Choosing Your Business Structure - LLC or Sole Proprietorships
Is your business starting to generate more income? Are you wondering if now is the right time to change your business structure? Your business structure determines a lot of key factors in your organization, including how you’re taxed, your capital-raising options, and your continuity options.
In this article, we’ll cover the basics, pros, and cons of sole proprietorships and limited liability companies, helping you choose the right structure for your new business.
What is a Business Structure and Why is it Important?
A business structure, also known as an entity classification, describes the legalities of your business, which determines how you’re taxed and the manner in which operations are conducted. In other words, it’s how the IRS, lenders, investors, and other third parties view your business.
Your business structure influences most aspects of your business. For one, your business structure dictates how your business is taxed and the filing requirements you must abide by. In addition, business structures control the type of capital raising activities you can use.
For example, a sole proprietorship can’t bring on additional partners with capital, while a limited liability company can, meaning switching to an LLC might be beneficial. We’ll dive into these types of differences in more detail below. Nevertheless, another reason that choosing the right business structure is important is because of personal liability. Certain structures provide more protection from creditors and lawsuits.
Choosing a business structure that fits the unique needs of your business can have a positive impact on the success of your organization, help you save money on taxes, and give you the tools needed to grow.
Sole Proprietorships
A sole proprietorship is one of the most common business structures offered by the IRS. In this structure, you are the entire business, owning 100% of the company. This means you are responsible for all operations, capital-raising activities, and taxation. Let’s break down the main components of this structure.
Setup
Sole proprietorships are the simplest business structure to set up, with no formal filing requirements. You aren’t required to file any paperwork with Federal or state agencies.
Instead, the business will operate under your Social Security Number and name. This means your business doesn’t have a separate legal name, which can make it difficult to establish a brand image without infringing on name rights.
Due to the simplicity of setting up a sole proprietorship, ongoing maintenance is also easy. There is no need to file any reports with Federal and state agencies outside of your annual individual tax return.
Taxation
Sole proprietorships report all income or loss on Schedule C, which is filed on your individual income tax return. This business structure doesn’t require the filing of a separate income tax return, which can save costs during tax time.
However, sole proprietorships can face stiff taxes on profit, with both self-employment and ordinary income taxes assessed. The net profit of your business (revenue minus costs) will be subject to both employer and employee payroll taxes, which is 15.3%. Sole proprietorships are eligible to take a deduction for the employer portion of taxes, which equates to 7.65%.
In addition to self-employment taxes, sole proprietorships pay ordinary income taxes on net profits. The tax rate will depend on other factors on your tax return, with the highest tax rate currently being 37%. This means you can pay over 50% in taxes on your business income, which is one of the main disadvantages of this business structure.
Liability Protection
There is no liability protection in a sole proprietorship, as you are the business. This means if you were ever sued for a business-related event, the courts could come after your personal assets to satisfy judgments. This is not ideal from a risk perspective.
Growth Opportunities
Sole proprietorships have limited growth opportunities since this structure does not support more than one owner. As a result, you will need to provide all of the funding for the business. Most of your loan options will be dependent on your personal credit score, which can make it difficult to secure the capital needed to grow.
Being highly leveraged with business-related loans can impact your personal financial situation. Qualifying for new loans, like a house or a car, becomes more difficult. Other financing options include securing funds from family members, friends, and debt investors. Remember, you are not able to take on equity investors.
Continuity
Continuity is an issue for sole proprietorships. If you decide to retire or exit the business, the business shuts down with you. Although you can sell out the rights to your products or services, a buyer will need to create a new business entity.
The IRS does not allow sole proprietorships to change owners since the business is usually listed under your Social Security Number. This adds a layer of complexity to trust and estate planning when nearing retirement age.
Summary: Pros and Cons
Pros
· Simple setup
· Minimal ongoing maintenance
· Full control over business decisions and operations
Cons
· Net profits can be taxed up to 50%
· Personal liability for business obligations
· Minimal growth opportunities
· No business continuity
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Limited Liability Companies
A limited liability company, known as an LLC, is a legally separate entity from its owners. Unlike sole proprietorships, LLCs can warp into a few different business structures. Let’s outline each of the potential structures of an LLC.
Single-Member LLC
A single-member LLC can elect to be taxed like a sole proprietorship. This means all income or loss is taxed on Schedule C, with both self-employment and ordinary income taxes paid on net profit. However, single-member LLCs do provide liability protection, continuity, and expanded growth opportunities.
Entrepreneurs can also form a single-member LLC and convert it into an s corporation by filing Form 2553. This is an entirely different business classification, requiring the filing of a separate business tax return and does offer more opportunities for growth.
Multi-Member LLC
A multi-member LLC has two or more owners, referred to as members. Each member receives a specified percentage of income or loss. When forming a multi-member LLC, the IRS will automatically classify the business as a partnership.
