Updated July 1, 2020:

California sole proprietorship vs LLC is a common consideration among aspiring business owners in California as they decide which business structure to adopt. A sole proprietorship refers to a business with a single human owner, while a limited liability company (LLC) is a company with one or more owners, who are also called members. Both of these business structures have their pros and cons.

Choosing a Legal Entity for Your Business

When you are choosing a legal entity for your business, you need to consider many things, including:

  • State and federal tax laws
  • Liability protection
  • Ownership structure
  • Management goals
  • Investment and funding considerations
  • Exit strategies

Doing proper planning in advance can help you avoid the need to restructure your business later, which can incur a lot of time, effort, and money.

California Sole Proprietorship Vs LLC

In California, you are allowed to conduct business as a sole proprietor or LLC, but not both. When you are choosing between sole proprietorship and LLC, you should take two key differences into consideration: liability and taxes. A sole proprietorship provides no legal separation between itself and its owner. The owner will receive all its profits and be accountable for all its losses and debts.

An LLC, on the other hand, gives its members limited liability, protecting them from being held personally liable for its financial obligations. A sole proprietorship and an LLC are typically taxed similarly because the IRS considers a single-member LLC a disregarded entity. A single-member LLC usually reports its income and expenses on its members' IRS Form 1040, the way a sole proprietorship does.

People who prefer to be their own boss might benefit from a sole proprietorship or single-member LLC. This provides the opportunity to handle all management, finance, marketing, and policies of the business. There is no need to wait for approval from other owners or consult with anyone else if you are a sole proprietor or owner in a single-member LLC.

Those who are not experienced business owners might prefer to collaborate with others on important business decisions. Having other members can help you learn from their experiences, distribute marketing and management duties, and there may be additional funding opportunities.

Pros and Cons of a Sole Proprietorship

Pros

  • Easy Formation — As a sole proprietor, you can start your business very easily and quickly since you do not have to file documents or deal with government procedures. However, you are required to file a “Doing Business As” (DBA) name if you do not want to name your business after your legal name. All you need to do to get your business started is obtain the necessary licenses and permits.
  • Flexibility — Sole proprietorship also gives you a lot of flexibility, allowing you to customize your ownership and management structures.
  • Pass-Through Taxation — One of the most important benefits of a sole proprietorship is that it has a pass-through tax structure. For federal tax purposes, its income is reported and taxed on its owner's individual tax return.
  • Minimal Recordkeeping and Compliance Requirements — In addition, a sole proprietorship does not have to submit annual reports or pay annual fees to the state. Besides keeping records for tax purposes, it is also not required to meet any specific accounting requirements.

Cons

  • Personal Liability — A major disadvantage of a sole proprietorship is that it does not separate your business and personal assets. Your personal assets may be accessible to creditors if you fail to pay your debts. As such, it exposes you to greater risks. With a sole proprietorship, you and the business are viewed as a single entity, which means your personal liability for all the liabilities and debts of the sole proprietorship is unlimited.
  • Difficulty in Securing Funding — As a sole proprietor, you will have to use your personal resources or seek out loans to fund your business. If you are a new entrepreneur, it may be difficult for you to get a line of credit or loan from a bank. Usually, you will have to provide a personal guarantee in order to secure a loan for your business.
  • State Franchise Tax — California requires a state filing, and it is required to pay the State Franchise Tax, which is a minimum of $800 per year, due at the end of the first quarter.
  • Reduction in Funding or Value — Because sole proprietorship business assets are accessible to claims of personal creditors, the value of the business may be reduced, or you may have difficulty raising capital.
  • Sole Proprietorships Can Cease to Exist — If you bring in additional investors or transfer any assets to another buyer, it will cause the sole proprietorship to end. You may find that there is a restriction on transferring licenses, contracts, or other business assets to another entity or buyer.

