Here, we teach people how to build business credit. And, establishing your entity is a super important step in the process — early on, the two most common choices are sole proprietor or LLC.
If you’re running a business as a sole proprietor, and considering an upgrade to LLC, you might already know that you can get some business credit even without registering as an LLC or corporation…But if you’re looking to take your business to the next level and secure larger no-doc business lines of credit (think 25k, 50k, 100k), you might find it challenging without a registered corporate entity.
Banks and lenders tend to prefer working with LLCs or corporations because they offer more protection and credibility. So, I highly recommend considering forming an LLC over a sole proprietorship if you’re serious about obtaining substantial business credit.
Don’t get me wrong — you can still apply for business credit cards as a sole proprietor. But, a registered LLC or corporation can make it easier to secure other types of financing and help you build a stronger credit profile for your business.
In this article, we’ll dive deeper into the differences between sole proprietorship and LLC, and explore their pros and cons, especially when it comes to business credit and financing options.
Here’s what we’ll cover:
- Are You Sure You Only Want to Look at Two Options?
- Sole Proprietorship vs Single-Member LLC
- Here’s How Sole Proprietorships & LLCs Pay Taxes
- How to Choose Between a Sole Proprietorship and an LLC
- How to Register Your Business
- Frequently Asked Questions
- Conclusion: Which Structure is Best for You?
Now, let’s get going!
Are You Sure You Only Want to Look at Two Options?
Before we get too deep into the pros and cons of LLCs vs sole proprietorships, let’s take a quick look at some more entity types — I want to cover it all and give you everything you need to know. After all, it’s crucial to choose the right structure for your needs.
A sole proprietorship is the simplest type of business structure and is owned by one person. The owner has complete control over the business and is personally liable for its debts and legal issues. Sole proprietorships are not taxed as separate entities from the owner, meaning that the owner reports the business income on their individual tax returns.
Limited Liability Company (LLC)
A limited liability company (LLC) is a type of business entity that gives the owners (“members”) “limited liability protection.” This is a swanky way to say that the member’s personal assets are separate from the company’s assets, and their personal liability is limited to the amount of money they’ve invested in the company.
LLCs can have one (“single-member”) or more (“multi-member”) members, and they can be taxed as either a sole proprietorship, partnership, S corporation, or C corporation, depending on how the members choose to be taxed.
An S corporation is another type of entity that you may want to consider — it’s a type of corporation that is taxed differently than a traditional corporation (C corporation). An S corporation’s profits and losses are “passed through” to its shareholders, who report the income on their individual tax returns.
This means that S corporations avoid double taxation. To qualify as an S corporation, a business must meet certain requirements set by the IRS.
Next, you have a C corporation — a traditional corporation that is taxed as a separate entity from its owners (“shareholders”); this means that the corporation pays taxes on its profits, and the shareholders pay taxes on the dividends they receive from the corporation.
C corporations offer limited liability protection for their shareholders, but they are subject to double taxation.
At this stage, it’s also important to look at the two types of partnerships:
General partnerships are a type of business entity where two or more people share the management and ownership and management of the company. The partners share the profits and losses of the business and are personally liable for any debts or legal issues that the business incurs.
A general partnership is typically not taxed as a separate entity from the partners, meaning that the partners report the business income on their individual tax returns.
Limited partnerships are similar to general partnerships but with two types of partners: general and limited partners. General partners have control over the day-to-day business operations and are personally liable for any business debts and legal issues. Limited partners, on the other hand, have limited liability and are not involved in the management of the business.
Limited partnerships are typically taxed as pass-through entities.
Sole Proprietorship vs Single-Member LLC
A single-member LLC is not the same as a sole proprietorship. In terms of liability protection, taxation, ease of formation and maintenance, and flexibility in management, there are considerable differences between sole proprietorships and limited liability companies (LLCs):
First of all, sole proprietorships provide no liability protection for their owners — basically, he owner’s personal assets are at risk if the business is sued or incurs debt. In contrast, LLCs offer “limited liability protection” to their owners (their personal assets are generally protected from the company’s debts and legal judgments).
