Which is Better: A Sole Proprietorship, Corporation or LLC?

Filed under: Business Law

Many small businesses begin as a sole proprietorship. This is often the best choice early in the life of a small business. But over time, needs may change. Frequently, as a business grows, becomes more profitable, and adds employees or owners, business owners begin to evaluate the structure of their business and weigh the option of incorporating or forming a limited liability company. Here are a few basic facts.

Sole proprietorships

A sole proprietorship is a business that is owned and operated with one owner (or sometime as husband and wife) where the business and the business owner operate as one. Moreover, the assets of the business are owned by the business owner. Instead of filing a separate tax return for the business, the business owner pays income taxes on the net profit from the business on the owner’s individual income tax return. Less complexity, more cost effective startup, and possibly a less complex income tax return are all benefits of a sole proprietorship. However, as the business grows, unlimited personal liability for the debts and liabilities of the business, an increased chance of IRS audit, and less flexibility regarding income tax planning are all drawbacks to sole proprietorships. As a result of the foregoing, sole proprietors often realize that their needs have changed and they need to protect their personal assets from the liabilities of the business and allow for more situation specific tax planning.

Corporations

As a corporation, the business stands as a separate entity independent from its owner(s). Generally, corporate owners (referred to as “shareholders”) are not personally liable for the debt and liabilities of the corporation, except to the extent of their investment in the corporation and any appreciation on the investment. From an operational and asset protection standpoint all corporation are generally the same. However, how the corporation is taxed varies based on the tax election made at or after formation. There are two different types of corporations from an income tax standpoint. All corporations are formed as “C” corporation (“C-corps”). C-corps are taxed as entities separate from their owner(s). C-corps file a separate income tax return and pay income taxes at corporate rates. Owner-operators of C-corps receive compensation in the form of salary and potentially corporate dividends. Corporations can also elect to be treated as a “S” corporation (“S-corp”) by timely filing the appropriate election forms with the IRS. S-corps are “pass-through” entities from an income tax standpoint. This means that all the income, loss and deductions created from the operation of the business will “pass-through” to the shareholder(s) in direct proportion to their ownership. S-corps’ file a separate income tax return that is informational only, and net profit or loss are ultimately reported on the owner(s) individual income tax returns. With the exception of certain state specific taxes, any income tax due is paid by the shareholder(s)s at the individual shareholder’s individual income tax rates.

Limited Liability Companies

A LLC is an entity structure whereby the owner(s) (referred to as “members”) of the company are not personally liable for the company’s debts or liabilities. Limited liability companies are hybrid entities that combine some of the characteristics of a corporation with that of a partnership or sole proprietorship. LLCs are the most flexible of all business entities and allow the business owner(s) to get the asset protection of a corporation with the ability to choose the income tax regime that best fits the needs of the business and its owners. If before formation the business was operated as sole proprietorship, then the LLC can elect to be taxed as either a disregarded entity, C-corp or S-corp. If the business has more than one owner, then the LLC can elect to be taxed as a partnership, C-corp or S-corp. Business owners should be aware that under California law not all types of businesses are allowed to operate as LLC. Therefore, business owners contemplating the formation of an LLC should take care to ensure that their business is allowed to operate as a LLC.

Asset Protection and Insurance

The primary difference between sole proprietorships, corporations, and LLCs lies in ownership of assets. When the business becomes its own separate entity, owners are generally protected from the debts and liabilities of the business.

Despite the asset protection provided by the forming of a corporation or LLC, business liability insurance is still recommended, and in many cases will provide essential benefits, such as paying for the cost of defense in the event of a lawsuit. Transitioning to a corporation does not eliminate the need for proper insurance.

Drawbacks of Operating a Business Through an Entity

If a business owner transitions to a corporation midway through the calendar year, he or she will be required to file tax returns for both the sole proprietorship and the new corporation during the following tax season. These situations can become complicated. Therefore, some business owners prefer to transition at the beginning of a new year, to avoid confusion and unnecessarily burdensome tax preparation. In addition, while forming an entity can limit the liability of business owner(s) and provide income tax benefits, business owners should be aware that running a business through an entity will likely increase your tax preparation costs, annual operational costs and complicate business operations.

If you’re a business owner considering a transition from sole proprietorship to a corporation or LLC, it would be wise to consult with a business planning attorney. A knowledgeable attorney can help you explore the different types of corporations, and assist you in deciding upon the structure that best suits your business needs.

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