You’ve probably heard it again and again for as long as you’ve had your small business: “You should form an LLC.” It’s common advice—but is it really the right move for your business?
Most small businesses start as sole proprietorships—it’s the most common form of business in the United States. Many of these businesses do eventually take the extra step of registering with the state and becoming an incorporated business like an LLC, but is it worth it? What is there to gain (besides the extra boost of legitimacy that an “LLC” at the end of your name adds)?
To know if transitioning to an LLC is right for you, it’s important to understand exactly what it means to be a sole proprietor—and how LLCs are different in the eyes of the law, the IRS, and the bank.
What is a Sole Proprietorship?
A sole proprietorship is an unincorporated business with a single owner. In other words, you’re considered a sole proprietor if both the following are true:
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You haven’t incorporated. This means you haven’t filled out the state paperwork to become a legal business entity like a limited liability company or corporation.
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You’re running your own business solo. You might have employees, but you don’t have any partners.
You can think of a sole proprietorship as the default starting place for someone starting a new business. You don’t have to do any sort of formal paperwork to create a sole proprietorship. This isn’t to say you don’t need any licenses or permits; it just doesn’t take any specific paperwork to officially be a sole proprietorship. All you need to do is start conducting business. For instance, if you start testing the waters of a business idea—maybe selling your handmade picture frames at craft fairs—you have a sole proprietorship.
A sole proprietorship isn’t a legal entity—so what is it?
It’s you. When you have a sole proprietorship, you and your business aren’t legally distinct entities. Essentially, you are your business.
The good news is that you get all the power and all the profits. You can make all the decisions and reap all the rewards. The bad news is that you also get all the risk, all the responsibility, and all the losses.
Benefits of Starting an LLC
Some of these downsides can be mitigated by forming a legally distinct entity like an LLC. People most commonly make the switch from sole proprietorship to LLC if they find they need one or more of the following: more personal liability protection, more tax options or more funding potential.
Limited liability
In a sole proprietorship, you are your business. This means all debts and legal issues are yours. When you form an LLC, however, your business becomes legally separate from yourself. The debts of your business belong to your business. The legal issues of your business belong to your business. This is the “limited liability” in “limited liability company.” So what does this mean for you?
Imagine someone decides to sue your sole proprietorship. They’re suing you. If damages are awarded, it’s your money you’re paying out. If damages exceed what’s in your bank accounts, you may have to liquidate your assets like your house or car or even declare personal bankruptcy.
Now imagine someone decides to sue your LLC. They’re suing the business, not you personally. If damages are awarded, they come from the LLC’s assets, not yours. Even if damages exceed your LLC’s assets, your personal assets are typically off limits. (Or imagine the situation in reverse—your LLC is doing fine, but you’re in personal financial crisis. Your creditors can’t typically go after your LLC’s assets.)
Note the word “typically.” To keep your limited liability protection, you have to make sure your personal and business assets are clearly separated. Be sure to keep separate bank accounts for yourself and your business, and don’t mix money. Don’t use your company credit card to go grocery shopping. And no funny business in general—illegal activity (besides being, of course, illegal) can also result in losing your limited liability.
So how important is limited liability really? Much like health insurance or car insurance, it’s something you may never need. But healthy people get sick and good drivers get hit. And low-risk businesses get sued. A consultant can give someone bad advice. A house painter can knock over a paint can on a Persian rug. An artisnal soap maker can give customers with sensitive skin a rash. Even if your business is something as innocuous as knitting hats or printing cute sayings on T-shirts, someone could claim your products or processes are too similar to theirs. All businesses have some potential risk. It’s a matter of assessing the level of risk you’re comfortable with.
Tax flexibility
When you have a sole proprietorship, you don’t have much input as to how your business is taxed. You fill out a Schedule C or C-EZ to calculate your business profits or losses, and you enter your totals on your personal return. If you make more than $400 in net profit, you also file a Schedule SE for your self-employment taxes.
By default, single-member LLCs are taxed the same way—they fill out the same forms and pay the same self-employment taxes. However, unlike sole proprietorships, LLCs don’t have to keep their default tax status. LLCs can choose to be taxed as a corporation. In particular, an S corp election is pretty common for LLCs because it can help some businesses save on taxes.
At first glance, S corps may not seem very different. With an S corp election, profits and losses are reported on your personal return, just like in a sole proprietorship. (Even though “corporation” is in the name, businesses taxed as S corporations aren’t normally subject to corporate income tax.)
The biggest difference (and potential benefit) of an S corp election is in self-employment taxes. Self-employment taxes include both Medicare and social security. Currently, the combined rate for these self-employment taxes is 15.3%.
