Which is a Better Choice for Company- Proprietary or Partnership

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10 Apr 2022
5 min read

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As a small business owner, one of the most important—and potentially most confusing—decisions you'll make is deciding on a business entity structure. The differences between each type of business entity can be difficult to understand in real-life terms unless you're a lawyer or a tax expert. However, the type of business entity you choose has real-world consequences, such as how much tax you pay, how much time you have to spend on paperwork, and what happens if your company is sued. In this blog, you will explore LLC vs. Sole Proprietorship extensively. #TWN

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New business owners often get confused when the topic is of Limited Liability Company (LLC) and Sole Proprietorship. We'll compare and contrast LLCs and sole proprietorships in this blog, and explain how they differ in terms of formation, taxes, legal protection, and more.

What is a Sole Proprietorship?

A sole proprietorship is an unincorporated business with one owner, and it is the most basic and least expensive type of business to establish. A sole proprietor is a person who owns and operates a business on their own. For example, unless you've chosen another business structure, if you work as a retailer, freelancer, run an online business, or otherwise sell goods and services, you're automatically a sole proprietor.

A sole proprietorship is typically identified by the fact that the owner's name is the business name, though sole proprietorships can also operate under a brand name or trade name. The main distinguishing feature of a sole proprietorship is that there is no legal separation between the business and the business owner, so the owner is personally liable for the business's debts.

What is an LLC?

An LLC is a legally distinct business entity formed under state law. An LLC combines elements of a sole proprietorship, partnership, and corporation and provides owners with a great deal of flexibility. An LLC's management structure, operational processes, and tax treatment are all up to the owners. A single-member LLC can be formed by one person, or a multi-member LLC can be formed by several people.

An LLC can be identified by the fact that its legal name includes the phrase "limited liability company" or the abbreviation "LLC." The distinguishing feature of an LLC is that it protects its members from the debts and obligations of the business. In the normal course of business, a business creditor or someone who sues the business cannot seize the owners' personal assets. In a moment, we'll go over what this means in greater depth.

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LLC vs. Sole Proprietorship: Formation

You might be surprised to learn that there’s nothing specific you necessarily need to do to form a sole proprietorship. In fact, you might be operating a sole proprietorship without even knowing it. Any person selling goods and services without a partner is a sole proprietor by default. Depending on where your business is located, you might need to apply for business licenses or zoning permits to legally operate your sole proprietorship. And any business, including a sole proprietorship, which operates under a trade name needs to apply for a fictitious business name, also known as a DBA or “doing business as” certificate. However, that’s it as far as formation paperwork goes, making sole proprietorships the easiest and least expensive type of business to start.

An LLC may also be required to obtain business permits and a DBA (if operating under a trade name). The articles of organization, on the other hand, are the most important formation document for an LLC. This document establishes the existence of your LLC and must be filed with the state in which you operate. The cost of filing articles of incorporation varies by state, but it typically ranges between $50 and $200.

LLC vs. Sole Proprietorship: Operations and Management

Because there is only one person at the helm of a sole proprietorship, the operational and management structure is straightforward. That owner is free to make any business decisions he or she sees fit, with no input from a third party. Of course, most sole proprietors choose to hire employees, legal experts, accounting experts, and other professionals to assist with day-to-day business management. A sole proprietor, on the other hand, only needs to ensure that their business is operating safely and legally and that there is enough profit to cover business debts.

The operational and management structure of an LLC is more complicated, and it is typically outlined in an LLC operating agreement. Though only a few states require an operating agreement, most LLCs, especially those with multiple members, have one. The operating agreement specifies each member's share of the company's ownership, voting rights, and profit share. An LLC can be managed collectively by its members or by an appointed manager.

Typically, LLC members vote on company matters in proportion to their ownership stake in the company (referred to as membership units). A 33 percent owner, for example, would have a one-third vote on company matters, while a 25 percent owner would have a one-quarter vote. Profits are typically divided in accordance with ownership percentages. In the preceding example, the 33 percent owner would receive one-third of the business profits, while the 25% owner would receive one-quarter of the business profits.

LLC vs. Sole Proprietorship: Taxes

In terms of taxation, a single-member LLC and a sole proprietorship are similar. Both are pass-through entities, which means the company does not pay income taxes. The owner reports business income on a Schedule C attached to their personal tax return, and the income is taxed at the owner's personal tax rate.

