What Are Sole Proprietorships, Corporations, and LLCs?
Sole proprietorships, corporations, and LLCs are three different types of business structures. Each has its own list of pros and cons, and the best structure will depend on your business’s needs.
A sole proprietorship is a business that is owned by one person and is not registered with the state. This is an informal business structure that does not have any formation requirements.
Sole proprietorships experience pass-through taxation, which means that all of the business’s profits and losses “pass through” to its owner to be declared on their personal tax return. All of the sole proprietorship’s profits are taxed once at the individual tax rate.
While sole proprietorships are simple in structure, they do not provide any limited liability protection. If someone sues your business, your personal assets (e.g., your home, your car, etc.) are at risk. Sole proprietorships may also appear less credible because of their informal structure.
A corporation is a formal business structure that is legally separate from its owners, which consist of shareholders. . Corporations benefit from limited liability protection in the event that the company gets sued, meaning that owners won’t be held personally liable in the event of a company-related lawsuit or bankruptcy.
C corporations pay taxes on their profits; then they distribute the profits to shareholders, who then pay taxes on the dividends.This is commonly referred to as “double taxation,” and can be appealing to investors because C corp shareholders only have to pay taxes on the corporation’s profits if they receive a distribution.
Corporations can also elect to be taxed as an S corporation, which allows the corporation’s profits to “pass through” to the owners’ individual income tax returns without being taxed the corporate tax rate. Instead, shareholders report their share of the profits as salaries on their personal tax returns and pay personal income tax on that.
A downside of the corporate business structure is that it is a complex structure. Corporations require more paperwork, more overhead, and more compliance requirements (e.g., board of directors, bylaws, recordkeeping, annual meetings, etc.) than other formal business structures like LLCs.
An LLC is a type of business organization that is a hybrid between a corporation and a sole proprietorship. Like a corporation, LLCs provide limited liability protection to its owners. Unlike a corporation, LLCs are simple to form and simple to maintain. Instead of bylaws, a board of directors, and shareholders, LLCs have operating agreements, members, and/or managers.
Because of their hybrid structure, LLCs have the ability to customize their tax structures. By default, LLCs are taxed as and considered by the IRS as “disregarded entities” (i.e., sole proprietorships for single-member LLCs and partnerships for multi-member LLCs). This means that LLCs can benefit from pass-through taxation.
However, LLCs can also elect to be taxed as a C corp or an S corp. This may prove beneficial to single-member LLC owners that may find it harder to keep themselves separate from their company.
Single-Member LLC vs. Multi-Member LLC
A single-member LLC is one person who is the only owner of the LLC. A multi-member LLC has more than one person with ownership.
A single-member LLC is owned by one person, who has the right to manage the company. A single-member LLC is not recognized in all states.
A single-member LLC is not subject to the same rules as a multi-member LLC. A single-member LLC has one owner and does not have any managers.
A multi-member LLC is owned by more than one person and has at least one manager.
Why Does the Right Business Entity Matter?
Choosing your business structure is extremely important. From taxes to how the business is run, your structure is almost like a rule book.
If you need to change your business structure, don’t worry. You can always change business structures. However, it may be a bit more difficult. You may have to deal with a lot of paperwork or even hire a lawyer.
LLC vs. Sole Proprietorship
A sole proprietorship is a business owned and run by one person. The owner has the complete authority to manage the company as he or she sees fit, without any legal requirements for consultation with other stakeholders.
A limited liability company, on the other hand, is a business entity that can provide personal protection to its owners. This means according to the Internal Revenue Service (IRS) that an LLC's owners have limited liability for the debts of the company, provided that all of the company's members are also members of the LLC.
LLC vs. Corporation
Corporations and LLCs are both formal business structures that provide limited liability to their owners, making them good business structures for companies with higher risks.
However, corporations are complex entities that require more recordkeeping and oversight than LLCs do. The C corp tax structure may also be unappealing to small business owners due to the risk of double taxation.
LLCs, on the other hand, are relatively simple to form and maintain, and businesses can choose whether to be taxed as a corporation or not. However, the LLC structure may make finding outside investments difficult, as investors typically prefer the ease of working with C corporations.
Rest assured that no matter what business type you land on, you will be able to operate. However, if you are a one-man show or if you are freelancing, you may want to file a sole proprietorship. With this structure, you may not need to file a separate tax return, but these business owners are personally liable. However, if you have multiple people within your company, and you do not want that personal liability, an LLC may be your route.
Frequently Asked Questions
Is business income treated differently for a sole proprietorship vs. an LLC or corporation?
The only difference is the type of taxes that may be owed on the money. Sole proprietorships and LLCs must pay taxes on income at their individual tax rates, while corporations must pay taxes on income at the corporate level and then distribute profits to shareholders.
Can a sole proprietorship have multiple owners?
No. A sole proprietorship only has one owner.
What personal liability protection does an LLC have?
An LLC has a shield against personal liability known as the “corporate veil.”
The corporate veil protects members of an LLC from personal liability for business debts and obligations. That is, if the LLC gets sued, the owners’ personal assets (e.g., home, car, personal accounts, etc.) are not at risk.
However, LLCs must also work to maintain their personal liability protection in order to avoid “piercing” the corporate veil. Keeping personal and business finances separate as well as maintaining compliance will help protect the corporate veil.
What is the right business structure for a small business?
For most small business owners, we recommend starting an LLC. LLCs provide personal liability protection, which can protect its owners’ personal assets in the event that the business is sued, and they also provide a simple structure to form and maintain.
However, the best business structure ultimately depends on a business’s needs. Read our guide to choosing a business structure to learn more.
Can a sole proprietorship deduct business expenses?
Yes, a sole proprietorship can deduct business expenses, provided that they meet the IRS definition of “ordinary and necessary” business expenses. Sole proprietors can deduct these expenses on Schedule C of their individual Form 1040 return.