A sole proprietorship vs. single-member LLC refers to the difference between those two corporate structures. As with all business structures, there are advantages and disadvantages to both. The main distinction between the two is that a sole proprietorship and the owner are one and the same, while a single-member LLC provides a divide between the two in both legal and tax matters.

Single-Member Limited Liability Company

A single-member limited liability company (SMLLC) is considered an alternative to sole proprietorship for small businesses. Small businesses often default into sole proprietorships because they fail to register with the state. An SMLLC is exactly the same as a limited liability company (LLC) except that it is designated as only having one member.

The separation between an SMLLC and its owner gives the owner personal protection from the liability of the company from obligations, debts, acts, and taxes of the company. The SMLLC can be taxed as a corporation or as a disregarded entity. A disregarded entity designation flows the income to the owner directly. The owner then pays tax on the income the same way the owner would pay any income tax.

The owner of an SMLLC is self-employed as far as the government is concerned. Income that flows to the owner of an SMLLC is considered a distribution rather than a salary or wage. Self-Employment tax is the tax levied equal to Medicare tax and FICA, and the owner of an SMLLC is subject to it.

Advantages and Disadvantages of LLCs and SMLLCs

There are a number of advantages with LLCs and SMLLCs:

  • Pass through taxation for SMLLCs where profits are passed along to its members who are then responsible for reporting the income on their personal tax returns.
  • SMLLCs do not pay federal business tax, and there is no business tax in most states.
  • LLCs are more informal when compared to a corporation that has to designate a board of directors and shareholders who are legally responsible.

There is also a potential downside with LLCs due to its less formal status. It can be harder to obtain credit, raise capital, and determine the value of the LLC business when compared to a corporation. A bank is likely to look at how the business is structured and the method for distributing profits and contributions to the owners. With a corporation, the risk is spread out among shareholders which could lead the bank to determine a corporation is less risky versus a single owner LLC.

Where Should You Form an LLC?

If you determine you want an LLC, you also have to decide what state will be the home base for your business. For most people, this is a fairly easy decision as they want the company registered where they are doing business. Other people prefer to file in a different state, like Delaware, even if they are not based there. Delaware is the state of choice for many investors. While the process is a little more expensive as you need someone to act as your local registered agent, it can be an important choice if you plan to raise capital for your business. It's also important to point out if you form your LLC in one state and plan to do business in another state, you will need to register in other ones where you do business, which will increase your startup costs.

Sole Proprietorship

A sole proprietorship has only one individual that owns all assets and liabilities of the business.

The business does not own assets in the corporate structure because they are all considered the property of the owner of the sole proprietorship. In a sole proprietorship, no documents need to be filed.

The only requirement is to comply with taxation laws at the federal, state and local levels. Of course, this makes them the easiest business type to form.

If the owner is disabled, retires, or dies it terminates the sole proprietorship. Continuation of the business by another individual requires a new sole proprietorship. There are no annual reporting requirements for a sole proprietorship. Due to its ease of formation, the sole proprietorship is very popular.

Advantages and Disadvantages of Sole Proprietorships

Like the LLC or SMLLC, sole proprietorships have their own advantages and disadvantages as well.

  • It is considered one of the easiest and least costly business types thanks to an absence of filing fees and need for formal agreements.
  • Sole proprietorships are popular for people who want to be their own boss.
  • A potential disadvantage is that courts have ruled that doing business under another name does not qualify as creating a separate and distinct legal entity from the owner.
  • Insurance coverage might be pricey for sole proprietors.
  • Sole proprietorships do not have access to venture capital.
  • Sole proprietorships can be limited in scope and their lifetime, which means they end if the business is discontinued or the owner passes away.

Comparison

There are advantages and disadvantages to each structure. While a sole proprietorship is considered less complex, less demanding and has fewer requirements than an LLC, it doesn't provide the types of protections that an SMLLC provides to the owner.

