setting up an LLC could position you for growth and protect you from liability. People also consider opening up an LLC when they reach a certain income threshold in their business and the additional fees and paperwork make sense from a tax perspective. This varies by state and the type of business, so its a good idea to speak to your accountant and compare the taxes youll be paying with each business structure.
Should You Start An Llc Or Sole Proprietorship
Forming an LLC is a good option for those who have assets and want to protect them. Although an LLC is often a good choice, sometimes the costs that go along with an LLC make a sole proprietorship a better choice for your business.
If your business is a side hustle or part time business with no employees, a sole proprietorship may be the way to go. If there is any chance that you may need to protect your personal assets due to the possibility of being sued, then forming an LLC can provide you that protection. Additionally, if you are looking to maintain anonymity, an LLC provides the opportunity to stay that way.
The final aspect to take into consideration when choosing whether to form as an LLC or sole proprietorship in Delaware, is how it is seen in the courts. Some states do not look favorably on single-member LLCs.
Although Delaware treats all single member LLCs as a disregarded entity and as a sole proprietorship for tax purposes, it is still something to think about. Typically this can come up in legal proceedings, regarding which interests you are protected against. By contacting a business attorney you can make the best decision for yourself and your business.
Pros Of A Sole Proprietorship
Easiest to Set Up
As we said, theres no formal process with the state to start a sole proprietorship. Still, if you want the business to go by a name other than your own personal legal name, youll need to apply for a DBA name. Note that different states use different names for this, such as trade name or fictitious name.
To operate legally, youll also need any required business licenses and/or permits. This is true regardless of the business entity type you have. Some states and localities require a general business license to operate any kind of business. You also need to think about professional licenses, signage permits, zoning, and a host of other possibilities. If you have employees, youll also need an employer ID number .
Easy to Dissolve
If you want to end your sole proprietorship, its as easy as starting it. You dont need to file anything with the state, other than to cancel your DBA and other licenses/permits you may be using.
Sole Control of the Business
Unlike a multi-member LLC, you get to call all the shots for the business. You dont need to consult anyone else. Of course, this is also true of a single-member LLC.
Unlike a multi-member LLC or partnership, you only have to deal with your own personal tax form. Just list the businesss revenue and expenses on Schedule C.
Again, because a sole proprietorship isnt registered with the state, youll have less government paperwork to keep up with.
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