Ready to start a one-owner business? Well, one of the first things that you’ll need to decide upon is whether you should run your business as a sole proprietor or form a separate legal entity to own and run it.
By far, the most popular separate entity for one-owner businesses is the single member limited liability company, also known as SMLLC. But should you work as a sole proprietor or form an SMLLC? To come to the right answer, you have to weigh the pros and cons associated with both of these options and then decide which one would be most appropriate for your business and your aspirations.
Below is a guide to sole proprietorships and single-member LLCs in California. Bear in mind that, although we’ve made every effort to ensure this information is accurate and up-to-date, it doesn’t constitute legal advice, and you shouldn’t use it as a substitute for legal advice. It’s always recommended that you consult with your attorney for answers specific to your business.
What You Should Know About Sole Proprietorships
The default business form for a one-owner business is the sole proprietorship. Therefore, if you start your one-person business and you don’t bother forming a corporation or an LLC, you’ll automatically be a sole proprietor. Super simple!
Here are a few of the main things that you need to know about a sole proprietorship:
- Unlike an LLC or a corporation, a sole proprietorship isn’t a separate legal entity. The business owner, referred to as the proprietor, personally owns all of the assets of the business, and the owner is in sole charge of the business’s operations.
- To set up a sole proprietorship, you don’t have to do anything special or file any papers, other than the usual license, permit, and other regulatory requirements that California and your city or county impose on any business. As an example, you’ll probably need to get a business license form your city or county. Also, if you want to use a name other than your personal name to identify your business, you’ll need to file a fictitious business name statement in your county. And if you want to do so, you even have the option of creating a separate bank account for your business.
- Because it’s so easy and affordable to start and run a sole proprietorship, it’s the most common legal form of one-owner businesses. In fact, according to the U.S. Census Bureau, more than 86% of all single-owner businesses without employees are sole proprietorships. Wow!
Things to Consider Regarding Taxes for Sole Proprietors
When it comes to taxes, a sole proprietorship makes things simple. That’s because, as a sole proprietor, you and your business are considered one and the same for tax purposes.
Sole proprietorships don’t pay taxes or file tax returns. Instead, you report the income you earn and the losses you incur right on your own personal tax return (IRS Form 1040). So, if you earn a profit, the money is simply added to any other income you earn, such as interest income or your spouse’s income if you’re married and filing jointly. Then the total income from all sources is taxed at your personal income tax rate.
To show whether you have a profit or loss from your sole proprietorship, file IRS Schedule C, Profit or Loss from Business, along with your tax return. This form will list all of your business income and deductible expenses. Keep in mind that you’re entitled to deduct the same expenses as other types of businesses. Plus, you can even qualify for the new pass-through deduction that took effect in 2018, which means you can deduct up to 20% of your net business income from your income taxes. Nice!
There Is No Limited Liability for Sole Proprietors!
There are a lot of benefits that come with running your business as a sole proprietor, but one big drawback is the fact that sole proprietorships don’t provide owners with limited liability.
What does this mean? Well, as a sole proprietor, you’ll be personally liable for all debts and other liabilities incurred by your business. A business creditor can go after all of your assets, including your personal assets, when you owe them money. This means that your personal bank accounts, car, and even your house could be at risk.
On top of that, sole proprietors are personally liable for business-related lawsuits, such as in the case of someone injuring themselves in your office. You’d be personally sued for damages. Yikes!
But, wait, there is some good news here. If you still wish to operate as a sole proprietor, you can give yourself some extra protection from these liabilities by investing in the appropriate business insurance.
Types of Businesses That Do Well as Sole Proprietorships
Put simply, any one-owner business where the lack of limited liability isn’t a big deal is a great candidate for the sole proprietorship form of doing business. Beyond that, businesses that incur little to no debt will also work well as sole proprietorships.
Another advantage is the fact that sole proprietorships are so inexpensive. Therefore, this is a great choice for any business that expects to earn a low income, at least at first, such as a new small business or a side business. After all, if the business ends up being successful, you could always go through the process of converting it into an LLC or corporation later on.
Consider, too, that most sole proprietorships are small operations that don’t have employees. There’s no law that this needs to be the case, though, and some sole proprietors do own large companies that have employees. However, if you’re ever ready to hire employees, it’s best to form a business entity like an LLC or corporation so that the entity, rather than you, will be the one employing others. This can help you avoid being held personally liable for your employees’ actions.
Also, if you need to borrow a lot of money in order to get your business going, you might want to think about getting the limited liability status that comes with an LLC, which is discussed below.
What You Should Know About Single Member Limited Liability Companies (SMLLCs)
A single-member limited liability company, or SMLLC, is an LLC that’s owned by one person (LLC owners are referred to as members).
This is a great alternative to the sole proprietorship for anyone who’s starting or running a one-person business because it provides a few advantages.
Click here for our Freelancer’s complete guide to LLCs in California,
Advantages of SMLLCs
Limited Liability: When you form an SMLLC, you obtain limited liability (hence, the name “limited liability company”), and you’ll get the same limited liability as you’d get by forming a corporation. As the owner, you won’t be personally responsible for paying debts incurred by your business unless you personally guarantee to pay them. Only the LLC’s money and assets can be taken to pay debts, and your creditors won’t be able to touch your personal funds and assets. Also, because only SMLLC assets are used to pay off business debts, as the owner, you stand to lose only the money that you invested in your company.