If your business is taxed as a sole proprietorship or partnership, the IRS considers ALL your income to be self-employment income. This means ALL your income is subject to self-employment tax. When you combine self-employment taxes with your regular personal net income taxes, you’ll find yourself paying a pretty hefty portion of the money you make in taxes.
In an S corp, only SOME income is subject to self-employment tax. As to be expected, salary is subject to self-employment tax. However, S corps can also pay dividends to shareholders—and dividends aren’t subject to self-employment taxes. You can’t just take dividends in lieu of salary though—the IRS is very clear on this. As a working S corp owner, you’re not just a passive investor, so you have to pay yourself a reasonable salary before receiving any dividends.
So what does this mean for you? If your business is pretty profitable, then an S corp election may be able to save you money on self-employment taxes. Know that you don’t have to start out your LLC with an S corp tax election—you can wait until your business is profitable enough to see a tax savings before making the election. The bottom line is that an LLC gives you more tax options if you ever decide you want them.
Funding options
As a sole proprietor, it can be hard to raise the money you need for your business. Generally speaking there are three ways people usually fund their businesses: their own money, debt, or equity. While you’re on your own for the first one, LLCs can you give you more options when it comes to debt or equity financing.
Debt financing is when you borrow money that you have to pay back. Forms of debt financing can include loans, credit cards, or lines of credit. As a sole proprietor, you probably won’t qualify for many business loans, leaving you with the option of personal loans. Personal loans tend to have lower lending limits, so you may not be able to secure all the funding you need. They also tend to have higher interest rates. The same goes for credit—for instance, a personal credit card often has a lower credit limit and higher interest rate than a business card. Personal debt can also negatively affect your credit. Taking out personal loans or opening up personal credit cards can do damage to your credit score. And, if you fall behind on your card payments or default on your loans, that debt belongs to you—not your business. LLCs, on the other hand, more easily qualify for business loans and credit cards—and because of limited liability, those debts belong to the business (not to you personally).
Equity financing is when you give up ownership interest in your business in exchange for financing. Investors can’t buy shares of stock or membership interest in a sole proprietorship, so there is no real option for equity financing. While a corporation offers the most possibilities for equity financing (thanks to the versatility of stocks), an LLC can add members, giving a percentage of ownership in exchange for capital contributions.
Drawbacks to Starting an LLC
With limited liability, tax flexibility and more funding options, why doesn’t everyone turn their sole proprietorship into an LLC?
Price
The number one reason is the price. Sole proprietorships don’t cost anything to start (other than the fees for local permits or licenses). To form an LLC, however, your state will charge an initial registration fee and usually a yearly fee to file an annual report. These fees vary greatly by state. In Iowa, for example, it’s $50 to register your business and $45-60 every other year for a biennial report. In Massachusetts, you’ll pay ten times that: $500 to register, and $500 each year for an annual report. On average, however, most states charge around $100 to register and $100 a year in annual report fees.
There may be additional state and local taxes for an LLC as well. For instance, there’s a $300 a year tax for LLCs in Delaware. Some states have other costly requirements too. For instance, New York LLCs have to publish a notification for their new business in two local newspapers—and the newspapers have steep publishing fees.
Paperwork
Besides costs, there’s also more paperwork and details for LLCs to attend to. LLCs usually need to write an operating agreement and appoint a registered agent. You’ll also have to keep the state updated on your business. For instance, if you move your principal office, you’ll typically have to file a form (and pay a fee) to let the state know of this address change.
And if you decide to give it all up? In a sole proprietorship, your business ends when you stop working. If you have an LLC, you’ll have to submit paperwork to formally dissolve your business (or else you may continue to accrue fees, like annual report fees).
Sole Proprietorship vs LLC
When it comes to actually operating a sole proprietorship or an LLC, there’s not much difference. Unlike a corporation, LLCs don’t require a board of directors, officers, annual meetings, or other corporate formalities. If you transition from a sole proprietorship to an LLC, your actual business operations don’t have to really change at all. It really comes down to whether or not the benefits outweigh the extra costs and paperwork.
If you’re not making much profit, don’t need a lot of capital, and have a relatively low-risk business activity, it might make sense to hang on to your sole proprietorship. If you’re not yet sure if you’re going to continue your business for long, it might not be worth the cost of formally incorporating (and potentially dissolving) your business.
On the other hand, if you’re struggling to find sufficient financing, an LLC could open a few more doors. An LLC also has multiple tax election options if additional tax flexibility could save you money. And most of all, if you’re concerned about your personal financial liability, forming an LLC could bring peace of mind—and prevent you from losing everything in a worst-case scenario.
Want to turn your sole proprietorship into an LLC? See how easy it is on our Start an LLC page.