Multi-member LLCs are also pass-through entities, with each owner reporting and paying taxes on their portion of the company's earnings. The only distinction is that a multi-member LLC is required by the IRS to file a business tax return, Form 1065, U.S. Return of Partnership Income. In addition, each member must include a Schedule K-1 with their personal tax return, detailing their share of the business's income.

In addition to income taxes, LLCs and sole proprietorships may be subject to additional tax obligations. If you have employees, you must pay payroll taxes regardless of the business structure you choose. If you sell taxable goods or services, you must also collect state and local sales taxes. Finally, as a self-employed business owner, you must pay self-employment taxes to the IRS. These taxes cover your social security and Medicare taxes.

A few states and municipalities impose additional taxes on LLCs. Depending on the state, this could be referred to as a franchise tax, an LLC tax, or a business tax. You will also be required to pay state and local income taxes, as well as payroll taxes.

Only LLCs can Choose Corporate Tax Status

Tax flexibility is a key distinction between LLCs and sole proprietorships. Only LLC owners can choose how their company is taxed. They have the option of sticking with the default—pass-through taxation—or electing to have the LLC taxed as an S-corporation or C-corporation. A pass-through entity is an S-corporation. If taxed as a C-corporation, the LLC will be subject to federal corporate income tax (most states and some localities also levy corporate taxes).

By electing corporate tax status, LLCs can sometimes save money. Dividends from a corporation are usually taxed at a lower rate than ordinary business income when the company is taxed as a corporation. Furthermore, retained earnings in a corporation are not taxed. In contrast, LLC members cannot treat income as dividends and must pay taxes on all business profits, whether or not they are retained in the company. A corporation is also entitled to more tax breaks and credits.

LLC vs. Sole Proprietorship: Legal Protection

There is no legal separation between the business and the owner in a sole proprietorship. The owner is personally liable for the company's debts. If the company goes bankrupt, the sole proprietor must file for personal bankruptcy, which includes both personal and business debts. Furthermore, a person who sues a sole proprietorship may name the owner personally in the lawsuit and seek their personal assets.

Creating an LLC is one of the best ways to protect your personal assets. Because an LLC is a legally distinct entity from its owner, the owner is not personally liable for the obligations of the business. If the company fails, the owners can declare business bankruptcy and avoid having to pay business creditors out of their own pockets. With a few exceptions, someone who sues an LLC cannot sue the owners personally. Owners of an LLC can, of course, be held personally liable for fraud, negligence, or personally guaranteed debts. No business structure provides complete protection for owners against business liabilities.

LLC vs. Sole Proprietorship: Paperwork and Compliance

The final distinction between an LLC and a sole proprietorship concerns paperwork and compliance requirements. As previously stated, a sole proprietorship necessitates the least amount of paperwork before launch. After that, a sole proprietor only has to worry about federal, state, and local taxes. Furthermore, a sole proprietor may need to renew business permits.

An LLC is subject to more regulatory requirements. In many states, LLCs must file an annual report after filing the initial articles of the organization. An LLC with multiple members is responsible for even more tasks, such as drafting an operating agreement, issuing membership units, recording ownership transfers, and holding member meetings. None of these steps are legally required, but they are highly recommended for LLCs to maintain member liability protection. Furthermore, because an LLC is a registered business entity, dissolving an LLC necessitates additional paperwork.

LLC vs. Sole Proprietorship: Which should you choose?

Because it is simple, many business owners, particularly freelancers or consultants, begin as sole proprietors. There is minimal paperwork required at the start, and there is no large outlay of funds, which is appealing to new entrepreneurs, particularly those testing a business idea. Taxes are also simplified for sole proprietors because no separate business tax return is required.

When your company begins to expand, the rubber meets the road. Because a sole proprietorship structure provides no legal protection for your personal assets, you may end up personally bankrupt if your business does not succeed as planned or encounters an unexpected challenge. LLC owners, on the other hand, are not personally liable for business debts, providing you with greater protection in the event of a business bankruptcy or lawsuit.

Also, LLCs provide tax flexibility. The majority of LLC owners adhere to pass-through taxation, which is how sole proprietors are taxed. You can, however, choose corporate tax status for your LLC if it will save you more money. The LLC structure is recognized in all 50 states as a way to encourage small business growth. Many factors will influence the best business structure for you, so it's best to consult a business lawyer before making this important decision. An LLC, on the other hand, is often a great fit for a small business owner due to the combination of liability protection and tax flexibility.

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