By Beth Borrego / Published December 2014
Editor’s Note: This is part one of a two-part series examining which business structure is best for your business. In the February 2015 issue, part two will examine corporations: subchapters C and S.
One of the most important decisions a new business owner will ever make is the decision regarding how to set up their business structure. It’s a decision that should be weighed carefully, and it’s recommended that any new business owner speak to an accountant before making a decision on their own. There are a variety of options such as an LLC, an acronym for a Limited Liability Company; or a Corporation with a subchapter of C or S; and, of course, there is the Sole Proprietorship. Each of these has distinct advantages and disadvantages, as well as state and federal tax laws and business implications specific to each of them. First, let’s break each one down and take a look at not only the definition of it, but the pros and cons of it as well. Once we have accomplished that, we’ll compare them to one another.
Let’s start with the simplest of structures, the Sole Proprietorship. If you go into business for yourself and do not form an LLC or a Corporation with a subchapter of C or S, then by default you’re electing a Sole Proprietor structure. This is a common structure used by many independent, small business owners who do not have too many concerns. A Sole Proprietor is typically a one person show, and an example of a Sole Proprietor might be someone who creates arts and crafts to sell. It is an unincorporated business. There is not too much overhead, the profit and expenses belong to the creator, and there is a low probability of liability. It is important to note that if there is a situation exposing the Sole Proprietor to any significant liability, that liability will fall on the owner, and any ramifications such as the outcome of a lawsuit or a lien on personal property, such as on a home residence, leaves the business owner highly vulnerable and can put the family at risk. For this reason alone, it is typically not viewed as a good fit for contractors.
There are benefits to forming a Sole Proprietorship. It’s easy and inexpensive to set up and the tax filing is not overwhelmingly complex. You can probably accomplish all that is required with a Schedule C and a Form 1040. However, you will be looking at having to file estimated taxes. As an owner, the decisions you make will be yours and yours alone, allowing you the freedom to do as you like without having to consult with a business partner.
If you establish your business as a Sole Proprietorship, you’ll be increasing your risk of liability, since the introduction of employees means an increase in risk and circumstances that will be beyond your control. The actions of your employees could translate into the risk of debt that you would be personally responsible for if your business is structured as a Sole Proprietorship. What about business loans? The banks will not look at your business the same way as a Sole Proprietorship as they would a Corporation or LLC, and you are less likely to get any needed funding. If you do get a loan and your business fails, you would personally be required to pay that back, which could be a tremendous blow to your own financial well-being.
The IRS definition says that “A sole proprietor is someone who owns an unincorporated business by himself or herself. However, if you are the sole member of a domestic Limited Liability Company (LLC), you are not a sole proprietor if you elect to treat the LLC as a corporation.” (See Table 1.)
Table 1: Sole Proprietorship
Inexpensive and easy to start up. A Sole Proprietorship is the least costly and easiest structure to establish. Minimal up-front cost, easy to set up and maintain, and your legal costs are fewer, just the necessary license or permits specific to your business type.
Complete control of your business. As the sole owner of the business, you maintain control over all business decisions. There’s no need to meet or consult with a partner when making a decision or enacting a change.
Tax preparation is simple. The tax rates are lowest for this type of structure. Because the business is not taxed separately, it’s easy to fulfill the tax reporting requirements.
Unlimited personal liability. It’s important to remember that there’s no legal separation between you and your business. You can be held personally liable for all of the debts and obligations associated with the business. This risk further extends to the liabilities that could result due to employee actions. Your home may also be at risk if you are sued.
Hard to raise money. Sole proprietors face challenges when trying to acquire working capital. Banks are hesitant to lend to a Sole Proprietorship, due to a perceived lack of credibility, or stability, regarding the repayment of the debt should the business fail.
Heavy burden. The down side to complete control of your business is the stress of having everything on your shoulders. The burden of success or failure lies with you alone.
Unlike the Sole Proprietorship, an LLC, or Limited Liability Company structure offers the owners of the business protection from a possible lawsuit. The owners of an LLC are referred to as members. The LLC is considered to be a separate entity so that creditors cannot seize personal property such as your home or car. This is comforting to the small business owner who is concerned about how close to his or her family the risks associated with the LLC’s business activities may reach. According to Entrepreneur magazine, the LLC is the favored corporate structure for small businesses with between one and three owners, in circumstances where the owners do not plan to grow the business into a more sizeable entity.
There are several appealing reasons why a small business owner would choose to set up as an LLC, but a thorough explanation of the tax structure should be discussed with a Certified Public Accountant. The Small Business Administration states that “In the eyes of the federal government, an LLC is not a separate tax entity, so the business itself is not taxed. Instead, all federal income taxes are passed on to the LLC’s members and are paid through their personal income tax. While the federal government does not tax income on an LLC, some states do, so check with your state’s income tax agency.” An LLC is a structure that is allowed based upon a state statute. The tax laws for LLCs vary from state to state and the IRS website says that “Depending on elections made by the LLC and the number of members, the IRS will treat an LLC as either a corporation, partnership, or as part of the LLC’s owner’s tax return (a “disregarded entity”). Specifically, a domestic LLC with at least two members is classified as a partnership for federal income tax purposes unless it files Form 8832 and affirmatively elects to be treated as a corporation. And an LLC with only one member is treated as an entity disregarded as separate from its owner for income tax purposes (but as a separate entity for purposes of employment tax and certain excise taxes), unless it files Form 8832 and affirmatively elects to be treated as a corporation.” (See Table 2.)
Depending on the state, members of an LLC may include individuals, other businesses like LLCs and corporations, and possibly foreign companies as well. An LLC may have one or many members.
Table 2: LLC—Limited Liability Company
Limited Liability. The members of an LLC are protected from personal liability for business decisions or actions. In most cases if the LLC incurs debt or is sued, the members’ personal assets are exempt, but not always. In this way an LLC is similar to a corporation. However limited liability means “limited” liability. The members of the LLC are not necessarily protected from wrongful acts of their employees for example. It is not overall blanket protection.
Reduced Record Keeping. Compared to a S-Corporation, there is less registration paperwork and reduced start-up costs. It’s an easy structure to manage in this sense.
Sharing Profits. How profit is shared by the members of an LLC is at the discretion of the members themselves. It’s up to the members to decide who gets what percent of the profit. There are fewer restrictions on profit sharing within an LLC.
Limited Life. In many states, a member leaving an LLC means the dissolution of the business. The remaining members fulfill all legal and business obligations to close the business. Next, the remaining members decide if they want to create a new LLC or part company. However, it is possible to include specific verbiage in your operating documents to extend the life of the LLC should a member decide to exit the business.
Self-Employment Taxes. Members of an LLC are considered self-employed and must therefore pay self-employment tax contributions toward Medicare and Social Security. The entire net income of the LLC is subject to this tax.