Limited Liability Corporation Versus a Sole Proprietorship
Understanding the Pros and Cons of Limited Liability Corporation Versus Sole Proprietorship Vital Before Starting a New Business
By Kenneth J. Bloom
Every April we celebrate Small Business Week, and the dream of owning a business is still alive and well for many people, both young and old. Today, everyone from those taking early retirement to recent college grads have been hit with the entrepreneurial bug.
Yet many new businesses are started without proper understanding of the financial and legal ramifications. There are many legal ways to structure a new business, such as partnerships, S Corporations and regular corporations. However, the most common forms are the Limited Liability Corporation (LLC) and the Sole Proprietorship. While the Sole Proprietorship is the simplest and most popular form of business start up, it may not provide entrepreneurs with the legal and tax advantages that an LLC does.
As a sole proprietor, you report net income or loss from a business on the "proprietor's" personal income tax. Generally, sole proprietors own small or part-time businesses with no employees. It costs nothing to establish a sole proprietorship.
Unlike a sole proprietorship, an LLC is a hybrid of the partnership and corporate forms that allows the liability protection of a corporation with the tax advantages of a partnership. An LLC is a separate business entity that is owned by investors known as members. It is managed either by the members themselves, or by designated managers.
If the LLC is structured properly, the income from the LLC is taxed directly to the members at their rates.
One of the key benefits of an LLC versus the sole proprietorship is that a member's liability is limited to the amount of their investment in the LLC. Therefore, a member is not personally liable for the debts of the LLC. A sole proprietor would be liable for the debts incurred by the business. Creditors can go after a sole proprietor's home, car and other personal property to satisfy debts.
If you are planning to be a sole proprietor, you should first establish a D.B.A. ("doing business as") with the county clerk's office. This D.B.A. ensures that no one else is doing business under your name or your business name in the county, and enables you to open bank accounts, apply for credit cards and small business loans, and other vital business services under your assumed name.
While there are many differences between a sole proprietorship and an LLC, there are some things that are the same from a business standpoint. For example, if you are a sole proprietor or the only "member" of an LLC, you will be required to report your income and expenses on Schedule C of your Form 1040. The net income will be taxable to you regardless of whether you withdraw cash from the business or not. Business expenses will be deductible against your gross income and not as itemized deductions. You must maintain complete records of your income and expenses in order to be able to take the full among of the deductions to which you are entitled. Expenses can include automobile mileage for business travel, entertainment, meals while traveling for business, office equipment or home office expenses. If you are paying your health insurance costs, you will also be allowed to deduct 100 percent of the cost of health insurance premiums as a business expense.
If you hire any employees as a sole proprietor or an LLC, you will also need a taxpayer identification number and will have to withhold and pay various payroll taxes. If you don't hire employees, you will be able to use your social security number as your taxpayer identification number.
While the sole proprietorship mirrors the LLC in some areas, the LLC has distinct advantages in the areas of legal protection and liability. Setting up an LLC will cost $1,000 on average, but that cost is well worth it when compared to the thousands of dollars you could be liable for as a sole proprietor.
If you are currently a sole proprietor, or are planning to start a small business soon, I highly recommend spending the money and becoming an LLC.