Congratulations, you’re starting a new business! You likely know enough to know that you should establish a business entity but may not be sure which entity is right for you. We don’t blame you! There are various options to choose from, which can make it challenging to determine which is the right fit for you.
It’s important to review your options and decide which entity is right for your business. You may be wondering, what is an LLC? What is a sole proprietorship (aka “sole prop”)? What is a corporation? What’s the difference among them? Well, we’re here to help!
LLC stands for “limited liability company.” An LLC is “a business ownership structure that separates your personal affairs from your business affairs.” LLC owners are called “members” and they each own a portion of the business.
Benefits of an LLC include the following:
- Limited personal liability: In a sole proprietorship you and your business are legally the same entity. In an LLC, your personal assets cannot be claimed to satisfy business debts.
- Less paperwork: LLCs are not required to hold annual board meetings or retain as extensive records as other business formations.
- Tax advantages: The IRS, by default, classifies LLCs as partnerships or sole proprietorships. Therefore, LLCs can take advantage of “pass-through” taxation in which the LLC does not pay any LLC taxes or corporate taxes.
- Management flexibility: LLCs don’t have to follow the same strict management structure as corporations. Instead, LLC owners have more control over their own decisions and how to run their business.
- Flexible profit distribution: LLCs are not required to distribute profits equally or proportionately according to ownership percentages.
Disadvantages to forming an LLC include:
- Cost: In comparison to a sole proprietorship or partnership, LLCs have higher operating costs.
- Taxes: Forming an LLC may require its owner to pay unemployment compensation to themselves. Forming an LLC in California requires the business to pay a minimum franchise tax, currently $800, even if the business didn’t make any money!
- Banking requirements: Checks made out to an LLC may not be cashed and instead must be deposited into a corporate bank account. Some banks charge more for the use of these accounts.
- Separate records: LLC owners must be extremely careful to keep their personal records separate from those of their business, so this means you have to start using a bookkeeping software or hire a bookkeeping professional.
A sole proprietorship is the most common structure business owners choose when starting a business. It is an “unincorporated business owned and run by one individual with no distinction between the business and you, the owner.” The owner is entitled to all profits and is responsible for all of the business’s debts, losses, and liabilities.
Benefits of a sole proprietorship include:
- Ease of establishment: Sole proprietorships are the easiest to form in addition to being the least expensive to get started. Legal fees are limited to obtaining any applicable licenses and permits.
- Control: Because sole proprietorships are run by a single owner, there is no requirement to compromise or collaborate with a partner.
- Easy tax preparation: sole proprietorships are not taxed separately from personal taxes so are easy to declare. They are also taxed the lowest of all business structures.
While there are significant benefits to establishing a sole proprietorship, there are also some distinct disadvantages involved.
- Personal liability: because there is no difference between you and your business, you assume full financial responsibility. You may be held personally liable for any debts of your business.
- Difficulty raising capital: In a sole proprietorship, you are unable to sell shares in your company, which limits investor opportunity. Banks are often reluctant to lend to sole proprietors due to the liability involved and risk of downfall.
- Burden: You alone are ultimately responsible for the successes and failures of your business.
- Lack of structure/sophistication: many of your customers and/or potential business partners will see that you are not operating under an LLC or corporation and be hesitant, or will flat out refuse to do business with you, due to lack of structure/sophistication.
A corporation is a structure that enables a business to organize as a separate legal entity from its owners. Like the previously mentioned business formation options, corporations have various pros and cons associated with them.
Advantages of forming a corporation include the following:
- Personal protection: The most valuable advantage of forming a corporation is that shareholders are not personally liable for the corporation’s liabilities and debts.
- Easier access to capital: Forming a corporation allows you to sell shares of your business to investors, making it easy to raise capital.
- Perpetual Existence: A corporation can continue indefinitely, regardless of what happens to its individual directors, officers, managers, or shareholders.
Disadvantages of a corporation are:
- Double taxation: A corporation likely pays taxes on its income and additionally, shareholders pay taxes on any dividends received.
- Excessive tax filings: Corporations require various taxes to be paid based on income, which in turn require a substantial amount of paperwork to be completed.
- Independent management: If there is no one clear majority interest holder, the management team may be capable of operating the business with little insight from the owners.
If you’re looking to start your own business but aren’t sure of what your first steps should be, you may benefit from talking to the experts at @VirtualCounsel. With years of trusted experience, we can evaluate your business proposition and help you make the decision best suited for you. If you’ve already decided how you’d like to establish your business, we are here to help answer any questions you have to get the ball rolling.