According to taxfoundation.org, approximately 23 million businesses in the United States operate as sole proprietorships. That’s more than 2.5 times the number of companies set up as all other types of business entities.
Because a sole proprietorship is the least complicated type of business entity to start and operate, I can understand why many new entrepreneurs go that route. There’s a lot to be said for the simplicity of a sole proprietorship. With so many other things to pay attention to as a startup, who wants to haggle with more formation paperwork and tax documents than necessary?
But simple isn’t always better.
Although starting your business as a sole proprietorship may be the best decision in the beginning, it doesn’t mean it will remain the best choice as your business grows.
And even if you’re a one-person business (such as a self-employed business consultant or website designer), you might benefit from running your business as a different type of legal entity.
The cons of sole proprietorship
As a sole proprietor, your personal assets are not considered separate from your business. Therefore, they could be exposed to business liabilities. You might also miss out on some tax advantages as a sole proprietor.
For those reasons, it’s important to learn about the other legal structures before you, by default, form — or continue — your business as a sole proprietorship.
The lowdown on your options
LLC (Limited Liability Company)
Business owners who want liability protection without cumbersome formality can have the best of both worlds by forming an LLC. LLCs shield business owners’ personal assets from business liabilities (as do S-Corps and C-Corps). But because the IRS views the LLC as a “disregarded entity,” LLCs don’t file separate taxes from their owners. The business’s profits and losses flow through to the owner’s tax returns and are subject to the owner’s individual tax rates.
C Corporation (C-Corp)
If you’re a small business owner, this type of entity might not make sense. It is, however, typically ideal for businesses that plan to raise money through venture capital funding or by issuing stock. C-Corps must follow more stringent internal and external corporate formalities and obligations than LLCs.
S Corporation (S-Corp)
This structure works well for small business owners who qualify — the IRS limits how many owners can be involved and who can be an owner in an S Corporation. All owners of an S-Corp are taxed based on their percentage of ownership. Besides liability protection, S-Corps offer a tax advantage over sole proprietorships; only the owners’ and employees’ salaries and wages — not all business income — are subject to Social Security and Medicare taxes. On the flipside, like C-Corps do, S-Corps present more internal and external formalities than LLCs.
What to consider
As you explore your options, keep these questions in mind:
Are you losing sleep over not having your personal and business assets separate? The LLC and the corporation (C Corporation and S Corporation) protect your personal assets from any liability of the company. If on the off-chance someone sues your company, valuable items like your house, personal savings accounts, kids’ college funds, etc., are shielded from any court judgments.
Are you looking for flexibility in how your business may be taxed? Federal income tax rates can be lower for corporations than for individuals. Plus, you might find yourself entitled to additional deductions when your business is a corporation.
Do you want prospects and potential partners to take your business more seriously? By adding “LLC” or “Inc.” after your company name, others may perceive your business as more credible than if it’s a sole proprietorship.
Will you need access to a line of business credit, or are you seeking venture capital? As a corporation or LLC, you’ll make both of these objectives more achievable.
Would you like to retain more privacy? When you register your business as an LLC or corporation, generally the company’s registered agent (the business or individual designated to receive service of process if your business is a party in a legal action) goes on public record rather than your home or business address.
Fortunately, changing from a sole proprietorship and forming an LLC, S-Corp or even C-Corp has become less daunting than in years past. Still, you should carefully weigh all of your options and seek professional legal and accounting guidance before making a decision.
Your selection of a business legal structure will affect you legally, financially and operationally. Getting it right matters.
The above content should not be construed as legal or tax advice. Always consult an attorney or tax professional regarding your specific legal or tax situation.
Also published on Medium.