Next, sole proprietorships are typically taxed as pass-through entities, which means that the business’s profits and losses are reported on the owner’s personal tax return. LLCs can also be taxed as pass-through entities, but they provide the option to be taxed as a corporation (this can be advantageous for LLCs that want to cash in on lower corporate tax rates or retain earnings in the business without paying personal income taxes on them).
And, sole proprietorships are the easiest and cheapest business entities to set up…in most states, they require no formal paperwork or registration. Now, while LLCs require more paperwork and filing fees to establish, they offer formal structure and protection. Both types of businesses require ongoing maintenance, such as keeping accurate financial records and filing tax returns, but LLCs typically have more stringent compliance requirements.
Finally, sole proprietors have complete control over the management of their businesses…but (big but), this also means that they have full responsibility for all aspects of the business. LLCs are more flexible in terms of management structure — they can be managed either by the members or by outside “managers.” LLCs can also have varying degrees of ownership and voting rights among members, which allows for more customized ownership structures.
While both sole proprietorships and LLCs offer benefits and drawbacks, LLCs typically offer more liability protection, tax flexibility, and management structure options, but require more paperwork and ongoing maintenance.
Here’s How Sole Proprietorships & LLCs Pay Taxes
Sole proprietors report their business income and expenses on their personal tax returns using Schedule C (Form 1040). The net income from the business is then subject to self-employment taxes, which include Social Security and Medicare taxes. Self-employment taxes are calculated on Schedule SE (Form 1040) and are owed in addition to income tax.
→ Sole proprietors are also responsible for paying estimated taxes quarterly throughout the year.
LLCs have more flexibility in how they pay taxes — by default, single-member LLCs are taxed as sole proprietorships and report their business income and expenses on the same Schedule C as a sole proprietor (Form 1040).
Multi-member LLCs are taxed as partnerships and file Form 1065 to report their business income and expenses annually. But, LLCs can also choose to be taxed as S corporations or C corporations by filing Form 8832 or Form 2553, respectively.
Comparison of Tax Rates & Deductions
Sole proprietors and LLCs taxed as sole proprietorships pay income tax at their individual tax rates, which range from 10% to 37% depending on their taxable income. They are also subject to self-employment tax, which is currently 15.3%.
LLCs taxed as partnerships, S corporations, or C corporations are not subject to self-employment tax — Instead, the owners or shareholders pay income tax only on their share of the profits.
Both LLCs and sole proprietors can deduct typical business expenses, such as rent, supplies, and equipment, to reduce their taxable income.
Can an LLC Be Used to Reduce Taxes?
You can use an LLC to reduce taxes in a couple of ways:
- Elect to be taxed as an S corporation — this allows the owners to pay themselves a reasonable salary and take the remaining profits as distributions. This can reduce self-employment tax, as only the salary is subject to Social Security and Medicare taxes.
- Take advantage of deductions and credits — LLCs can deduct business expenses, such as rent, supplies, and equipment, as well as contributions to retirement plans and health insurance premiums. They may also be eligible for tax credits, such as the Research Tax Credit or the Small Business Health Care Tax Credit.
Note that sole proprietorships are eligible for many of the same write-offs and credits as LLCs. So, how can you choose between them?
How to Choose Between a Sole Proprietorship and an LLC
Here are some factors to consider when deciding whether to choose a sole proprietorship or an LLC:
- Simple to set up and maintain — A sole proprietorship requires minimal paperwork and legal formalities, making it easy and affordable to start and operate.
- Complete control — As a sole proprietor, you have complete control over your business decisions and operations.
- Tax benefits — As a sole proprietor, you report your business income and expenses on your personal tax return, which can simplify tax preparation and potentially lower your tax burden.
