Deciding to start a business is a lot of work. Not knowing which entity structure is right for you can cause stress, headaches, money, and time. This blog will discuss two common entity types; sole proprietorships and LLCs.
What is a Sole Proprietorship?
A sole proprietorship is a business that is owned by one person. If there is more than one owner, then the business is no longer a SOLE proprietorship, but I am sure you caught onto that pretty quickly. The set-up for this type of business is very easy. Even if you have not registered with the State, but you own and operate a business by yourself, you have a sole proprietorship.
Just because you are already operating a sole proprietorship without filing any documents with any state or local agencies, does not mean that you do not need to. When operating a sole proprietorship, you need to register with the city and/or county you are located in to pay the appropriate taxes. You will also need a business license and a seller’s permit, if you are indeed selling goods.
So, what are some of the characteristics of a sole proprietorship? First, it is not a separate entity from the individual owner. Meaning that the individual owner is personally liable for any and everything that the business does. This includes debts, lawsuits, and contracts.
Second, the income is treated as pass through income. This means that when the business makes money it is considered earned by the owner. The business does not file taxes, has no deductions, and again is not a separate entity. If the business is profitable this could mean a very large tax bill in April. Additionally, this means that there is no minimum tax to be paid by the business itself, and everything will be paid by the owner as personal income.
What is an LLC?
An LLC is a Limited Liability Company. An LLC is more formal than a sole proprietorship, can have more than one owner/manager, and involves filing incorporation paperwork with the State. To properly incorporate an LLC with the State, one needs to file Articles of Organization. This document gives general information such as what the LLC does, the name, contact information, agent of service (if applicable), and the name of the owners/managers. This must be filed! The filing and acceptance by the State form a separate entity from the individual owners. The cost of registering an LLC in California is $70 for the filing fee, this excludes the minimum tax discussed below.
Other than having to formally register with the State, what makes an LLC different from a sole proprietorship?
- An LLC cannot be formed for the purposes of providing professional services. For example, lawyers, accountants, and architects (only to name a few), cannot form an LLC as its entity. Any service that requires a license, certification or registration cannot form as an LLC.
- Unlike a sole proprietorship, an LLC provides personal liability protection to its owners. Therefore, if the LLC is sued, maybe for a breach of contract or a slip and fall on the premises, the individual owners are protected and only the LLC will be liable. This is a huge advantage over a sole proprietorship because, as long as the owners were acting within their capacity as managers of the LLC, then their personal assets cannot be subject to litigation when the LLC is sued.
- The income of the LLC is, by default, treated as pass through income, just like with a sole proprietorship. However, the LLC can be elected to be taxed like corporations. This will create additional deductions, write offs, and other tax benefits that are better discussed with an accountant or tax attorney. But, with every upside there is a downside. This downside comes in the form of a minimum tax of $800 which is due each year. No matter how much your LLC may make, or not make, it must pay $800.
- An LLC can have more than one owner. If an LLC decides to have more than one owner it is a good idea to have a few documents drafted. An operating agreement which states how the company will be run, share allocation, and duties/responsibilities of each owner should be agreed to at the outset of the formation process. Second, a buy-sell agreement should be agreed to by all the owners. This will dictate how shares of the LLC can be bought, transferred, and/or what happens when a manager retires, is disabled, and/or dies. Both of these documents are vitally important when there is more than one owner of an LLC.
As you can see there are a number of differences between a sole proprietorship and an LLC. This does not detail all of the differences, but the main ones to consider.
All information provided in this article is for educational purposes only, and does not constitute legal advice. Each situation is dependent on the specific facts and must be evaluated on a case-by-case basis. If you’d like to discuss the specifics of your situation, please call our office at (213) 784-3640.