You’ve come up with a great business idea, but now you have to execute it. One of the first dilemmas an entrepreneur will face is what type of business entity to create. For a small business owner, three of the most popular options are a sole proprietorship, an S corporation (S corp) or a limited liability company (LLC).
While each has its merits, only one is a perfect fit for you. See our breakdown below for some of the pros and cons of each.
Quick, easy and cheap, a sole proprietorship is the default business entity for single owners. As such, it requires little to no formal legal documentation. In fact, unless you have a storefront that calls for local licensing, you’re generally considered a sole proprietor the minute you make your first transaction. Business expenses can be deducted from your personal income because in the eyes of the law, you’re one entity. Best of all, you retain complete control both operationally and financially – no need to check with a board or partners!
The downside is that you also retain complete liability. As a single entity, you and your business face legal and financial issues together. Should the business be fined, sued or go belly up, your private accounts are fair game for banks and creditors. Even the illegal actions of an employee could cost you personally should the company be prosecuted.
Owners or “members” of a limited liability corporation enjoy a lot of flexibility with structure and taxation, making it a favorite among small businesses. LLC members can choose to be taxed on both the personal and corporate levels like a standard C corp, or they can opt for the same pass-through benefits found in a partnership. They can also apply varying levels of control and profit to each of their members or decide to treat all members equally. Some LLCs don’t even have multiple members and are instead one-man operations. Regardless of the numerous variables, all LLCs do have one thing in common – limited liability. The personal assets of LLC members are separate and protected from all business dealings…as long as they follow the rules.
As mentioned above, the “LL” part of “LLC” is contingent upon all members following certain legal restrictions. For example, LLC members cannot use personal funds to address business expenses. Violating such rules AKA “piercing the corporate veil” opens the door for a judge to set aside your limited liability and hold you personally liable for the LLC’s actions. Some other downsides to running an LLC include filing fees, self-employment taxes, annual paperwork and difficulty raising capital. Investors are often turned off by the flexibility of an LLC’s management structure. Different members receiving varying degrees of control and profit is complex and sometimes unsustainable. Also, since an LLC cannot issue stock, investors would need to buy in as full members. Many investors don’t want to muddy their personal taxes by becoming members of a pass-through entity.
There are a lot of similarities between S corps and LLC’s, especially since an LLC can opt to be taxed the same way. Like LLCs, S corps feature limited liability. Pass-through taxation is also available with S corps, however, an S corp’s self-employment taxes are handled differently. Where an LLC member’s self-employment taxes are based on the full company income, S corps allow owners to file based only on their own salary. Another benefit is that S corps can issue stock. Even better, the stock is freely transferrable, which makes it more appealing to potential investors.
Of course with the ability to issue stock comes the need for government regulation. From annual shareholder meetings to keeping corporate minutes, S corps have stricter standards for maintenance than LLCs or sole proprietorships. They are also less flexible in terms of management, so if you’re looking for a less cut-and-dry structure, the S corp is not for you. Ownership rights, financial gains/losses and tax burdens are all directly correlated to the percentage of the corporation held by each owner, and even stock options are limited to one class. Finally, although an S corp faces no limit to the size of its managerial team, it can have no more than 100 total shareholders which limits your fundraising abilities.