By Beth Borrego / Published February 2022
Editor’s Note: This is part one of a two-part series examining which business structure is best for your business. In the March issue, part two will examine corporations: subchapters C and S.
One of the most important decisions a new business owner will ever make is 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; a corporation set up under subchapter C or S of the Internal Revenue Code; and, of course, 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 its definition but also the pros and cons. 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 under subchapter 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, such as 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. Any ramifications, such as the outcome of a lawsuit or a lien on personal property, such as on a home residence, leave 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 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.)
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 sizable 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 state statute. The tax laws for LLCs vary from state to state, and the IRS website says, “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.