A common question that I'm often asked is what business entity should a person choose when starting a business. In most cases, creative entrepreneurs choose between forming an LLC or they decide to go with a Sole Proprietorship. While a Sole Proprietorship is the simplest entity to form, an LLC provides a layer of liability protection. Let's dive into the differences.
A sole proprietorship is an unincorporated form of business run by one person (the business owner). There is no separation between the business and the person, it is seen by the IRS as one. Formal action is not required, it is assumed once business activities start to take place. This type of business entity is very common among freelancers. In contrast, an LLC requires you to file Articles of Organization and depending on the state, has specific registration requirements. More importantly, the IRS views the LLC as a separate legal entity. This business will have its own tax id number and business activities can occur under its own name.
The biggest difference in the two forms of businesses is the area of liability. As a sole proprietor, you are personally responsible for all debts incurred as well as any conflicts that may arise. There is no separation between you and your business. In the event that a creditor or customer wanted to come after the business, you will personally he held responsible. This also extends to liabilities that may occur on behalf of employees. As an LLC, under most circumstances you have no personal liability. Generally when creditors or customers go into business with you, they are working with the LLC not you personally. Should an issue arise, the issue is with the LLC and not you personally.
Under a sole proprietorship, there is one owner, you. You call the shots and make the decisions. You are also the go-to person (unless otherwise designated) that people will go to when there are questions, issues, or concerns. As an LLC, this type of business can be formed by one person or by more than one owner (also called members). You can set how you want the business to run and how profits and losses will be split in the Articles of Organization.
As the sole owner of a business, the life of your business is only as long as your life span (harsh, right?). If it is your hope to build a legacy or to expand and have your business around even after you're gone, this may not be the best type of entity for you. On the other hand, LLCs can have term life or perpetual life. The longevity of the business depends on the Articles of Organization. Normally, the owners (members) determine the duration period at the time of formation. If the duration period is not specified, the LLC is assumed to have perpetuity. In the event that the LLC is perpetual, the business will dissolve once a member disassociates or once a member files a certificate of cancellation or dissolution.
Before you get in an uproar, let me make it plain for you. As a sole proprietor, you will report your business income and losses on your personal tax return. In addition to the 1040 form filed, Schedule C will be filed to account for your business profits or losses. Being organized and tracking your expenses come into play here if you want to deduct business expenses and claim certain write-offs. As I mentioned in Accounting 101 for The Creative Entrepreneur, when you don't have an employer deducting taxes from your income, you will still be liable to pay taxes. In order to lighten the tax burden and to comply with IRS regulations, you can estimate your taxes and pay them quarterly (if required).
Although an LLC is a separate legal entity, it is not a separate tax entity. For the sake of taxes, the LLC can be treated as a sole proprietorship or a partnership. If you own a multi-member LLC, all owners report their share of the business profits and losses of the LLC on their personal tax return. In addition to the 1040 form filed, each member files Schedule K-1 which shows each members share of the profits and losses.
How do you know what's best for your business?
The answer is dependent on the owner and the type of business they want to run; there is no right or wrong answer. However, if you plan to grow your business, have it operating without your day to day direction, or if you don't want your personal assets at risk, you should create the business as a separate entity.