As a budding entrepreneur, you may face the issue of whether to start out as a sole proprietorship or a limited liability company (LLC). There are key advantages and disadvantages to each form of business and the nature of your enterprise and other business and personal circumstances may impact your choice. Here are some important factors to consider when assessing the main pros and cons of a sole proprietorship versus an LLC.
- Ease and Costs of Formation. In the United States, a sole proprietorship is the most popular business entity because it is the easiest to form. Compared to an LLC, a sole proprietorship is less complex and less expensive and demands less paperwork to start. You only need to begin transacting business and make sure you have any required licenses and permits and you have started your new enterprise. To establish an LLC, you must form and register your LLC entity with the applicable state agency, often the secretary of state’s office. You must draft and file articles of organization and pay a filing fee which can be hundreds of dollars in some states. Your LLC filing typically spells out your LLC’s name, principal office’s location, your owners’ or members’ names, the expected term of your LLC, and any other state-mandated information. If there are two or more owners of your LLC, you may want to seek the assistance of a legal professional to draft an operating agreement which spells out such details as each member’s duties, capital contributions, and rights to profits. Setting up an LLC requires more upfront time, money, and effort than a sole proprietorship so you’ll have to factor that in when deciding which entity is best for you.
- Raising Capital for Your Start-Up. Every business needs capital in order to start and maintain its operations. With a sole proprietorship, you will need to fund your own business using your personal resources or by seeking out loans. Establishing a line of credit or receiving loan approval from a bank or other lending institution may be a daunting challenge for a new entrepreneur. Often, you will be required to provide a personal guaranty for any loan to your business. However, if your LLC has other members, you and your fellow owners can pool together your resources and reach out to a broader network of potential business contacts. Bringing in additional members may also help to fund your new LLC. Reviewing your financial resources, credit history, and business investment potential will help determine if you can afford to go it alone as a sole proprietor or if you will need the additional resources that other owners can provide.
- Taxation of Your Business. For federal tax purposes, a sole proprietor’s income is taxed on an individual income tax return. Similarly, LLCs receive “pass through” treatment allowing allocated profits to be taxed on each member’s individual income tax return. If your LLC qualifies as a partnership or S corporation, it may also receive “pass through” treatment. Since federal income tax treatment is similar, this factor may not play a major role in choosing between a sole proprietorship and LLC. Consult a tax professional to determine if state or local taxes will impact your start-up’s tax situation.
- Your Role in Daily Business Management. If you like being your own boss, then a sole proprietorship or a single member LLC may be right up your alley. Under either of these approaches, you have the opportunity to go solo in managing, marketing, financing, and determining the policies and direction of your business. You won’t have to consult with or receive prior approval from other owners on your business decisions. However, if you have fellow LLC owners you will need to delineate your roles and expectations in running your LLC under an operating agreement. If you are not an experienced business person, you might find it helpful to collaborate with other owners on business decisions. It may be useful to have other LLC members so you may learn from their professional experiences, share management and marketing duties, and draw additional funding from your fellow LLC owners. Determine if you prefer to operate your business solo or manage it with other owners.
- Risks of Personal Liability. Under the sole proprietorship, you and your business are viewed as one in the same. Therefore, you have unlimited personal liability for all of the debts and legal liabilities of your sole proprietorship. Your personal assets, such as your home or personal bank account, could be at risk to satisfy unpaid debts, legal judgments, and other legal obligations of your start-up. On the other hand, an LLC is a separate legal entity and an LLC member is normally not personally liable for the LLC’s debts or legal liabilities. As an LLC owner, you are mainly putting your financial contribution to your LLC, not your other personal assets, on the line. However, as an LLC owner, you may still be personally liable for your own conduct or LLC loans in some cases. For example, you may still be responsible if you personally guaranteed repayment of an LLC loan or if your own acts cause harm to a third party or to your LLC. Like any business person, it is important to consider appropriate liability and other forms of insurance to help protect your personal assets and your business. Overall, the sole proprietorship tends to expose a business owner to greater risks of personal liability. Assessing your comfort level with personal liability risks should be an important aspect of your decision-making process.
The Small Business Administration provides general information about starting and managing your new business at www.sba.gov/category/navigation-structure/starting-managing-business. You can also check out information about small business loan and grant programs at www.sba.gov/category/navigation-structure/loans-grants.