You’re ready to form a new business, or perhaps you’ve already launched one. For tax purposes, you’ll have to define what type of business it is: a sole proprietorship and an LLC.
If you’re someone looking to start a business in the internet era, you might be confused about which type of entity would be best for your new business. Before we dive in, it’s important to understand that this isn’t legal advice. This is just a guide to help you decide which business type is right for you. Let’s get started!
Definitions of Sole Proprietorship and LLC
Let’s begin by defining what a sole proprietorship and an LLC are. The IRS defines a sole proprietorship as “someone who owns an unincorporated business by himself or herself.” This type of business structure allows you complete control of your business. As the SBA puts it, you’re automatically considered to be a sole proprietorship if you do business activities but don’t register as any other type of business.
An LLC means you’re protected from personal liability in case of unforeseen events. If your LLC faces bankruptcy or lawsuits, your personal assets like your vehicle, house, and savings account won’t be at risk. It’s important to know that members of an LLC are considered self-employed and must pay taxes toward Medicare and Social Security.
The Pros and Cons of Sole Proprietorships
First, we’ll discuss the pros and cons of a sole proprietorship.
If you’re a sole proprietorship, that means you’re not a separate business entity. You’re liable for the debts and obligations of your business, and your business assets and liabilities aren’t separate from your personal liabilities. It’s important to know that banks are often hesitant to lend to businesses lend to sole proprietorships. It’s also hard to raise money because you can’t sell stock, so you should brush up on some must-have financial skills.
The pros? Sole proprietorships are very easy to form. If you want a low-risk business, or to test an idea before forming a more formal business, they’re a good option. Additionally, there’s no limit to the number of people you can hire. This does come with some risks, as WeWork points out. You’re personally liable for your employees’ well-being and benefits. However, a sole proprietorship allows you to hire top talent as soon as you’re able to when they’re available and without any adjustments to your business structure.
The Pros and Cons of LLCs
With LLCs, you’ll have the advantage of both corporation and partnership business structures. As discussed, you have personal liability protection. People can sue your business for business-related issues but not you personally. Profits and losses can go to your personal income without facing corporate taxes.
Another benefit is tax advantages based on how much money you earn. The Tax Cuts and Jobs Act of 2020 increased these benefits, according to the Small Business Chronicles. You can pay yourself a regular salary, leave all or some of your profits, or take a distribution of the profits. The amount of taxes you pay on income changes depending on how you decide to pay yourself. To get these benefits, you’ll need to incorporate yourself as an LLC and choose your tax status (an S corporation or C corporation). You’ll need to file two sets of taxes: business and personal, and keep separate business records.
One major disadvantage of LLCs is that they can have a limited life in many states. When a member joins or leaves an LLC, some states may require the LLC to dissolve and re-form a new membership. The exception is if there’s already an agreement in place for buying, selling, and transferring ownership.
Another downside to an LLC is that some states charge extra fees for operating an LLC. These can be anywhere from $50 to $500 depending on the state. It’s also important to know that LLC requires more diligent record-keeping than other structures since the business owner has to keep his or her personal earnings separate from business earnings. If you’re wondering how to choose the best payroll system for your small business, a dedicated technology platform just for SMBs will be a tremendous asset.
Which type of business is right for you?
It’s important to weigh the plusses and minuses of each business structure against what’s optimal for your lifestyle and capabilities. If you want to want to get a business off of the ground quickly, a sole proprietorship may be your best bet. If you have a side hustle that’s only earning a small amount of income, the tax benefits of an LLC may not be worth it.
However, if you want liability protection, an LLC would be a better option. Additionally, the process of getting an LLC means you’ll have to register with the state. It will make your business seem more trustworthy to banks and consumers, and help you build stronger client-vendor relationships. This is an asset for marketability as well as when you want to take out loans.
Choosing between a sole proprietorship and an LLC depends on your business goals and lifestyle. However, when you make the choice, it’s important to be well-informed about the ins and outs of both structures so that your business is protected, compliant, and profitable.
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