Think fast. Do you know the key differences between being a sole proprietor and having a formal business structure?
Do you know what business structure you have for your business? If not, chances are your business is a sole proprietorship.
If you don’t actively choose a business structure (i.e. form an LLC or incorporate), then by default your business is structured as either a sole proprietorship (single owner) or partnership (multiple owners). A lot of small businesses get their start as one of these structures before ultimately transitioning to a more formal entity like an LLC or corporation.
If you’re not sure about the differences between a sole proprietorship and a formal business structure, here are some of the key things to know.
Sole Proprietorship vs. Formal Business Structure
When you’re operating your business as a sole proprietor, there’s no separation between your business and you.
This means that if you’re sued as a sole proprietor, you are sued personally, putting all your personal assets at risk.
Once your business is incorporated (whether you form an LLC or Corporation), it now exists as its own business entity. As a result, the corporation or LLC is responsible for any of its debts and liabilities. This is often called the “corporate shield” as it protects the owner’s personal assets from the business.
Sole proprietorships are known as ‘pass-through’ entities. That’s because a sole proprietorship doesn’t file business taxes with the IRS; instead, you report your business profits and losses on your personal income tax return.
When you form a corporation, your business must file its own tax return (this often can result in “double taxation” where your business first pays taxes on its profits, and then you need to pay taxes on any distributions you receive personally).
There are two business structures that allow you to “pass-through” your business taxes to your personal return. Both the LLC and S Corporation are taxed similarly to a sole proprietorship; they don’t file their own tax return; all profits and losses are passed to your personal tax return. But unlike the sole proprietorship, both the LLC and S Corporation can shield you from personal liability.
A corporation (C Corp and S Corp) has a formal structure consisting of shareholders, directors, officers and employees.
Every corporation must select at least one person to serve on its board of directors and officers are required to manage the day-to-day activities of the company. Corporations need to vote on important company issues.
By contrast, a sole proprietorship has an informal structure that doesn’t require officers or a board of directors. You have full control over every aspect of your business. Note that the LLC offers a middle ground between the two: with an LLC, you just need to create an informal operating agreement; you don’t need to have a board of directors or shareholders.
LLCs and sole proprietorships have a lot less paperwork and fewer ongoing administrative formalities to follow than a corporation.
For example, a corporation must hold at least one annual meeting and keep strict financial records, including records on how a company reached certain important decisions. Sole proprietorships don’t need to file or keep any records (other than what’s required for tax purposes). An LLC just needs to file an annual report (a simple form that takes just minutes to complete).
How to form
There are no documents to file to begin a sole proprietorship; a sole proprietorship automatically begins as soon as you decide to go into business.
To form a corporation or LLC, you’ll need to file a certificate of formation (or articles of incorporation) in your state.
While there’s a small fee (paid to the state) that accompanies the filing, the act of incorporation or LLC formation won’t break the bank, particularly if you use an online legal filing service or file the forms yourself. Unless your business is particularly complex or you’re dealing with millions of dollars upfront, you should be able to incorporate or form an LLC for your business online without needing to hire an attorney.
Are you a sole proprietor or do you have a formal business structure?
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