Successful entrepreneurs need more than luck—or a good idea—to succeed in business; they also need a plan. Part of that plan involves choosing a business structure.
When you are first starting a business, operating it as a sole proprietorship may make a lot of sense. Sole proprietorships are simple and inexpensive, both to set up and to maintain. Because they are operated by a single taxpayer, they are the most common form of business organization.
But as your business grows, matures, and becomes more complex, it may be beneficial to structure it as a separate legal entity, such as a limited liability company (LLC).
The following is some basic but important information all business owners should know about the differences between sole proprietorships and LLCs:
Sole Proprietorship: The Basics
For legal and tax purposes, there is no distinction between a sole proprietorship and the person who owns it. As a result:
- Business profits and losses are passed through to the owner, making a sole proprietorship what’s known as a pass-through entity;
- Business assets and liabilities are not separate from the owner’s personal assets and liabilities. That means creditors can pursue the owner’s personal assets to satisfy the business’s debts, judgments obtained in a lawsuit against the business, or other financial obligations of the business;
- The owner’s personal credit is also not separate from the business’s credit. This may make it more difficult to build business credit and obtain funding for the business;
- The owner is not responsible for paying any separate business taxes, although they are responsible for self-employment taxes; and
- A sole proprietorship requires no state filing or annual paperwork.
In short, a sole proprietorship may be sufficient for a newly formed business with a single owner if there is no plan to add other owners and if the business does not need significant capital, has a low risk of being sued, and is not yet experiencing significant growth. It may also work for a new business when an owner wants to test the entrepreneurial waters prior to creating a separate legal business entity.
Limited Liability Company: The Basics
On the other hand, one of the more formal business structures available to entrepreneurs is an LLC. An LLC can have a single owner (called a member) or multiple members. The former is known as a single-member LLC: it is an alternative to the sole proprietorship that should be considered because of the following benefits:
- An LLC’s members are typically not personally liable for the company’s debts or obligations. This is what is meant by a liability shield. Only in rare cases can a court pierce the veil of an LLC and disregard it as a separate legal entity. However, depending on state law, creditors of single-member LLCs may not be limited to a charging order entitling them only to distributions made to the member from the LLC. In some states, creditors may be entitled to foreclose the member’s interest or get a court to order its dissolution.
- The owners of a single-member LLC can be treated as a self-employed individual and taxed the same as a sole proprietorship. Unless an election is made to be taxed as a C corporation, profits and losses pass through to the owner’s personal income with no separate corporate taxes owed.
- Because they are legal entities separate from their owner, LLCs have their own credit score and may be able to obtain funding more easily than a sole proprietorship.
- LLC ownership interests can be owned by a trust. Transferring a single-member LLC to a trust may provide estate planning benefits because the trustee may choose whether to continue or wind down the business. In contrast, sole proprietorships generally cease operations at the death of the owner.
That being said, LLCs do carry formalities that sole proprietorships do not. For example, LLCs are created and governed by state law and have state-specific filing requirements. States require the owner to file a certificate of formation (e.g., a certificate of organization or articles of organization) that meets the criteria established by state law. Typically, this includes providing the business name, purpose, address, owners, and other information about the business, as well as paying a filing fee.
Some states require LLC owners to file an annual or biennial report and pay an associated fee, and several states require LLCs, including single-member LLCs, to have an operating agreement that governs company ownership, management, and financial matters. Without an operating agreement, the default LLC rules set forth in state law apply. (Note: even if your state does not require an operating agreement, they are generally recommended.)
Is It Time to Change from a Sole Proprietorship to an LLC?
As your business changes, it may be prudent to take steps to convert your sole proprietorship to an LLC. Here are some signs that it may be time to make the switch:
- Your business is growing
- You are earning (or expect to earn) more profits
- You are considering hiring employees or bringing in other owners
- Your business needs a loan or investors
- You require greater personal asset protection
- You want more tax flexibility
- You would like to pursue bigger clients and deals
- You are getting closer to retirement
If you started a business that is currently organized as a sole proprietorship and you want to change the business structure to an LLC, you must choose a registered agent, file articles of organization with the appropriate state agency, pay any required fees, and comply with any other requirements under state law. As mentioned, it is prudent to create an operating agreement. You may also need to apply for an employer identification number (EIN), update any existing licenses and permits to reflect the new business structure, and open a business bank account to separate company and personal finances.
Embrace Change with Help from Our Business Attorneys
Change in business is inevitable. Markets change, customers change, and your business must change to keep up. We can assist with all legal aspects of starting a business, changing a business structure, and preparing a business for sale, acquisition, or succession. To speak with a business attorney, please reach out to us at 651-738-3433.