  • Sole proprietors file only their personal income taxes which are taxed at their income level. SMLLCs are taxed at a corporate rate after all of their business deductions and losses.
  • In a sole proprietorship, every liability is the responsibility of the owner. This is not the case in an SMLLC where the member is shielded from liability.
  • All of the assets of a sole proprietor are all subject to the legal and business claims of customers and creditors. While the assets of an SMLLC member are generally protected, with some exceptions.
  • Raising capital is one difficulty for a sole proprietor. The only option for an infusion of capital is a small business administration loan for the sole proprietor. The SMLLC can take investments by allowing new members into the LLC.
  • Tax consequences for each corporate structure are important. Sole proprietors who don't make a lot of income may suffer if their household income pushes them into a higher tax bracket. That is not the case for SMLLC which pays the corporate tax rate.

What Is the Extent of Liability Protection for SMLLC Owners?

The SMLLC is a separate entity from the owner, which differs from a sole proprietorship where the owner and business are considered one in the same. If an owner of an SMLLC makes any personal guarantees or pledges to financial institutions in an attempt to guarantee financing, a loan, or other credit, the owner will be liable. An SMLLC owner will also be liable for all negligent or deliberate personal torts.

It's important to keep all SMLLC documents, like purchase orders, bids, checks, and contracts with the business name and “LLC” on them. If an owner signs a contract and it's not clear he or she is acting on behalf of the SMLLC, the owner can be held personally liable. It should be clearly noted on any signature line that the owner is an authorized signer and is entering the agreement on behalf of the SMLLC rather than in a personal capacity.

Higher Loss Basis

Prior to the existence of the LLC business entity, owners who wanted to avoid personal liability issues with a sole proprietorship would need to create an S corporation. S corporations are not always ideal since they limit the basis of the company to losses. This means losses can only be deducted up to the cash and personal loans owners made to the company. Bank loans are not considered to be a portion of the company's basis. Now, the LLC provides the full tax basis advantage of the sole proprietorship along with the S corporation's desirable limited liability protections.

Frequently Asked Questions Regarding Taxes and SMLLCs

Q: Can an SMLLC owner deduct business or trade expenses on his or her personal income tax returns?

A: Per treasury regulations, an owner of an SMLLC would be treated like a sole proprietor and he or she can deduct business or trade expenses, including the LLC's portion of employment taxes for any activities that are carried on behalf of or through the SMLLC. The owner would report these on Form 1040, Schedule C, E, or F, which will depend on what the nature of the business is. Since the owner is a self-employed taxpayer, he or she can also deduct health insurance costs for the owner, his or her spouse, and their dependents.

Q: Do SMLLCs have to file an IRS election to be taxed as a disregarded entity?

A: No, only SMLLCs that want to be taxed as a corporation are required to make the election and file Form 8832. Regulations state that an eligible entity, like the SMLLC, would be treated as a disregarded as an entity separate from its owner if there is a single owner, provided they don't file any election.

Q: Are you required to have a Federal Tax Identification Number (TIN) as an SMLLC?

A: No, if the SMLLC doesn't have any employees, the business owner can use his or her social security number rather than obtain a different tax identification number. If the SMLLC has employees, then it will need to apply for a tax identification number in order to make employment and FICA payments, as well as to file quarterly and annual tax returns for its employees.

Q: Can an LLC with only spouses as owner-members be classified as an SMLLC?

A: If an LLC is only made up of a husband and wife, it can be an SMLLC if the owners elect to be taxed as a disregarded entity, and the LLC is titled as community property under state law, along with several other factors. There is a section of the Internal Revenue Code that allows for a husband and wife who have an unincorporated owned “qualified joint venture” to decide not to be taxed as a partnership and opt for each spouse's respective income to be taxed if it was sole proprietorship income. However, the website also states that a business owned and operated as an LLC by the husband and wife does not qualify.

It is always best to get the advice of legal and accounting professionals when making decisions about the structure of your company. Your circumstances should be taken into account, for example, your household income per year.

Other considerations can be your comfort with the personal liability involved in having a sole proprietorship. Reporting tolerance is also something to consider. SMLLCs are required to report annually and taxes must be filed more often than with a sole proprietorship. Qualified and experienced legal counsel can walk you through all of these decisions.

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