Whether based online or working as a home remodeler, deciding how to form your entity can be challenging when you start a new business. Do you choose the limited liability company (LLC) model or operate as a self-proprietorship? How these two entity structures work are drastically different and come with their own advantages and drawbacks.
The Differences Between LLCs and Sole Proprietorships
According to the IRS, sole proprietors are unincorporated business owners. This means that their enterprise isn’t registered as a specific entity structure. Nor does it receive liability protections like that of an LLC.
If you were to accrue a company debt, you are personally liable for it. For example, if a customer sues you for poor quality work, they could pursue your personal assets if your business can’t afford it.
However, if you opt to create an LLC business model, your personal assets get protected from creditors and liability claims. These characteristics of a sole proprietorship and LLC are the primary differences that set them apart, but there are several more you should know about:
Ownership Characteristics
Sole-proprietorships are singly-owned entities where LLCs can include multiple members, partnerships, estates, and even other corporations! While this means the business structure requires more planning and has more legal requirements to operate, this is advantageous for entrepreneurs wishing to share management responsibilities and garner more capital investment.
Funding Options
At some point, your new company will need credit to invest in new equipment, pay operating expenses or expand your services. Therefore, the model you choose can directly impact access to financing and business loans.
LLCs typically have more credibility with lenders than sole proprietorships. LLCs can use an ownership stake as collateral, but sole proprietorships cannot. Why? Because offering interest would create another member in the entity.
Costs of Business Filing
Another significant difference between sole proprietors and LLC owners is the cost of filing their businesses. Limited liability companies must register with the state they do business in for a set fee, depending on the location. In addition to this expense, yearly statements must be sent in, and any amendments made to company details, members, and other information incur filing costs.
On the other hand, sole proprietorships typically have no filing fees, though they still must pay taxes, carry required business insurance, and obtain necessary licensing to operate. Nevertheless, this is still a notable saving on costs and legalities compared to other entity formations.
Business Duration
As a sole proprietor, your company’s life cycle typically lasts until the day you sell or pass away. Therefore, LLCs will continue protecting business assets according to the operating agreement so long as it remains in good standing and has other members to manage should you pass away or sell your stake.
Taxes
Both LLCs and sole proprietorships benefit from pass-through taxation by the IRS. Typically, LLC profits get taxed only once, and this liability is yours to process on your tax return. However, you can choose to be taxed as a partnership or corporation depending on the formation selected for your limited liability company.
A Sole proprietorship files taxes based on overall profit and not the entirety of its income, much like an LLC. However, these entities can only file on their personal income tax return because filing as a corporation is not available to them.
Employment
In most states, the entity structure you have won’t matter regarding workers’ compensation coverage for employees. Businesses with employees will need this insurance because state and federal regulations demand it. However, sole proprietorships may have different requirements than that of LLCs, so check with the Workers’ Compensation Bureau where you operate for clarification.
Small Business Liability Insurance
Another characteristic between LLCs and sole proprietors that don’t have a lot of difference is commercial coverage requirements. While it’s true that LLCs keep their personal assets shielded from business liabilities, it’s crucial to protect your company’s finances from devastating losses. For example, whether damages occur due to a natural disaster damaging your office or an employee causing an auto accident with one of your fleet vehicles, adequate coverage can absorb these costs and help offset the harm.
A sole proprietor’s insurance policy is twice as significant because all liability scenarios fall squarely on the owner. Since both business and personal assets are up for grabs in claims situations, having comprehensive insurance protection may be the only way your company survives.
Policies that both an LLC and sole proprietorship would benefit from include:
- General Liability
- Commercial Property Coverage
- Business Interruption
- Cyber Liability
- Commercial Auto
- Professional Liability (E & O)
- Workers’ Compensation
Determining which coverage and policy limits are appropriate depends on your industry and your business. If in doubt, take time to research risks unique to your market and speak with an insurer about their recommendations.
Which Entity Is Better? It Depends
For many entrepreneurs starting out, a self proprietorship is ideal and doesn’t involve costly commitments that are difficult to amend later. When the time is right, and they have experienced enough growth, these companies can then form an LLC and take on the legal requirements that come with it.
Ultimately, limited liability companies benefit their owners in several critical areas of their business model. But, you can bridge this gap with insurance. So, it’s really about what works best for you and your startup and how your model supports your long-term vision.