Limited Liability Company (LLC):
- Limited liability protection — An LLC provides limited liability protection to its owners, meaning that the owners are not personally responsible for the company’s debts and liabilities.
- Credibility and professionalism — An LLC is often seen as a more credible and professional business entity than a sole proprietorship, which can be an advantage when dealing with customers, vendors, and investors.
- Flexibility in taxation — LLCs have the option to be taxed as a partnership, an S corporation, or a C corporation, providing flexibility in tax planning and potentially reducing overall tax liability.
In general, if you’re a small business owner with low risk and relatively simple operations, a sole proprietorship can be a decent choice. However, if you are concerned about personal liability or are looking to grow your business and establish credibility, an LLC may be a better option. It’s always a good idea to consult with a lawyer or accountant to determine the best business structure for your specific needs and circumstances.
With that said, I know that you can get business credit with a sole prop but you can get serious no-doc business lines of credit (25k, 50k, 100k) without a real entity. so I recommend getting an LLC. You can get business credit cards but banks want to see an LLC or corporation to extend business lines of credit.
How to Register Your Business
Here are the basic steps to file the necessary paperwork for forming an LLC and registering as a sole proprietor.
Of course! Here are some more conversational explanations of the steps to form an LLC and register as a sole proprietor:
How to form an LLC:
- Pick a name for your LLC that’s not already taken in your state and meets your state’s requirements.
- File an Articles of Organization form with your state’s Secretary of State office. This form typically asks for basic information about your LLC, like its name, address, and the name and address of your registered agent.
- Draft an operating agreement for your LLC. This outlines how your LLC is run and who owns it. Some states don’t require an operating agreement, but it’s still a good idea to have one.
- Get any necessary licenses and permits for your business. Depending on where you live and what you do, you might need specific licenses or permits to operate your LLC.
- Apply for an EIN from the IRS if you plan on hiring employees or opening a bank account for your LLC.
How to register as a sole proprietor:
- Decide on a name for your business, whether it’s your own name or something else.
- Get any licenses or permits you need to legally run your business in your area.
- File a “Doing Business As” (DBA) form with your state’s business registration office to register your business name.
- Apply for an EIN from the IRS if you plan on hiring employees or opening a business bank account.
Remember, the specific rules and requirements for forming an LLC or registering as a sole proprietor vary by state and local municipality, so be sure to do your research and follow the guidelines for your location. For example, in Oregon, you can legally run a business after filing an “Assumed Business Name” alone, but may still need local business licenses.
Frequently Asked Questions
What are the disadvantages of an LLC vs a sole proprietorship?
LLCs can be more costly and require more paperwork than sole proprietorships, but they offer greater personal liability protection. Sole proprietorships are generally easier and cheaper to set up, but leave you personally responsible for any business debts or legal issues.
What is more risky, a sole proprietorship or an LLC? Why?
A sole proprietorship is generally riskier than an LLC, as sole proprietors are personally liable for any business debts or legal issues. Forming an LLC can offer greater personal liability protection, which can help shield the owner’s personal assets from business-related risks.
How do business owners pay themselves?
Business owners can pay themselves in different ways, including salary, dividends, or draws/distributions from business profits, depending on the business structure and personal financial needs. And, some companies pay the owner’s salary with a business credit card. It’s important to consult with a financial advisor or accountant to ensure compliance with legal and tax requirements.
Conclusion: Which Structure is Best for You?
Whether you should choose a sole proprietorship or an LLC is based on a number of factors. Do you want more ease or more protection? Do you have specific tax needs? By now, you should have an idea which is best for your operations.
However, if you want substantial lines of business credit, there is a clear choice: form an LLC…You can certainly obtain business credit cards as a sole proprietor, but to get those larger lines of credit in the tens and hundreds of thousands range, most banks will want to see a more formal business entity like an LLC or corporation.
To learn how to obtain up to $100K in business credit in as little as 30 days, join Business Credit Workshop today.