Choosing the right business structure will have a huge impact on the financial health of your business.
While the wrong structure could leave you vulnerable to lawsuits or leave you with a large tax debt—the right structure will protect your assets and ensure steady growth.
For small business owners, the choice between an LLC, LLP, or sole proprietorship can be confusing at best. To help you out, we’ve created an easy-to-digest comparison of the three major types of small business structures, how they affect your tax liability, and the pros and cons of each type.
What is a sole proprietorship?
A sole proprietorship means that you are an individual, independent contractor who is in business for and with yourself; the term “solopreneur” perfectly embodies this business structure. Sole proprietorships are the most popular business structure in the United States.
What are the advantages of a sole proprietorship?
A sole proprietorship is easy to form and cost-effective. This business structure allows you to hit the ground running—all you need to start your business is, well, some business! When your first customer makes that first purchase, a sole proprietorship is born. As long as you have any required certifications and licenses for your particular industry, you don’t even have to make any special tax considerations for your business until it’s time to file.
What are the disadvantages of a sole proprietorship?
As a sole proprietorship, all of the costs and risks associated with your business are yours, and yours alone. Since you and your business are one entity, you are personally liable for any and all debts or legal action brought against your company, and your personal assets, such as your car, house, and bank accounts, are at risk.
LLC: Limited liability corporation
What is a LLC?
A Limited Liability Corporation (sometimes called a Limited Liability Company) is a business structure that can be formed by an individual or multiple people. Unlike a sole proprietorship, an LLC differentiates between the individual and the business, offering personal protection from business liabilities.
What are the advantages of a LLC?
In most states, LLCs can be formed by any professional or group looking to do business together. This means you can work with other people and pool your resources to start a business. Under an LLC, your personal assets, such as your savings and your house, are usually protected if the company is sued. It may also be easier for startups to raise capital as an LLC.
What are the disadvantages of a LLC?
LLCs are expensive and time-consuming to start compared to sole proprietorships, and require a lot more paperwork upfront. Members of an LLC may not be held personally liable for company debts, but they can be held liable for mistakes made by another member of the LLC. For instance, if one business owner defaults on a loan made to the LLC, all parties can be held responsible. Also, if an LLC is formed as an S or C corporation, it can be taxed twice on the same profits by the IRS.
How to pay yourself from an LLC
When you run an LLC (Limited Liability Company), getting paid is not straightforward compared to if you own a sole proprietorship. Additionally, you’ll need to earn a significant wage if you work for your business. Follow these simple steps below to get paid and ensure you obey all IRS requirements for tax filing.
Step 1. Determine the status of your business—a sole proprietorship, partnership, or corporation.
Your LLC can file taxes as a business entity, which can help you save on tax payments. The IRS will consider it a sole proprietorship, partnership, or corporation, depending on the format you choose when filing your taxes.
Step 2. Get paid by setting up an owner’s draw for your LLC.
To have an owner’s draw, first, write a check from your business account for the amount you are withdrawing from your business and then place this check in your bank account. Secondly, document the withdrawal as a reduction in your owner’s equity account. Credits from the owner’s equity or capital account are given to you.
Step 3. Make sure you pay the correct amount of taxes for your income.
As a sole proprietor, the IRS requests that you pay income tax on all of your money, whether or not you ever use that money. Even if you don’t take your profits (money you make from your business), you still have to pay taxes. You also have to pay taxes on your income from self-employment. When you work for someone else, your employer pays part of your Social Security and Medicare contributions. When you’re self-employed, you still have to pay your share of these taxes. The self-employment tax rate is 15.3% of your income.
LLP: Limited liability partnership
What is a LLP?
A Limited Liability Partnership is similar to an LLC, but offers slightly different tax implications. In many states, LLPs can only be formed by licensed individuals like lawyers, architects, and doctors.
What are the advantages of a LLP?
Unlike some LLCs, which may be double-taxed by the IRS, LLPs are treated as partnerships and offer ‘pass through taxation. This means that partners in the LLP are only taxed once on their personal income taxes. Another big advantage of forming an LLP is that partners are protected from one another, in that they’re not liable for the other’s mistakes. If one partner behaves badly and the LLP gets sued, the other partner can’t be held personally responsible for their actions.
What are the disadvantages of a LLP?
This business entity is not available to everyone, and is restricted to licensed professionals only in many states. Other concerns include the following:
- It’s not possible for an LLP to file taxes in an S corporation category.
- Tax and business-related filing are more challenging than that of an LLC.
- There must be a managing partner for an LLP. And other partners are required to assist in the business operations.
The business structure you choose should take into consideration your industry, budget, assets, and business goals. Consider consulting a tax professional to see which structure is the best bet for your business.
Frequently asked questions
A husband and wife can act as LLP partners. However, a special tax liability agreement must be set up to reduce family tax liability. If spouses share in the profits and losses of their business, this is called being a partner. Even without a formal partnership agreement, their involvement in the business is still considered a partnership. If they have income or loss from a business, the couple should report the loss on Form 1065 instead of Schedule C (Form 1040). On the other hand, the couple is not required to submit their joint business as a partnership by turning in a qualified joint venture election.
An LLP is a type of business organization that is made up of partnership owners, while an LLC is made up of individual members. One of the most crucial differences between limited liability companies (LLCs) and limited liability partnerships (LLPs) is how each organization is identified. Limited liability protects the owners of an LLC from personal liability for business debts. This means that, as long as the owners have contributed money to the business, they are not responsible for any financial losses that occur as a result of the business. The owners of the LLC are also not personally liable for the negligence or misconduct of their co-owners. But LLC partners have to be responsible for their due diligence and behaviors. Some states offer the same liability protection to LLCs as to LLP’s. In some states, partners are only liable for their own negligence, while in others they are fully responsible for business obligations. Some states request LLPs to assign a general partner who is entirely accountable for the LLC’s debts and obligations, while the other partners have limited liability.
Your business framework will significantly determine how much you will need to invest in the business. A sole proprietorship is an option if you plan to be the sole owner. To establish a business partnership with someone else, you must set up your business under the LLP—as a partnership structure.
Bonus infographic on LLP vs. LLC vs. sole proprietorship
Originally published on January 5, 2016. Updated on August 26, 2022.
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