One of the first crucial decisions any business makes is determining its corporate structure for both tax and liability purposes. These days, there are several ways to position and protect your business, each having its own advantages and disadvantages.
With that in mind, today, we’ll review two of the more commonly selected structures—sole proprietorships and LLCs. We’ll compare and contrast so that you can decide which one suits your specific needs. Let’s get to work.
Types of business structures
As mentioned, there are several different business entities you can choose from, including:
- Sole proprietorship
- Limited Liability Company (LLC)
Let’s dive into the first two.
Sole proprietorship (SP)
An SP is designated as a single-person business and requires that you report your net income and losses when you file personal income taxes. The business is unincorporated; therefore, the sole proprietor is personally liable for any debts or damages caused by the business (whether they be financial obligations or liability claims). This means that it’s easy to set up, but doesn’t turn the business into a legally binding and separate entity.
- A local grocery mart
- An IT consultation service
- Music teacher
- Art vendor
In such a case, if the sole proprietor has outstanding debts arising from a lawsuit or the like, the creditors will first go after the business’ assets, and then, if those aren’t enough, the sole proprietor’s personal assets.
Any financial or legal liability is the sole responsibility of the sole proprietor.
To apply for this, you simply file the relevant legal documents, including your contact info and the local licenses to operate in the city or state. If you wish to name the business something other than your legal name, you’ll have to file a DBA (Doing Business As). In sum, it’s cheap, it’s easy to start, and when it comes to taxes, you list everything related to the business on a single individual 1040 tax form.
Sole proprietor vs. independent contractor
It’s worth noting that an independent contractor and a sole proprietor are not the same thing. An independent contractor provides a service, whereas a sole proprietor typically sells a product they created or purchased wholesale in advance. So, independent contractors are hired to work for someone else, but not as an employee. They may be brought in to consult or help on a specific project and will always provide their client with a contract prior to work beginning.
Limited liability company (LLC)
An LLC signifies a legal division that separates the owner(s) of the business and the company’s various liabilities. When forming an LLC, you cut any direct connection linking you as an individual to the business itself once you register. An LLC shields you from liability while also acting as a pass-through for tax purposes. This means taxes are handled quite similarly to how they would be for an individual or sole proprietor. As its own separate and legal entity, an LLC provides the owner shelter from liability. So, a theoretical plaintiff would be forced to sue the LLC, and if they won, they’d be limited to the assets of the LLC. In other words, lawsuits, debts, and various other financial obligations would stop with the separate business entity and not extend into your personal property.
There are filing fees and other necessary steps in order to designate your business as an LLC, but the extra liability protection—combined with the air of legitimacy it gives your business—makes it well worth the effort.
Sole proprietorship vs. LLC
Now that we’ve defined a sole proprietorship and an LLC, what are the differences separating them? What are their unique advantages? Which one is right for you? Compare and contrast them with four key categories in mind:
Establishing the Company
SP – All that’s required of you to get started is to hang a sign and commence with the selling. The company must comply with the local rules and regulations for legal protection, so there may be permits, licenses, and fees in order to run it. That said, starting up is typically fast and cost-effective.
LLC – There is more paperwork involved with registering an LLC. You must form the company, register it with the authorities, and file an article of incorporation. There will be some costs involved, but these will be minimal, and the process takes a few weeks to a few months.
Credits and Loans
SP – Raising money requires traditional means, like taking out a loan or a line of credit from the bank. You can’t sell a portion of ownership in the business because it would no longer be a sole proprietorship.
LLC – LLCs are considered to be more trustworthy and less of an investment risk. If needed, the LLC can offer ownership interest as collateral for capital infusion. In addition, debts and other financial obligations can’t be leveraged against the owner, so if loans do go unpaid, the owners’ personal bank accounts aren’t on the hook.
SP – Taxes are tied to your net business income; however, the taxes are included on your individual tax return, at the business owner’s tax bracket.
LLC – LLCs require more tax paperwork, but for all intents and purposes, they’re treated quite similarly to a sole proprietorship.
SP – Owner is exposed to all of the company’s liabilities, debts, and financial risks. In the case of a liability suit or credit default, the courts or the creditors can go after the owner’s personal finances. As such, an SP has a much larger need for business insurance coverage than an LLC.
LLC – The owner’s personal assets are delineated from the business’ assets. Whatever hardship that befalls the company can’t be used against them, barring a personal guarantee against a business loan. An LLC will still require business insurance, but they’re not nearly as concerned with regard to personal financial liability.
Sheltering your business from risk
Regardless of whether you decide to designate your business as a sole proprietorship or LLC, you’re going to need a Thimble General Liability Insurance and Professional Liability Insurance policy.
Small business insurance has never been more affordable or flexible. With Thimble, you can sign up for the liability coverage your business needs in under a minute. Our on-demand policies can go by the hour, day, or month.
Want another necessary shield from liability? Download the Thimble app, select your coverage and time window, input a few details about your business and your ZIP code, and receive your free quote instantly.