What is a Sole Proprietor?
A Sole Proprietor is what you are if you sell a product or a service. It is not a choice, you are a sole proprietor by default
The moment you start marking money, in the eyes of the Internal Revenue Services (IRS), you are a Sole Proprietor.
Bottom line, in the eyes of the government, YOU ARE YOUR BUSINESS.
Sole proprietor literally means:
Proprietor- Business owner/Property owner
If you put that together, being a Sole Proprietor is being on a one-man show. A one-person business.
Easy right? Let’s get further into detail:
Although a Sole Proprietor is the most simple business structure, that doesn’t mean you can ride it out on autopilot.
To establish a Sole Proprietor, as the business owner you must file necessary legal documents with local and state authorities. Depending on your industry and location, you may have to comply with obtaining business licenses and permits to be legitimized.
With a Sole Proprietor, YOU (the business owner) are personally responsible for everything.
Any financial or legal liability is 100% the responsibility of the Sole Proprietor owner.
Due to the fact that you are the business in the eyes of the law, in the event that your business is sued, you are personally responsible for all liabilities and debts.
A Sole Propriety offers no protection whatsoever.
As a Sole Proprietor, you can open a separate checking account for your business (which you should do on day first).
Go to any bank of your choice and ask to set up a DBA account (Doing Business As). DBA is also known as a “fictitious business name”.
A DBA allows you to open a bank account, receive checks or payments under your business name and not your personal name even though you’re a Sole Proprietor.
This keeps your business organized and tax season will be that much easier when it comes around.
Okay, so how does that affect Tax?
Good question, any money that you make through your Sole Proprietor must be reported on your personal tax return.
The IRS looks at the profit (Income minus Expenses) you made and taxes you at your tax bracket plus something called Self Employment Tax.
Self Employment Tax is a tax that covers your social security and medicare expenses. Today Self Employment Tax is 15.3%.
So you are taxed at your personal tax bracket PLUS and Self Employment Tax.
let’s move over to LLCs and see how they compare.
What is a Limited Liability Company (LLC)?
LLC stands for a Limited Liability Company, and that’s exactly what it is. A company that you form, that has Limited Liability for the OWNER.
An LLC is a recognized legal entity that can be used to run a business or hold assets.
Structuring your business under an LLC gives your business its own identity. As the owner of an LLC, you set up a separate entity that runs the business, that is the business, but that ISNT YOU.
Yes, you OWN that entity and you might work for your entity, but you are not it and it is not you.
Note: Don’t be get confused, there is a difference between LLCs and LTDs. Check that out after you finish reading this post.
Forming an LLC isn’t as difficult as most people think. It is important to understand that forming an LLC is a more time consuming and expensive process compared to forming a Sole Proprietor.
We’ll run through the steps so you can get an idea of how to set up an LLC.
- First and foremost, you’ll have to choose an available LLC name.
- Youll have to file formal paperwork such as “Articles of Organization”. Depending on the state, the cost ranges from $100-$800.
- Some states require an Operating Agreement, some don’t. An Operating Agreement is a legal document that explains how the LLC is run.
- Obtain licenses and permits for your business.
Remember, this is a macro view of the process of filing and legalizing your LLC. Depending on your state, details will vary.
Having an LLC can come in handy when lawsuits emerge. An LLC is like a barrier, wall or fence, however you want to think of it, that separates YOU from IT.
That means that your personal assets are separate from your LLC. An LLC owner is largely protected from creditors or legal trouble.
One of the first things you want to do after opening your LLC is to open a business bank account.
The process is very straightforward. Head over to the bank of your choice and be sure to have the following documents:
- LLC approval documents
- Personal ID
- EIN of LLC (an IRS confirmation letter)
Unlike a Sole Proprietor, you don’t need a DBA because you LLC operates under its own name.
The main difference between having an LLC is that your LLC has to file “its own” tax return. Remember, your LLC is its own entity separate from you.
The Profits of your LLC (Income minus Expenses) are then Passed Through to you, the owner of the LLC. You actually pay taxes on those profits, on your personal tax return at your personal tax bracket.
Just like a Sole Proprietor, you also have to pay Self Employment Tax, which is 15.3%
Sole Proprietor vs LLC: Head to Head
Now what we have an understanding of a Sole Proprietor and an LLC lets compare:
- Forming a Sole Proprietor is very easy and inexpensive. It’s almost as easy as painting a sign and hanging it up on your door. Of course, there are minimal fees and licenses that are required depending on the state you do business in.
- Forming an LLC takes longer and is more costly (if you’d like to know the cost or the amount of time it takes to form an LLC we have in-depth articles). Filing an LLC starts with a mountain of paperwork.
Forming as a Sole Proprietor is much easier and less expensive. There’s no comparison.
- With a Sole Proprietor, the owner assumes full responsibility. There is no protection if you run into a lawsuit.
- As an LLC, the business is regarded as a separate entity. This keeps the liabilities of the business to the business, not the owner.
LLCs were designed to protect business owners and their personal assets from the liabilities of their LLC. Simply having a Sole Proprietors doesn’t offer protection.
- Opening a bank account is simple with a Sole Proprietor. All you need to do is establish a DBA account.
- Opening a bank account as an LLC is a walk in the park. After your LLC is established, go to the bank of your choice with the proper documentation (mentioned above).
Essentially, they both offer the same thing. The main difference is that you’re not legally protected from creditors or lawsuits with a Sole proprietor. With an LLC you are.
- Filing taxes as Sole Proprietor isn’t that much of a headache (if you open a DBA and things are organized). You will be taxed on your personal tax return at your tax bracket.
- The IRS views you and your LLC as 2 people. The means double the work and possibly double the cost (for an accountant)
Both Sole Proprietor and LLC take advantage of “Pass Through” deduction and are relatively similar in the taxation process. At the end of the day, there is more possibility to receive tax benefits/breaks with an LLC. We recommend speaking with an accountant on this topic.
There is no doubt that setting up a Sole Proprietor is much easier and less expensive than an LLC.
There’s also no doubt that an LLC protects you as an owner from legal trouble.
Both Sole Proprietor and LLCs have their upsides and downsides. No business model is perfect.
The difference in making the right decision for your business will fall on the amount of due diligence that you do. Before making the final decision, speak with a financial planner to work out the small details.
We hope you gathered the right information and found our resources helpful. If you have any questions, feel free to leave a comment down below.
Good luck with your business structuring journey!