If you’ve been operating as a Sole Proprietor and are wondering if you should register your business with the state and form a Limited Liability Company (LLC), the answer is a definitive “yes.”
Although Sole Proprietorships are the most common type of business entity in the United States, they come with significant risk for owners. That’s because a Sole Proprietorship is not a separate entity from its owner – there’s no legal distinction between the two. If a Sole Proprietorship is sued or can’t pay its debts, the personal assets of the owner are at stake.
An LLC, on the other hand, is registered with the state and considered a separate legal entity from the owner or owners. That separates owners from the business in the event the LLC is sued or can’t repay debt and protects their personal assets. For that reason alone, I argue that an LLC is normally a better – and safer – type of business entity under which to operate.
About Sole Proprietorships
If you’re operating as a Sole Proprietor, you, essentially, are your business. The assets and liabilities of the business are also your personal assets and liabilities, as there is no legal separation between the two. If someone starts getting paid to make wedding cakes or build decks and patios or provide childcare, that person is, by default, a Sole Proprietor.
Many people like Sole Proprietorships because they’re easy to get up and running – no paperwork required. A Sole Proprietorship is not registered with or recognized by the state, meaning the owner doesn’t have to file any paperwork to get started, or submit annual reports and pay yearly fees.
Sole Proprietorships are subject to pass-through taxation, meaning that all income and losses of the business flow through to the personal tax returns of owners, who use their own Social Security numbers to file.
It’s likely that a Sole Proprietor will have to pay quarterly taxes, and they’ll be responsible for paying a self-employment tax, which is a combination of Social Security and Medicare taxes. While employers pay half of the Social Security and Medicare taxes for their employees, someone who is self-employed, like a Sole Proprietor, is responsible for the total amount.
A Sole Proprietor also may be required to obtain business licenses and permits, which may be issued by the local, state, or federal government. The types of licenses and permits needed depend on where you live and the type of business you have.
Also, a Sole Proprietorship that operates under a name that’s different than the legal name of the owner will need a DBA, or “Doing Business As” from the state.
About Limited Liability Companies (LLCs)
A Limited Liability Company is a business entity that registers with the state by filing Articles of Organization, which is a public document that provides information about the company. An LLC with one owner, known as a member, is called a single-member LLC, while a business with more than one owner is known as a multi-member LLC.
Once it’s registered with the state, an LLC must file annual reports and pay yearly fees to remain in compliance. It also must have a Registered Agent, which is an individual or company designated to accept and process important correspondence for the company. As the owner of an LLC, you’re responsible for obtaining all necessary business licenses and permits.
An LLC is taxed the same way as a Sole Proprietorship unless members choose to be taxed as a Corporation. In that case, the company would pay corporate income taxes, and members would be taxed on distributions they receive, a method known as double taxation. There are advantages and disadvantages to both methods of taxation, and I’d advise you to consult a tax professional if you need help.
Although it’s not legally required, all LLCs should have an Operating Agreement, which is a document that describes how the business will operate based on the needs and wishes of its owners. An operating agreement describes how the LLC will be managed, what happens if one member leaves the company, how members will vote, how money is handled, how the business will be taxed, and many other situations that could affect the company and its owners.
Making the Case for an LLC
Imagine that you’ve been operating a food truck business as a Sole Proprietor for five or six years. After a rocky start and several very lean years, you’ve finally developed a dedicated following and are making some good money.
And then, on a Friday morning shortly before the lunch crowd is expected, the brakes on the truck fail, resulting in a crash that damages property and injures two people. Suddenly, you’re facing several lawsuits and all your years of hard work to build a business are in jeopardy because your personal assets are not protected.
If you had registered the business as an LLC and complied with all laws and regulations, your business assets may be threatened, but your personal assets, including your home, savings accounts, vehicles, and others, would be protected.
While liability protection is the primary argument I make for LLCs, it is not the only one. Other reasons to consider changing your Sole Proprietorship to an LLC include the following:
- An LLC inspires greater confidence with customers, lenders, suppliers, and others than a Sole Proprietorship.
- An LLC can get business credit that is not tied to personal accounts.
- Members of an LLC can choose how they want the business to be taxed.
- An LLC has greater opportunity for growth than a Sole Proprietorship, which cannot expand. without changing to a different type of business entity.
- Members of an LLC have the option to hire an outside manager or to have members manage the business.
- An LLC normally will find it easier than a Sole Proprietorship to raise capital, as many lenders are reluctant to loan to a business without a history of reliable income and savings.
- An LLC may be able to take advantage of local, state, or federal tax benefits.
- It’s typically easier for an LLC than a Sole Proprietorship to keep business finances separate from personal finances.
I understand that someone considering changing their Sole Proprietorship to an LLC may hesitate due to the need to file paperwork, pay fees, hire a Registered Agent, and take steps to remain in compliance with the state. I argue, however, that the effort and expense is well worth the peace of mind that comes with knowing that your personal assets – those that you and any dependents you might have rely on – are protected.
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