The Differences Between a Sole Proprietorship, an LLC and an S Corp

sole proprietor sitting at desk on laptop
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When starting a small business, you'll have to determine what business structure you want to register as. There are a few different types, with the primary types being a sole proprietorship, LLC, or S corp.

While they share some similarities, they also have different advantages and disadvantages, as well as tax regulations, that need to be considered. Here's everything you should know about each business structure.

What is a sole proprietorship?

A sole proprietorship is a business type that gives the person registering complete control of the business. A person is automatically considered a sole proprietor if they're conducting business activities, but they do not register as any type of business. Because of the lack of government involvement, they are easy to establish and dismantle, and are a preference of self-contractors and consultants.

Since sole proprietors are not a separate business entity, only one person pays personal income tax on the profits earned from the business each year. This also means that a person's business assets and liabilities are not separate from their personal assets and liabilities, meaning they can be held personally liable for the debts of their business. Many sole proprietorships expand and restructure into an LLC as the owner becomes more successful.

Benefits of a sole proprietorship

Starting a sole proprietorship is good for a business owner who is looking for a low-risk, low-cost option. It is also a good choice for someone who is uncertain about the viability of their business and wants to test the idea out before registering it formally. What attracts so many first-time entrepreneurs to a sole proprietorship is its ease of setup and lack of business taxes.

Other benefits for owners of starting a sole proprietorship include:

  • Easy setup

  • Low cost to start

  • No corporate business tax

  • No annual tax reports or filings

  • No formal business structure restrictions

  • Easy record-keeping

Drawbacks of a sole proprietorship

Having no distinction between personal and business assets, the biggest downside to a sole proprietorship is the lack of liability protection. This means if an owner falls into debt, their personal assets can be taken as collateral. Their limitations could also make a company look unprofessional, adding an extra challenge for owners who are looking to raise money for their venture.

The other disadvantages of a sole proprietorship include:

  • Unlimited liability for an owner

  • No ongoing business life

  • Difficulty raising capital

  • Inability to take on business debt

  • Can seem unprofessional

What is an LLC?

A limited liability company (LLC) gives the business owner basic benefits of liability protection, as well as allowing them to start a business with two or more people, known as partners. Registering as an LLC will protect the business owners’ personal assets from any losses, debts, bankruptcy, or legal consequences that are ruled against the company. If the company takes any losses, creditors can only take assets from the company and not the individual owners.

A single-owner LLC is considered a “disregarded entity” for tax purposes, and the profit and loss from the LLC are passed through to the owners' tax returns. It is still considered a separate entity legally, but the tax obligations are passed through directly to the owners' tax returns on a Schedule K-1.

An LLC with two or more owners can be classified as either a partnership (disregarded entity) or a corporation, depending on the elections made during the setup of the LLC. The default classification is that of a partnership unless you file Form 8832 with the IRS to change your structure to a Corporation.

When your LLC is considered a partnership, each owner's pro-rata share of profits/losses will pass through to their personal tax returns on a Schedule K-1. When your LLC has filed a Form 8832 and is considered a corporation, it will file its own separate tax return.

The owners of an LLC can choose any business structure they would like to run their business, with few restrictions. They are allowed to have as many owners or employees as they desire, and structure them in whichever management style best fits their company.

Benefits of an LLC

Registering as an LLC gives business owners the distinct advantage of not being personally liable for any debts and lawsuits that could belong to the company. This can be advantageous for owners, as many small businesses don't turn a profit their first couple of years in business.

LLCs also have flexibility when it comes to their corporate structure, not limiting the number of owners they cooperate with or requiring themselves to appoint board members.

Some other benefits of registering as an LLC include:

  • Limited liability

  • Pass-through taxation on profits and losses

  • Management flexibility

  • Easy to start up

Drawbacks of an LLC

One of the biggest downsides to an LLC relates to obtaining funding. If an LLC is unsuccessful in obtaining private financing or a loan from the bank, it can be difficult to attract outside investors. Venture capitalists typically only fund corporations and not privately owned LLCs, making it a challenge to find alternative funding.

As in its name, LLCs are only limited in the liability protection they provide. In certain core proceedings, a judge can rule that an LLC does not protect your personal assets. This typically happens if business and personal transactions are not separated or if the business has been run fraudulently.

The primary drawbacks of registering as an LLC are:

  • Legal limitations

  • Filing and paying self-employment taxes

  • Some fees to register

What is an S corp

An S Corp is a type of corporation that avoids the double taxation consequences of a regular C corp. Registering as an S corp, allows profits and some losses to pass through to a shareholder's personal income without that person being subject to the corporate tax rate. However, the S corporation can still be held responsible, at an entity level, for certain taxes, so an entity-level tax return may still need to be filed.

Unlike LLCs, S corps cannot have more than 100 owners or shareholders, nor can they be owned by another corporation. S corps are required to have a board of directors and corporate officers to oversee the management of any major corporate decisions. For these reasons, S corporations are typically used by larger entities, not small businesses.

In order to achieve S corp status, owners must register their business with both the state they are working in and file with the IRS.

Benefits of an S corp

S corps have many tax advantages, including the same pass-through tax LLCs have. They also avoid corporate taxes and have reduced tax gains.

Other advantages of filing as an S corp include:

  • Write off startup losses

  • Liability protection

  • Reduced tax gains

  • Pass-through taxes

Drawbacks of an S corp

As a corporation, registering as an S corp means the owners must create a board of directors. Financially, S corps have different tax rules depending on the state and typically incur more fees than an LLC or sole proprietorship.

Other drawbacks of registering as an S corp include:

  • Following regulations and guidelines

  • More operational strain

  • Higher financial burden

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