Setting up your small business may seem simple… well until it’s time to pick a legal structure.
Do you keep things simple as a sole proprietor, or go the corporation route?
As an owner-operator or a freelancer, who may be starting a business as a side-hustle, we rarely think about the need for business structures and such, all we care about at the start of our budding businesses is that it needs to turn in maybe some extra income on the side, then probably replace our full-time income from work.
Most entrepreneurs starting side-hustles and the like don’t think of registering their businesses at the start. Well, in all fairness, you can register as a sole proprietor or even operate as a freelancer, doing business under your own name.
If you’re not yet familiar with the different types of business structures, they are as follows:
- Sole Proprietorship
- Partnership
- Corporation, and
- LLC (Limited Liability Company)
Most entrepreneurs operate as sole proprietors, and even if you didn’t formally register your business with the government, your self-employment activities are classified as sole proprietorship come tax time.
The flexibility and simplicity of an LLC, however, make it the best choice if you are unsure what your business will entail in the future or do not want to commit to a single legal entity yet. However, corporations offer higher levels of protection against personal liability that should also be considered when making this decision. Regardless of the form you choose, it is important to always have an attorney look over documents before signing so any unforeseen consequences can be addressed as soon as possible.
In the end, the best decision for you will depend on the needs and goals of your business.
It’s always advisable to consult with an attorney who specializes in the type of entity that interests you to learn more about the advantages and disadvantages before making a final choice.
What is a Sole Proprietorship?
To better understand the pros and cons of setting up your business as an LLC, let’s talk about sole proprietorship, first.
Sole Proprietor is basically the owner(s) of the company who runs the day-to-day operations.
In this scenario, you are responsible for all aspects of the enterprise from accounting to marketing—and everything in between!
You also have complete control over the decisions that affect your small business but there can be some drawbacks such as not having access to any of the legal advantages that corporations and LLCs enjoy.
As a sole proprietor, you, as the business owner remain responsible for any business debts, and as such, can be held personally liable for those obligations even if the company goes under or is forced to file bankruptcy. This means that your company’s creditors can go after your personal assets to recoup your company’s debts.
You’ll also need to purchase extra insurance coverage such as third-party liability insurance to cover yourself and your personal assets should any of your clients or customers file a case against your company.
As a sole proprietor, the business owner has no formal separation between his personal assets and those owned by the business. Any profits or losses are added or deducted from one’s taxable income.
On the other hand, the main benefit of starting a business as a sole proprietor is its low start-up costs.
If you’re bootstrapping your business from the ground up with low to no capital, the last thing that you may want to deal with is the higher business registration and tax filing costs of an LLC or a corporation.
A Sole Proprietor has the least legal formalities to worry about when starting out; an LLC needs articles and operating agreements, while corporations require bylaws.
What Is an LLC?
LLC stands for “Limited Liability Company.”
An LLC is a legal entity that protects the members from personal liability for business debts if the company follows the rules set by the state in which it was formed.
The biggest advantages to using this type of organization are the flexibility afforded its owners and managers with respect to taxes (since they’re treated like partnerships) and limited asset protection against creditors or lawsuits filed against the company’s members. There are also several disadvantages – one being increased administrative costs such as the need for formal meetings, the retention of annual financial records, and the requirement to follow particular state statutes.
Another downside is that LLCs are treated by the IRS as a pass-through entity for taxation purposes; this means that each member must pay self-employment taxes on their share of profits, whether or not they receive any money from the company. Think of it as a partnership, with corporate features in terms of liabilities.
There’s also no limit to the number of members in an LLC – unlike corporations where there’s a maximum number of shareholders (usually 50). What does this mean? Well, it could be good if you have multiple employees with ownership shares but at some point, it will probably become too difficult to keep up with all those people within one type of business structure. But then again, because the liability protection remains the same the more members you have the better.
Types of LLC
There are many types of LLC, the most common being single-member and multi-member LLCs. The primary difference between the two structures has to do with how the ownership shares within the company are distributed. Generally speaking, in a single-member LLC owned by one individual, that person owns all the company’s assets; whereas in a multi-member LLC there may be more than one owner or “member.” This allows members to contribute capital into the company at different points as needed without affecting their proportional share of profits if they leave later down the line. In other words: you get what you put in with an LLC when it comes to its share structure.