Pros and Cons of a California LLC

Pros

  • Personal Liability Protection — The main benefit of an LLC is that it separates its debts from your personal assets. If your LLC is sued, the plaintiff can only access the LLC's assets, not your personal assets, if he or she wins.
  • Pass-Through Taxation — Additionally, an LLC is also a pass-through entity, allowing allocated profits to flow through to its members' individual income tax returns. An LLC with partnership or S corporation classification may also have a pass-through tax structure.
  • Greater Availability of Funds and Resources — As a member of an LLC, you can bring in new members to fund the company. With more members, you will also have access to more resources and contacts.

Cons

  • More Formation Requirements — Starting a California LLC is more difficult as it requires you to register with the California Secretary of State. You are also required to draft and submit the Articles of Organization to the Secretary of State and pay a filing fee.
  • Assets are Reachable by Creditors — Although your personal assets are protected in a lawsuit if the LLC is sued, whatever assets you contributed to the LLC are available to judgment creditors, but at least the risk is usually capped.

How to Establish an LLC

In order to set up an LLC, you have to form and register the business with the applicable state agency, which is usually the Secretary of State's office. You need to draft and file your articles of organization and pay the applicable filing fee, which could be hundreds of dollars in some states. Your filing information typically includes information like:

  • LLC name
  • Owner or members names
  • Main office location
  • Intended term of the LLC
  • Any other information mandated by state

If you have two or more members in your LLC, it's recommended to speak with a skilled legal professional in order to draft a comprehensive operating agreement that includes important details like capital contributions, members' duties, and the rights to profits. Setting up an LLC takes more time, effort, and money versus a sole proprietorship, so factor that in when deciding on which business entity is right for you.

Review your investment potential, financial resources, and credit history to determine whether you can start a business as a sole proprietorship or if you will need more resources that bringing in other partners would provide. If you consider starting an LLC with other members, you can pool resources and money to increase your potential network reach and help you fund your new business.

You will need to determine how you want your LLC to be taxed. LLCs are considered a pass-through entity, which means profits are taxed on each member's individual tax returns. Federal income tax treatment is similar, which means this factor may not be as important when deciding between a sole proprietorship or LLC.

What Are Federal and State Taxes That Both LLCs and Sole Proprietorships Must Adhere To?

No matter what type of business entity you decide on, you will always need to pay federal tax and California state income tax on your business income. The IRS and the state both tax a single-member LLC in the same manner as a sole proprietorship. If you opt to hire employees and have to pay employment taxes or excise taxes, the LLC will be responsible for the payments, not the single owner. This is why it's recommended to apply for a Federal Employer Identification Number (EIN).

By forming an LLC, you have the option to have business income taxed like a traditional corporation. Without choosing the corporate election, all business income would be added to your personal returns whereas a corporation allows you to file a separate corporate tax return.

Other Types of Business Entities Available

There are several other types of business entities in addition to a sole proprietorship or LLC in California. One of these is a general partnership. This doesn't require any state filings and also offers pass-through taxation. Partners are jointly and severally liable for the partnership's debts, which means each partner is liable for the full debt until it's completely paid off.

Limited Partnership

Another business type is the limited partnership (LP), which has more formal requirements, including a filing with the California Secretary of State, a thorough partnership agreement, and the LP must hold annual meetings. Limited partners are typically just passive investors while general partners handle management duties. Limited partners' liability is typically limited to their investment amount while general partners have unlimited liability. Limited partnerships are also required to pay the California Franchise Tax.

Limited Liability Partnership

California also offers an LLP, or limited liability partnership. This is only available for certain professionals like architects, lawyers, or accountants. Each partner in an LLP shares in liability for partnership debts, but each one is protected from individual liability that arises from another partner's actions. If a partner engages in a wrongful activity like fraud, he or she will be personally liable for the misconduct.

C and S Corporations

C corporations are also subject to the State Franchise Tax and must file with the state. There is a lot more recordkeeping involved and all assets must be held separately. Shareholders have liability protection, but the limited liability is not ironclad. There are instances where someone may “pierce the corporate veil” which would open shareholders up to personal liability. Shareholders in an S corporation are ones who elect to be taxed as a pass-through entity. There are very specific requirements on what corporations qualify for S corporation status.

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