At the very beginning of your journey to entrepreneurship (and possibly again later in the evolution of your business) you must decide what form your organization will take. Typically, the main contenders at start up are Sole Proprietor and Limited Liability Company (LLC). We’ll talk here abut the advantages and disadvantages of each structure.
What Is a Sole Proprietorship?
In laymen’s terms, a sole proprietorship is the most basic business structure with a single owner. It is easier and cheaper to set up than an LLC with fewer requirements. The profits of the company belong to the proprietor, not the company.
The responsibility for everything pertaining to the company rests squarely with the proprietor.
Taxes on profits “pass through” to Schedule C of the owners’ individual tax return, thereby escaping the double taxation which occurs when the company pays corporate tax on profits and then the owner pays individual income tax on the same profits.
What Is an LLC?
A Limited Liability Company may have more than one owner, all of whom are protected through dollar limits on individual liability. It shares pass trough taxation (see above) with the Sole Proprietorship but offers some shields like a corporation. Some jurisdictions levy a tax or fee for the limitation of liability. In some states non-profits may organize as LLCs.
The LLC must be operated as an entirely separate entity from the owners and you may not comingle the funds of the company with your own.
An LLC must have an operating agreement and bylaws which cover the operation of the business, the method whereby new members are brought in and how the shares of those leaving are handled. It will detail the ownership interest of the members.
This structure is similar to the Professional Limited Liability Company (PLLC) which is the form used by licensed professionals (e.g. lawyers, engineers, medical practices).
Sole Proprietorship vs LLC
In a Sole Proprietorship the owner is responsible for all company business including adherence to business and tax laws. All financial decisions rest with the owner and so financial problems, such as debt, become the owner’s. Many companies are started with a loan in the owner’s name. If the loan isn’t paid the lender may come after business assets and, if that doesn’t satisfy the debt, take personal assets (such as bank accounts, home, car, etc.) .
In an LLC, the owner’s personal assets are shielded up to the amount of the limit of liability. However, the shield may be pierced if one or more of the following situations exist:
- If a member has personally guaranteed the debt.
- If you have comingled your personal funds with those of the limited liability company.
- If your limited liability company has minimal insurance or capital.
- If the company has failed to pay its taxes.
- If the LLC breaks any laws, such as committing fraud.
Raising capital for a Sole Proprietorship is difficult for a range of reasons including the fact that an investor may have some difficulty getting verifiable information on the company. Unless the organization has a solid track record, banks may not be an option.
LLCs have more venues available to raise capital. For instance, the LLC can take on new owner/members who will provide investment through their buy in.
Transferring the Ownership
An LLC may be sold in whole or in part. When a member wishes to leave or an new member joins the company, the buyout or sellout will be governed by the contract or operating agreement created at the time the company was formed. Selling the entire company will likely be more difficult than transferring ownership of a Sole Proprietor since there are contracts and multiple owners. The tax implications of a sale may complex and expert advice should be sought.
As Sole Proprietorship is a more straightforward sales event since few owners are involved. In effect, the owner is selling the assets of the company and the buyer is creating a new company to receive them, including new tax numbers. State and local permits and licenses may be transferrable, or the governments may require that the new owner apply for his or her own. See our article ‘Selling Your Business’.
The Set Up
It costs more to start up a limited liability company than a sole proprietorship. For an LLC, you have upfront costs for insurance, formation, and filling fees. The more complex nature of an LLC will require some significant expertise in the creation of the operating contract and bylaws. There will be more paperwork and the process by which you determine how ownership is distributed and how that will affect operations could cost you a lot of hours with a lawyer.
With a sole proprietorship you fill out the forms, submit your filing fees, and get on with it. I am not suggesting no advice is necessary. It just isn’t required.
Keeping Separate Records
The LLC must maintain a completely separate existence from it’s owners and is prohibited from comingling funds. The required records are more numerous and possibly onerous. However, when you have multiple owners it only makes sense that records be detailed and verifiable.
A sole proprietor is at liberty to maintain his or her records as he or she sees fit. HOWEVER, maintaining the business as a separate entity with its own discrete financial records will benefit you and your business.
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