A single-member LLC is the simplest of the two structures and can be used to conduct business as a sole proprietor, or if you want the protection against personal liability that an LLC offers without the added expense of filing articles of incorporation in your state (since there’s no need for more than one owner). A multi-member LLC may seem like the better option at first because it protects all members’ assets from any liabilities incurred by the company, but this comes with some downsides: namely, double taxation on profits earned by the company along with high administrative costs to maintain records for what could be many owners.
What Are the Benefits of an LLC?
Below are the top advantages of registering your business as an LLC:
Individual Asset Protection
The main advantage of setting up your business as an LLC is the individual asset protection that limits your liability against your company’s debts to the extent of your business assets, not unless if you personally guarantee your company’s debts, which is the case for many new companies seeking financing with not many assets to show for.
In other words, the main reason you should set up your business as an LLC is to legally separate yourself and your partners from your company to limit your liability if in the worst-case scenario that your business fails, with outstanding liabilities.
The members are typically not named in legal proceedings, making them less of a target for lawsuits. This means that if someone were to sue your business because they got injured while there, you would have limited liability for the debts arising from the injury claim against your company.
Liability also extends to what’s called “negligence per se”—the idea that just running an organization with more than one person can create enough confusion about how decisions are made, and responsibilities should be divided up so as to make it easier for negligent parties or those suffering damages at the hands of negligence (say, due to unsafe working conditions) to sue the company for damages.
The limited liability that an LLC provides as opposed to a sole proprietorship or corporation (limited exposure in the event of lawsuits against the organization, and therefore less risk involved with starting your own business).
In short, an LLC provides personal protection against loss of assets in case there’s a lawsuit filed by one or more creditors against you as the company owner. It also allows your business to have different classes of ownership interests that allow contributions for capital without making everyone equal co-owners with voting power over how the money should be spent.
The limited liability that an LLC provides as opposed to a sole proprietorship or corporation (limited exposure in the event of lawsuits against the organization, and therefore less risk involved with starting your own business).
In short, an LLC provides personal protection against loss of assets in case there’s a lawsuit filed by one or more creditors against you as the company owner. It also allows your business to have different classes of ownership interests that allow contributions for capital without making everyone equal co-owners with voting power over how the money should be spent.
Ease of Registration and Legal Administration
Compared to a Corporation, setting up an LLC is quick.
With taxation, there are no sub-filing requirements or taxes on earnings like capital gains and dividends; this gives you more flexibility when managing your money. You don’t have to file anything other than what would otherwise be due as one individual filing their own income tax return if they were self-employed without being incorporated – again, fewer formalities! An even greater benefit comes with the flexibility of the structure itself: the LLC can be a corporation with the protection and benefits of an LLC, or it can simply exist as your personal business.
In short, an LLC offers a lot of flexibility but isn’t as complicated to set up and maintain as a corporation.
Pass-Through Entity
LLC are considered as pass-through entitities for federal income tax purposes.
Unlike a corporation, the LLC doesn’t pay taxes on business income, instead, the income from the LLC is passed through to the members or owners and then taxed as personal income.
If you ever considered registering as a partnership (if you have a business partner), taxation is similar to a partnership organization where the business income is split between the partners, and are taxed in their individual income even if the money remained in the business and not distributed to themselves.
An LLC Establishes Higher Credibility
An LLC offers credibility that operating as a freelancer, sole proprietor, or partnership does not. It offers you creditors and customers better peace of mind than when dealing with a freelancer, sole proprietor, or partnership.
As a legal entity, customers and creditors know that they are dealing with a professionally established company that’s here for the long haul.
Most people would feel at ease to deal with an organization that has gone through the formalities of registering a legal entity than someone operating under his or her own name or a partnership that quickly grabbed a business permit and name registration without establishing a legal entity for business purposes.
Still, it’s worth noting that there would likely be restrictions imposed by lending institutions when applying for loans because many banks consider LLC owners as ‘self-employed’.
Taxation Flexibility (Not Applicable to All States)
Some of the benefits that come with the LLC structure are flexibility and protection. The way you’re taxed can be different, depending on your needs.
You have a choice in how to set up your business taxes: as a sole proprietorship or corporation if there is enough income for it to matter (some states don’t allow this).
What Are the Disadvantages of an LLC?
An LLC Is More Expensive to Setup and Maintain
First, the cost of setting up an LLC is more expensive than setting up a sole proprietor or a partnership. You’ll need to spend money on the initial legal fees and ongoing annual costs (which are not optional).
The cost of registering an LLC ranges between $40 to $500 depending on your state with an average of around $132.
Of course, $40 to $132 isn’t much if you’re serious about building a successful business but there are arbitrary costs such as lawyer or agent fees that you may have to pay to make sure that your legal entity is properly structured.