Just bear in mind that owners of SMLLCs are often required to personally guarantee bank loans and other SMLLC debts, so the limited liability may turn out to be less than you’d like to have. Plus, it’s important to know that, even if you form an LLC, you remain personally responsible for your own wrongdoing, such as committing professional malpractice or fraud, so it’s wise to have adequate liability insurance in place.
Flexibility in Choosing How the SMLLC Will Be Taxed: The default form of taxation for an SMLLC is as a “disregarded entity.” This means the IRS will ignore your LLC and treat it the same as a sole proprietor for tax purposes. You’ll file a Schedule C to report income and expenses for the business, and any profits or losses are passed to your personal tax return.
But, with an SMLLC, you also have the option of having your business taxed as a regular C corporation or S corporation. This is accomplished easily by simply filing a document called an election with the IRS. After that, even though you formed an LLC, you’ll be treated the same as a corporation by the IRS and the California Franchise Tax Board. You’ll file the same tax forms as corporations and be subject to all the corporate tax rules.
Something to consider — you can save money by being taxed as a C corporation or S corporation. S corporation taxation, in particular, has become popular because it can enable an owner to save money on Social Security and Medicare taxes. That’s because you’ll work as your business’s employee, and your employee wages are subject to Social Security and Medicare taxes. As an alternative, you don’t have to distribute all of the profits your business earns as employee wages, and you can pay yourself dividends instead, which aren’t subject to Social Security and Medicare taxes. And your S corporation pays no tax at all on the money that it earns.
Another way to save some money is by choosing C corporation taxation. This is great for high-income earners. Unlike an S corporation, a C corporation is a separate taxpaying entity. It pays tax at the corporate tax rate on all profits. Because of the Tax Cuts and Jobs Act, the tax rate on corporate profits was lowered to 21% starting in 2018—a 14% reduction—and this 21% rate is lower than all but the two lowest individual income tax rates. However, when the SMLLC distributes profits to the owner, the money ends up being taxed twice: first, at the 21% rate and then at the owner’s capital gains tax rate, which can be 0% to 23.8%. At all but the two highest tax brackets, the combined tax is more than you’d pay for your profits if taxed as a sole proprietor or S corporation. Therefore, you generally need to have a minimum of $200,000-400,000 in profit to make C corporation taxation actually work in your favor.
Credibility: Some people might take your business more seriously if you’re operating as an LLC rather than as a sole proprietor. Going through the trouble of creating a formal business entity shows that you’re serious about having a real business, and when you form an LLC, you get to put the letters LLC (or some variant) after your business name so everyone will know.
Disadvantages of SMLLCs
Here are some of the disadvantages of SMLLCs:
More Costly to Form: It costs more to form an SMLLC, compared to a sole proprietorship, which costs next to nothing to form. When you form an LLC, it can cost up to a few hundred dollars because you’ll need to file articles of organization with the California Secretary of State, and you should also create an operating agreement. However, you can minimize these costs if you use a service like Hyke to get through the process and make sure it’s all done right. You can also see our article, Freelancer’s Guide to the Costs of an LLC in California, for more information.
Costlier to Maintain: Annual maintenance expenses should also be considered, as these will come into play once your SMLLC is up and running. As an example, if you hire a registered agent to accept court papers and other important documents on your LLC’s behalf, the annual cost is usually anywhere from $75 to $150. On the other hand, you don’t need a registered agent when you’re a sole proprietor. Check out our article, Freelancer’s Guide to LLC Maintenance in California.
Taxes: The biggest downside to SMLLCs in California is the annual LLC tax that the state imposes on these businesses. Every LLC registered to do business in California, and LLCs that have elected to be taxed as a corporation, must pay minimum $800 annual tax. This is the highest minimum LLC tax in the United States. No such taxes are imposed on sole proprietors, though, so if you opt to form an SMLLC instead of working as a sole proprietor, you’ll need to allocate at least $800 annually to pay this tax.
Is the SMLLC Form of Business Right for You?
In the end, an SMLLC can work just fine for any one-owner business. The only real downside is the cost (especially the $800 annual California LLC tax). Consider that it might not be worth it to pay the extra $800 annually if you’re running a small side business or a business that earns little to no profit. However, an LLC does come with limited liability, which is a huge plus, so you should form an SMLLC if you absolutely want and need that protection.
Whichever form of business you decide to pursue, keep in mind that your initial choice isn’t permanent. You could always start out as a sole proprietor and establish an SMLLC later on as your business grows.
If you choose to set up an LLC and file your new business with the State of California, we put together a list of 6 things you will need to do post LLC formation setup.
Feeling overwhelmed, get help!
No matter what, Hyke can help along the way. We can help you form and maintain your SMLLC so that you don’t miss any important documents or deadlines. Feel free to reach out if we can be of assistance.
Stephen has dedicated his career as an attorney and author to writing useful, authoritative and recognized guides on taxes and business law for small businesses, entrepreneurs, independent contractors, and freelancers. He is the author of over 20 books and hundreds of articles and has been quoted in The New York Times, Wall Street Journal, Chicago Tribune, and many other publications. Among his books are Deduct It! Lower Your Small Business Taxes, Working with Independent Contractors, and Working for Yourself: Law and Taxes for Independent Contractors, Freelancers & Consultants.