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Understanding the differences between a sole proprietorship and an LLC (Limited Liability Company) is essential for any business owner – but especially important for a business owner trying to decide the best structure for their startup. Understanding the pros and cons of a sole proprietorship versus a Single Member LLC can be confusing, so we’ve created a simplified comparison in an effort to make it easy to decide which structure is best for your business.
Sole proprietorships and single-member LLCs are common options for solo entrepreneurs trying to determine the best way to structure their new business. A sole proprietorship is easy to get up and running and requires virtually no financial or structural documentation, but also offers no liability protection to its member, and may be difficult to fund. Conversely, single member LLCs require more structure, but also offer certain liability protections and increased business legitimacy.
Both options are fairly inexpensive and simple to start. Keep reading to learn more about the characteristics that make up each structure.
Sole Proprietorship Schedule C
A sole proprietor has no formal business structure whatsoever. Any income earned or expenses paid by the sole proprietor are not separated from any other personal income the sole proprietor my earn, or pay in expenses. From a legal perspective the sole proprietorship is one and the same as the individual who operates the business.
Sole proprietors are generally required to report their business losses or profits on their personal tax returns, using Schedule C. The business owner is required to report the net profit or losses (by adding up company revenue and subtracting business expenses). Any loss being reported can be offset by other income on the owner’s tax return.
Keep in mind that some sole proprietors may report their profits or losses differently (like farmers, who use a Schedule F).
Disadvantages of Sole Proprietorship
There are some notable drawbacks to organizing your business as a sole proprietorship:
Unlimited liability: Unlike an LLC, your business doesn’t exist as a separate legal entity, and your personal wealth is at stake. This means that the owner is personally responsible for bad business debts and lawsuits. If the assets of a sole proprietorship fall short of satisfying debts or any other type of liability, creditors can go after the owner’s personal assets – including their bank accounts, homes, real property of any kind, automobiles, etc.
Lack of financial controls: No financial statements or meeting minutes are required of a sole proprietorship, which may result in lax financial and accounting control. Poorly managed finances can quickly escalate into a big problem.
Difficulty raising capital: Sole proprietorships require very little documentation (including financial statements and meeting minutes), making them a risky bet for any investor. Even if you are able to secure financing in the startup stages, be sure to think about the long-term implications of lax financial reporting, and the potential difficulty of securing additional financing in the future.
And last, but not least, selling a business to a new owner, when it has been operating as a sole proprietorship, is very difficult. Typically buyers want to review the business’ financial statements and perform due diligence. Doing so is nearly impossible because there is always a good chance a seller has excluded either income, (and more importantly) expenses and liabilities when reporting its profit/loss to the IRS.
Single Member LLC Definition
While sole proprietorships are easy and inexpensive to form, they don’t offer the limited liability or business legitimacy that an LLC does. A solo entrepreneur isn’t eligible to form a traditional (multi-member) LLC, but they can register as a single member LLC, which offers similar benefits.
A single member LLC is defined as a limited liability company that is owned by one member. A single member LLC must report its income and expenses with the IRS as either a sole proprietorship or as a corporation. If the member elects to file as a sole proprietorship, the business is disregarded for federal income tax purposes. This means that the member isn’t required to file a separate tax return for the LLC, but instead would report earnings and losses on their personal tax return on Schedule C.
Because single member LLCs are relatively easy to start and operate, they remain one of the most popular business structures for small business owners. To start a single member LLC, the member must simply draw up the formation articles, file with the secretary of state for the state where business will be conducted, and pay the necessary fee. In certain states, other steps may be necessary.
LLC Limited Liability
Likely the most important benefit of a single member LLC is that, in most cases, the LLC shields the individual member’s personal assets in the event the LLC cannot pay back debts or faces a lawsuit. Though the protection isn’t quite as robust as it is for a traditional LLC, the member still enjoys some protection under most circumstances.
Limited liability is based on the premise that the company and member are individual entities, but it’s very easy for a single member to blur the boundaries between personal and business affairs. In some cases, the court may overturn the member’s liability protection if these boundaries have not been maintained, holding the individual member liable.