When starting in business, most people begin as sole proprietors because it’s the easiest way to start. But with time, and as the business scale increases, the conversation around formalizing your business may surface.
This brings you to the question: Which business structure is best suited for your business? That’s not a simple question. Therefore, there are a few things you ought to consider. Here are some points to give you some perspective.
Sole Proprietorship
A sole proprietorship is simple and easy to establish. It has one owner, hence the term ‘sole’ proprietorship. So, if you run your business individually, you’re essentially a sole proprietor. It’s common for people involved in freelancing or consultancy.
Unlike corporations, sole proprietors are unincorporated. The biggest distinction between a limited liability company (LLC) and a sole proprietorship is that the latter isn’t a juristic person. This is a big downside and makes the sole proprietorship a risky business structure.
Advantages
- Paperwork: There’s not much paperwork required. But if you need a practicing license, you may need to fill in some paperwork.
- Profits: As the owner, you get to enjoy all the profits from your business operations.
- Tax Benefits: Depending on the state, you may also qualify to get some tax benefits.
Disadvantages
- Liability Protection: This is the biggest drawback of a sole proprietorship. If something goes wrong and you’re unable to pay for your personal loans, the creditors have a right to claim your belongings, which isn’t an ideal situation.
- Financing: Because your entity isn’t incorporated or registered as a formal business, it would be challenging to secure finances outside the immediate family. For instance, a bank might not lend you a considerable amount of money if you’re a sole proprietor.
- Credibility: The sole proprietor is not as credible as an LLC. It’s also partly why it’s hard to get debt or investor financing as a sole proprietor.
Limited Liability Company
An LLC draws elements from various business structures. It’s a legally separate entity from the owners of a corporation. This is an enormous advantage because it means members of the LLC aren’t liable for paying off debts incurred by the business. Bear in mind that states may deal with LLCs differently. Therefore, you may have to do some research to find out about Alabama LLC formation.
Plus, while one person runs the show under sole proprietorship, the LLC doesn’t have restrictions on the number of members that can join. Even so, it can be owned and managed by one person. Here are some of the other pros and cons of an LLC.
Advantages
- Credibility: The LLC is more credible than a sole proprietorship because it’s a business entity registered by the state. Also, you have to file some paperwork with the state to get your business registered, so it’s a big deal.
- Limited Liability Protection: Since an LLC is a separate legal entity, owners have limited liability protection. This means that your personal assets cannot be used to settle the LLC’s debts. The owner of the business and the business are separate. Your creditors have no claim on your assets in the repayment of liabilities.
- Raising Investment Finance: Compared to sole proprietors, it’s easier to get an investor or debt financing as an LLC because they’re more credible.
- S-Corporation Tax Option: By default, LLCs are taxed similar to sole proprietors. However, the members of an LLC can elect to be taxed as an S-Corporation, which sometimes is the more sensible choice from a tax perspective. For example, LLC members could opt to receive salaries, which can be taxed. Then get the rest as dividends, which are taxed at a lower rate. This is better than having all your income taxed at the income tax rate.
Disadvantages
- Paperwork And Compliance: Unlike in a sole proprietorship, you’ll need to submit some paperwork during and after registration. It’s not exactly what you would call a simple process. Therefore, you might need the help of a financial advisor to get things started. Those LLCs with more members may need more time to meet compliance standards.
- Costs: To form an LLC, you have to pay a certain amount to get it up and running. There are some licensing fees that, depending on the state, may be required to form the LLC.
Conclusion
A lot of businesses start as sole proprietorships, particularly consultants and freelancers. It’s ideal for them because it’s easy and presents fewer hassles as far as setting it up and managing it are concerned. It’s also cost-effective. However, as the business grows, protection and credibility become more important. That’s when most people upgrade to an LLC or something else.
Sole proprietorships are risky if you deal with creditors since it provides no legal protection. So, you’re better off upgrading to an LLC. In addition, LLCs are advantageous because they’re more flexible and have more tax options than sole proprietorships. Ultimately, the choice is yours.