However, like a single-member LLC, multi-member LLCs can file Form 2253 to convert the business to an s corporation. Both partnerships and s corporations retain slightly different characteristics, but are initiated by forming an LLC.
Setup
LLCs are formed by filing articles of organization with your state’s department of revenue. You can form an LLC in any state, but it’s generally easiest to register in the state you plan on doing business in.
If you are forming a multi-member LLC, you may need to submit a formal document outlining ownership percentages and the contact information of each member. Each state will have a different fee they charge for this process.
After you’ve registered with a state, you will need to apply for an EIN through the IRS website, which is free. Your EIN will be used to take out business bank accounts, file tax returns, and apply for licenses.
LLCs have regular maintenance considerations, including the filing of an annual report with the state and a separate business tax return. In addition, you will need to adjust your articles of organization each time your partnership ownership percentages change.
Taxation
One of the main advantages of LLCs that file as an s corporation is the ability to avoid self-employment taxes. S corporations file a separate business tax return and pass all income or loss down to shareholders on Schedule K-1.
The business income will then be reported on the individual return, with applicable ordinary income taxes paid. The profit generated at the entity level is not subject to self-employment taxes. LLCs structured as a partnership can also shield income from payroll taxes. However, certain payments to members, known as guaranteed payments, will be assessed payroll taxes.
The ability to save 15.3% in taxes is a huge deal, especially as your business begins to grow and generate more income. Nevertheless, there are usually extra fees associated with filing a separate business tax return, especially as there are more rules and regulations surrounding reporting.
Furthermore, LLCs taxed as a partnership must take proportionate distributions. Let’s say that you own 75% of a business and your partner owns the other 25%. If you decide to pay $100,000 in distributions, you will need to take $75,000 and your partner will receive $25,000. All distributions need to match ownership percentages.
Liability Protection
LLCs create a barrier between your business and personal assets. This is beneficial from a risk perspective, as your personal assets are safeguarded from any business judgments. Proper separation of business and personal transactions is critical when operating under an LLC. If the courts see the comingling of business and personal transactions, the corporate veil is pierced, and your personal assets are up for grabs.
Growth Opportunities
One of the features that draws entrepreneurs to an LLC structure is the growth opportunities. In an LLC, you can borrow money without impacting your personal financial health. These loans will be in the name of the business. Additionally, you have the ability to secure different types of financing, like equipment loans, term loans, and lines of credit. Having debt financing opportunities is important for scaling a business.
In addition, LLCs can easily bring on new members, shareholders, and investors. If your business needs access to added resources, you can alter your ownership percentage and add owners to your team. It’s important to note that LLCs cannot raise capital through initial public offerings. That is reserved for c corporations. Nevertheless, you can leverage other types of capital raising activities like debt and equity financing.
Continuity
LLCs have expanded continuity options upon your passing or retirement. If you are planning on leaving the business to your heirs, having a flexible structure is crucial. Similarly, selling your business is less complex when you are in a structure that can change ownership. Even if you aren’t planning on retiring or exiting the business for a few decades, taking a proactive approach helps minimize challenges down the road.
Summary: Pros and Cons
Pros
· Potential for self-employment tax savings
· Additional liability protection
· Growth opportunities through debt and equity financing
· Business continuity upon death
· Flexible exit strategies
Cons
· Added steps in the registration process
· More ongoing maintenance with annual filing requirements and reporting
· Distributions must match ownership percentages
Making the Choice
So, which option is best for you? Changing your business structure can be difficult, so it’s best to weigh all of the pros and cons before starting the registration process. Here are some final considerations to keep in mind as you make your choice:
· Business Size – Are you expecting your business to stay small or are you looking for rapid growth over the next few years? The setup simplicity and easy reporting makes sole proprietorships great for small businesses, but less than ideal for growing organizations.
· Ownership – Do you want full control of the business or are you looking to bring on other owners from the start? If you are looking to start a business with someone, a sole proprietorship structure is automatically ruled out. However, if it’s just you starting out, a sole proprietorship might be exactly what you need.
· Liability – Are you operating in an industry with a high risk of being sued or is your business model relatively safe? If you are making products for customers, the added liability protection of an LLC is important. On the contrary, if your business model is relatively safe, you could get by with a personal umbrella policy.
· Profitability – Are you expecting to have high profit margins or just break even for a few years? Higher profit margins in a sole proprietorship structure mean more self-employment taxes. An LLC structure might be more beneficial if you are expecting to generate income.
Which structure are you leaning toward? Take the time to carefully think about your operations before deciding between a sole proprietorship and an LLC. As always, consulting with a business expert can be a great way to get you jumpstarted on this decision. Reach out to a team member today to learn more.