The additional expense would include accounting services, officers’ salaries, professional liability insurance premiums, state franchise taxes as well as various other expenses such as leasehold improvements for office space if you’re leasing rather than buying your premises. Note: depending on your company’s size and how you operate, these expenses may also be incurred even when you’re operating as a sole proprietor or partnership.
An LLC Can't Outlive its Owners
For tax purposes, an LLC is treated as a partnership—so if one member leaves the company or dies and their share is distributed among the remaining partners, then your business will be dissolved. This means that any assets in the name of the deceased partner will have to go through probate court before they can be transferred to another party.
A corporation is an independent entity with separate legal rights from its owners. It’s technically “a person without a soul” in the eyes of the government, which makes it outlive its owners. When one of the partners leave or passes away, the remaining shareholders can buy his or her shares or awarded to his or her heirs depending on shareholder agreement.
An LLC May Limit Your Company's Growth
An LLC is a right choice if you want to maintain the flexibility that comes with being a sole proprietor. As an owner, member, or manager of the business entity, your personal assets are not on the line in case of litigation, but the company’s assets can be seized for settlement purposes. This protects both members who may have limited access to their capital and those without any funds at all from liability.
Your company’s growth, however, may be limited when it’s operating as an LLC since you can’t issue shares to venture capitalists or angel investors. You also can’t make an IPO (initial public offering) as an LLC. So, if you’re launching an innovative business idea that may require outside backing, it in your best interest to register as a corporation.
Is It Necessary to Register an LLC?
Do you need an LLC? Not necessarily.
As mentioned in prior sections of this article, an LLC provides personal protection against loss of assets in case there’s a lawsuit filed by one or more creditors against you as the company owner. It also allows your business to have different classes of ownership interests that allow contributions for capital without making everyone equal co-owners with voting power over how the money should be spent.
There are many aspects that you may consider when deciding whether or not to register your business as a sole proprietorship, partnership, LLC, or Corporation.
Do You Have Partner(s)?
Building a business with one or multiple partners has its own pros and cons, and not a shortage of partnerships that went south. Based on my personal experience, I’m at a stage where I’m more careful in picking individuals with whom I may want to do business, much more, take them as business partners.
Pro tip: only work with people you personally, whose values, ethics, and work habits align with yours.
If you’re working with other business partners, an LLC is an excellent way to protect yourself and your assets from your business partner’s mistakes. So, instead of registering a partnership, you can get better legal protection with an LLC.
Is There a Possibility of Being Sued?
A sole proprietorship (or partnership) has unlimited personal liability for business debts and obligations – meaning, the owners can lose everything! An LLC provides owners with protection from liabilities incurred by the company, much like a corporation would.
This perhaps is the main reason you would set up your business as an LLC even if you’re operating as a sole owner or operator, especially if you work with clients, provide onsite services (plumber, handyman, electrician, etc.) where you’re exposed to possible lawsuits for third-party property damages or accidents.
In Canada, you can’t register as an LLC, either we operate under our names, register as a sole proprietor, partnership, or corporation.
Registering as an LLC or a Corporation may be worth it (despite the costs of registering and running a corporation) if there’s a possibility of a customer or creditor lawsuit in running your business.
Do You Plan to Go Full-Time?
If you’re doing your business on the side as a means of generating extra income, you may not need to register as an LLC, not unless if you’re working with a partner(s), or there’s a possibility that your customers or creditors may sue you as a result of doing your functions in your business operations.
Going full-time in your business is an exciting time, which means that your business is now in a position where you’re able to replace your full-time income from work. If you’re at this stage, you may consider registering an LLC to operate as a formal business entity to get slightly similar benefits from a corporate entity without having to register a corporation.
How to Register an LLC in the US
There are a few different ways of registering an LLC, but the most common way is by filing Articles of Organization with the Secretary of State for your state and paying the fee associated with that form.
You should also file it using one or more sets of government-approved forms, including articles (or certificate) that identify the company name; specify how much capital has been contributed so far, and what type, as well as any other authorized contributions; describe plans to issue shares if applicable, set transfer restrictions on the company’s ownership shares and address potential conflicts between members’ interests. These documents may need to change over time because companies evolve quickly.
If you’re not sure, the best way to structure your legal entity is by consulting with a lawyer.
You can also register an LLC easily online with the assistance of an agent or through sites like LegalZoom.
Online registration is an option if you’re the sole business owner with a simple business and ownership structure.
