Starting a small business is a goal for many Americans. If you’re about to make that move, your startup checklist should include choosing the way your business will be organized legally.
New business owners are often confused about whether to form a sole proprietorship or a limited liability company (LLC). It is important to understand the costs, paperwork, time required, and legal protections for a sole proprietorship and an LLC.
A sole proprietorship is a business owned, controlled, and run by one person. It provides no legal distinction between the owner and the business entity. You receive all the profit and are responsible for all the losses and debts.
A sole proprietorship does not necessarily mean you will work alone as you may employ other people. It means that you alone are responsible for the business. If there’s any legal action stemming from the business, it will involve you personally.
How to Form a Sole Proprietorship
The steps are simple. While it is tempting to just start doing business without any formalities, you can prevent many problems by doing things by the book.
Here are the steps you should take to form a sole proprietorship:
- Choose a business name.
- File a fictitious name certificate with the county clerk’s office.
- Obtain licenses, permits, and zoning clearance.
- Obtain an Employer Identification Number.
Tip: Make sure to find out what local (town, city, or state) permits and licenses you need.
All four steps will keep you from running into penalties from local authorities and will put you in good standing for your taxes.
Advantages of Sole Proprietorship
There are some good reasons to form a sole proprietorship.
- Inexpensive and Convenient. Starting a sole proprietorship is relatively inexpensive and convenient.
- Lower Business Fees. Business fees in a sole proprietorship are relatively low, and there is no annual registration procedure.
- Total Control. You have absolute control over the business and are not answerable to shareholders (there are none).
- Business Flexibility. A sole proprietorship can easily change its rules and methods to satisfy its customer’s needs.
- Hiring Ability There are no rules regarding the number of employees a sole proprietor can employ.
It is fairly simple to set up a sole proprietorship and run it. It is the quickest way to get started with your business.
Disadvantages Of Sole Proprietorship
For everything with an advantage, there is a disadvantage, and sole proprietorship is no exception.
- Time-consuming and Stressful: Running a sole proprietorship means you do everything yourself. It is hard to go on a vacation. Time away from the business can hurt profits.
- Lack of Durability of the Business: The death of the owner means the end of the business. You cannot transfer ownership in a will. You can sell the assets to family members, and they can use those assets to open a new business.
- Difficulty in Applying for Loans: Lenders are more concerned about the risk of lending loans to a sole proprietor. If your credit rating isn’t good it may be difficult to obtain financing.
- Unprotected liability: A sole proprietorship is considered the same as being self-employed. You are personally liable for every legal problem associated with your business. If the business can’t pay its debts your credit will be affected.
The disadvantages are real, and you must make sure a sole proprietorship fits your goals.
Limited Liability Company
A limited liability company (LLC) is a commercial business structure with up to 50 shareholders. The owners of the company are referred to as members. Profits and losses are shared among the members, and decision-making is shared among them.
How Do I Form an LLC?
An LLC is a more formal organization than a sole proprietorship and therefore has more requirements.
- File articles of organization with your state’s corporate filing office, often the Secretary of State.
- Designate a registered agent. This is an individual or company that agrees to accept legal papers on behalf of the LLC if someone sues the company. The registered agent must have a physical street address in the state where the LLC is registered. An LLC member can act as a registered agent.
- Create an LLC operating agreement. This is an internal document that establishes how your LLC will be run, including how the LLC will be managed. In the absence of an operating agreement, state law will govern how your LLC operates.
- Apply for an employer identification number or EIN.
- Obtain Business Licenses. Depending on the type of business and where it is located, your LLC may need to obtain local and state business licenses. Check with the appropriate state agencies to ensure you are properly registered, licensed, and permitted to do business in your state.
- Register with a state taxing authority.
You’ll need to register and pay taxes for your company in the state where it was formed.
Advantages of a Limited Liability Company (LLC)
There are various advantages of a limited company, and these are:
- Limited Personal Liability. In an LLC, the company is different from the owners, so the owners would not be held responsible for any negligence by the company.
- Flexible Management. Members manage the company. These members come together to make decisions and agree on the next steps to take in other to move the company forward.
- Pass-through Taxation. Profits and losses “pass-through” the business to LLC members. Each member reports that information on their own personal tax returns. The LLC does not pay federal income taxes as a company.
These protections can be valuable if you want to keep your personal financial affairs separate from those of the company.
Disadvantages of a Limited Liability Company
There are a few hurdles to overcome with an LLC.
An LLC costs more than a sole proprietorship to set up and run. Here are some of the expenses:
- The fee to form the LLC
- Fictitious Name Application
- Registered Agent Fee
- Name Reservation Fee
- Business Licenses
- State LLC Taxes
- Costs for Filing Annual Reports
- Business License Renewals
While all these costs certainly do add up, it is still cheaper to form an LLC than it would be to form a corporation.
Transferability of Ownership
It is pretty challenging to transfer ownership of an LLC to the next of kin. In an LLC, the members have to approve the addition of a new member before a new member can join.
It is essential to bear in mind the extra paperwork you must deal with since your finances must be kept separate from the company. The company will require a stand-alone ledger and individual bank accounts. Paperwork includes the filing of annual reports.
How to Choose Between a Sole Proprietorship vs. LLC
The most crucial difference between an LLC and a sole proprietorship is liability. The LLC protects members in the event of business-related lawsuits, and the sole proprietorship does not. Individuals in the LLC cannot have assets seized in cases where the company is sued. The business has its own credit rating separate from yours.
The LLC structure is more flexible and better protected, but it’s also more complicated and more expensive to set up and manage.
You can start your business as a sole proprietorship and move to LLC status later if it seems appropriate.
Neither of these structures is inherently better or worse than the other. They are designed for different types of businesses, or for different stages of business development. Your task is to assess your needs honestly and select the structure that best suits your needs. If you’re not sure, consider consulting an attorney with experience in handling startup businesses.