Occasionally we like to share some tips with our business partner, Law 4 Small Business. This week we wanted to share a quick Q&A with L4SB regarding choosing a business entity.
EMC: How would you define a Sole Proprietorship?
L4SB: “The sole proprietorship is what happens when an individual doesn’t create a business entity. It is historically the first method of doing business. An individual starts selling or trading goods or services and derives income (or loss) from that activity.” It requires no formal formation agreements and no governmental filings separate from those filed by the individual except as to some matters of taxation and employment.
While the simplicity of starting out as a sole proprietor is appealing, in the modern governmental and legal environment important areas of consideration should be addressed before making the choice to proceed in this manner.
EMC: What are some things to consider when deciding whether or not to form an LLC?
L4SB: Self-employed individuals, having no separately-recognized entity between themselves and third parties, are personally liable for every debt and obligation of the business and for their actions on behalf of the business and those of their employees. Unlike with some other forms of business, this liability is not limited to the amount of their investment in the business, absent some form of personal guaranty or voluntary assumption of liability. Thus, many business people elect to form a limited liability company or corporation in order to shield their personal assets from seizure to satisfy business obligations.
As with most things though, this decision is not as simple as it looks and professional advice would be prudent. The shelter seemingly provided by limited liability may be somewhat illusory. Many times, potential liability for negligence in the performance of services or for product deficiencies can be substantially reduced by affordable insurance coverage that would be advisable even for an LLC or corporation. In addition, creditors in the case of many operational liabilities such as leases, bank loans, credit cards or trade accounts will very likely demand personal guaranties or collateral anyway, especially in a startup scenario. Therefore, after all of the trouble of forming a limited liability company or corporation and maintaining the separate entity, many business owners find themselves liable for most of the company’s debts and obligations to virtually the same extent as in a sole proprietorship.
EMC: Do the tax implications differ with a Sole Proprietorship as opposed to an LLC?
L4SB: Unlike other entities, the sole proprietorship does not necessitate the filing of a separate income tax return for the entity. Income or loss from a sole proprietorship is reflected on Schedule C of the owner’s Form 1040 individual income tax return. However, the preparation of itself is comparable to the preparation of small business entity returns and will generally increase the cost or time required to prepare the individual return.
One tax advantage of a sole proprietor is that any losses incurred in the business are personally deductible in the year incurred. Thus, making some reasoned, well-informed predictions as to the level of success of the business over the first few years is often an important part of planning.
A tax dis-advantage is that the self-employed individual must pay both the social security and medicare portions. Moreover, since self-employed individuals do not have an employer to withhold FICA taxes, they must compute and pay Self-Employment tax when filing their individual tax returns.
There are no tax-free fringe benefits available to the self-employed individual, since he or she is the owner of the business and not an employee of the business. The types of retirement accounts available to a sole proprietor are also limited to those available to individuals. Payments to these are not deductible and they carry different restrictions and limitations in some respects to those available in a separate business entity.
EMC: What advice would you give to business owners who are considering which business entity to choose?
L4SB: Seeking professional advice would be prudent! Contact L4SB at (888) 992-4952 to help you get started!