Are you looking to start your own business, but aren’t if you should classify yourself as an LLC or sole proprietor? Or maybe you’re already a sole proprietor, and you want to see if forming an LLC will be beneficial for your business? Each classification comes with it’s benefits and risks, but here are a few characteristics of each one that may help make that decision a little easier.
As a disclaimer, please keep in mind that I recommend that you seek professional help from attorney or CPA on all business related decisions.
The Difference Between the Two
One of the first steps you will need to do when you start a business is to determine what type of business entity you will have. If you start to collect payments from customers or clients and you have taken no legal action and you have not registered any paperwork with the state, you automatically default to what is called a sole proprietor.
What is a sole proprietorship?
A sole proprietorship means that you and your business are one and the same. There is no legal or tax separation between yourself and the business. You are automatically defaulted to a sole proprietor if you don’t file any additional paperwork — however, that does not mean that your steps of action are complete.
As a sole proprietor, you’re still required to look up what permits, licenses and fees are required within your city, state, and county in order to legally conduct business. The best place to look this up for the State of California is Cal Gold.
If a sole proprietor wants to keep things simple, they can operate under their first and last legal name. This will mean that they do not have to file any additional paperwork to register a business name with the State of California.
Want a Custom Business Name?
If you’re a sole proprietor and you want to operate under anything that is not you first and last legal name, then you will need to register a doing business as name, also known as a fictitious business statement.
YOU Are Your Business
As a sole proprietor, you and your business are one and the same. This means that any lawsuits or debt can transfer over to each side. If your business is sued, then you are personally sued and you are liable to those damages. Likewise, if you carry credit card debt and you are trying to apply for business financing or business credit cards, then that debt also passes through as well. This is one of the major reasons why individuals may want to migrate over from a sole proprietorship to an LLC.
What is an LLC?
An LLC is a business classification that separates the business entity and the personal entity. That means that your business assets and liabilities are separated from your personal ones. If you’re someone in a high risk field where people have potential to file lawsuits frequently against you, then you’ll want to make sure that you are separated from your business and form an LLC.
If you choose to form an LLC, that means that any lawsuits that are filed against your LLC will not enter in and go against your personal assets.
How is an LLC Taxed?
In terms of taxation, an LLC is automatically a pass through entity when it comes to taxes — meaning all of the business taxes pass through onto your personal tax return. However, LLCs do have an option here to elect S-Corp status in terms of taxation.
What is an S-Corp?
An S-Corp is a taxation status, not a business entity. If you are a business with a larger income, you may want to switch to an LLC and elect S-Corp status. An S-Corp allows you to take your business’s net income and pay yourself a reasonable salary. You’ll also be able to take the remaining profits from the business and pay it out to yourself in the form of a shareholder’s distribution.
How Does an S-Corp Benefit Me?
If you are earning the same amount as a sole proprietor or as an LLC taxed as a pass through entity — meaning you didn’t elect S-Corp tax status — then all of your business’s net income is your income. Therefore, all of that net income is going to be subject to self employment tax, federal income tax, as well as state tax.
Self employment tax is in the amount of 15.3% and includes Medicare and Social Security taxes. If you have elected an S-Corp status, you pay yourself out a reasonable salary, and that salary will be subject to payroll taxes. Because you are an employee of your company, you are not self employed and that owner’s distribution is not subject to self employment taxes. This means that 15.3% on that remaining amount that wasn’t paid out to you as a regular salary does not undergo that 15.3% in taxes.
For individuals that are able to cover the cost of payroll, that are able to pay themselves out as an employee, and have a regular stream of income in their business, electing a S-Corp status makes sense, and can save them thousands of dollars per year.
Fees for LLC’s and Sole Proprietorship
Setting up a sole proprietorship is relatively quick and inexpensive. You will to be subject to paying fees to obtain a business license, register a fictitious business name, as well as other permits and fees required by your city, state and county.
With an LLC in the state of California, you’re going to be required to pay an $800 annual LLC tax for businesses grossing under $250,000. Additionally, there are going to be set up costs involved for registering and forming your LLC. Aside from the $800 annual LLC tax, the cost of setting up your LLC can vary greatly.
If you’re utilizing a service such as Legal Zoom or Inc File, then the cost can be several hundred dollars. If you’re utilizing the services of an attorney then the cost can be much greater — however, they can help guide you, issue you regular reminders, and be an excellent aid to successfully setting up your business. Lastly, If you set up your LLC yourself, you will be subject to the Secretary of state filing fee of $70.
Quick Recap
Setting up a sole proprietorship is relatively fast, easy, and cost efficient — you are automatically defaulted to a sole proprietor when you start your business and the fees involved in setting up minimal. However, you and your business are one in same — all taxes, debts, and liability of your business will pass directly on to you.
As an LLC, you and your business are two separate entities — all of your finances must be completely separate. Your personal assets are protected from any lawsuits that may fall into your business’s hands, and you have the option of either defaulting to a pass through tax entity or electing an S-Corp status for taxation. Electing an S-Corp status means you must treat yourself as an employee, but you may save additional money on your taxes if your business earns a substantial profit. Lastly, an LLC has additional fees that you’re required to pay annually.
Want to learn more about the difference between an LLC and a sole proprietorship? Watch the video here!
