What’s the Difference Between a Sole Proprietorship and a Formal Business Structure?

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

1. Liability

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.

2. Taxes

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.

3. Structure

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.

4. Formalities

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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Nellie Akalp

CEO of Corpnet.com at Corpnet
Nellie Akalp is a serial entrepreneur and small business expert. She currently serves as the CEO ofCORPNET.COM, an online legal document filing service, where she helps entrepreneurs START A BUSINESS, INCORPORATE, FORM AN LLC, and offers free BUSINESS COMPLIANCE TOOLS.
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3 Comments

  1. Amyli McDaniel

    Another common misperception new entrepreneurs believe is that as long as their business is small and not making a lot of money, then they are not subject to any real liability. This belief is wrong. I had a friend who started a small marketing freelance business out of her home as a way to supplement income for her family. She signed a small contract (less than $1,000) and ended up being served lawsuit papers from that client for over $20,000 in liability. It is really important to protect yourself and your family when starting a business with important risk planning- and creating a limited liability company vehicle like an LLC or corporation is part of that planning. Insurance is another vehicle to look into.

    Amyli McDaniel
    Founder, ParentEntrepreneurs.com

    Reply
    • Heather Allard

      Great point, Amyli! Thank you for sharing! 🙂

      Reply
  2. Amanda Sue

    I’m temporarily a sole proprietor while I’m getting my site/biz up & running. As soon as I’m able to do so, I plan to become an LLC. It’s out of my budget at the moment, but as quickly as human possible, I want that corrected…if for no other reason than because we live in a highly litigious society. If someone can sue for coffee being hot…no one is safe. lol

    Reply

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