Ready to start your business all on your own? Well, one of the first things that you need to decide is whether you should run your business as a sole proprietor or form a separate legal entity.
By far, the most popular separate entity for one-owner businesses is the single member limited liability company, also known as a single member LLC, or SMLLC. But should you work as a sole proprietor or form a SMLLC?
To know which is best for you you’ll need to weigh the pros and cons of both and 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.
Sole Proprietorship Basics
A sole proprietorship is the default business form for a one-owner business. If you start your one-person business and you don’t form a corporation or an LLC, you’ll automatically be a sole proprietor.
Here are a few of the main things that you need to know about a sole proprietorship:
1. 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 charge of the business’s operations.
2. To set up a sole proprietorship, you don’t have to do anything special or file any paperwork.
The only thing you need to do is get the usual licenses, permits, and other regulatory requirements that California and your city or county require for any business. For example, you’ll probably need to get a business license from your city or county.
Or, 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.
3. 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.
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). If your business earns a profit, the money is added to any other income you earn, like interest income,your spouse’s income (if you’re married and filing jointly), and any W-2 income you have. 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, you file IRS Schedule C, Profit or Loss from Business, along with your tax return.
This form lists 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 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.
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 that sole proprietorships don’t provide owners with limited liability.
What does this mean? Well, as a sole proprietor, you’re 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. For example, if someone injures themselves in your office. You’d be personally sued for damages. Yikes!
But, wait, there is some good news here. If you still want 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
Any one-owner business where the lack of limited liability isn’t a big deal is a great candidate for a sole proprietorship.
Beyond that, businesses that incur little to no debt will also work well as sole proprietorships. Here are a few other things to consider:
- Sole proprietorships are inexpensive. That makes it a great choice for any business that expects to earn a low income, at least at first. New small businesses or side businesses are both great candidates. And, if your business ends up being successful, you can always switch to an LLC or corporation later.
- 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 ready to hire employees, it’s best to form a business entity like an LLC or a corporation. That way the entity, rather than you, will be the employer. This can help you avoid being held personally liable for your employees’ actions.
- It’s easier to borrow money as an LLC. If you need to borrow a lot of money to get your business going, you might want to think about getting the limited liability status that comes with an LLC.
Single Member Limited Liability Companies (SMLLCs) Basics
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.
Advantages of SMLLCs
When you form an SMLLC, you obtain limited liability ( and you 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 only stand to lose the money that you invested in your company. Just keep in mind that owners of SMLLCs are often required to personally guarantee bank loans and other SMLLC debts, so the limited liability may be less than you expected.
Plus, 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 a “disregarded entity.” This means the IRS ignores your LLC and treats it the same as a sole proprietor for tax purposes. You’ll file a Schedule C to report income and expenses for the business. Any profits or losses are passed to your personal tax return.
You have the option of being taxed like a regular C Corp or S Corp. All you have to do is file 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.
You can save money by being taxed as a C Corp or S Corp!
S Corp taxation has become popular because it can help owners save money on Social Security and Medicare taxes. You’ll work as your business’s employee and only your employee wages are subject to Social Security and Medicare taxes.
You don’t have to distribute all of the profits your business earns as employee wages and you can pay yourself dividends instead. Dividends aren’t subject to Social Security and Medicare taxes. And your S Corp doesn’t pay corporate taxes on the money it earns.
Another way to save some money is by choosing C Corp taxation.
This is great for high income earners.
Unlike an S Corp, a C Corp is a separate taxpaying entity. It pays tax at the corporate tax rate on all profits. The Tax Cuts and Jobs Act lowered the corporate tax on corporate profits to 21% starting in 2018—a 14% reduction. The 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 is taxed twice:
- At the 21% rate
- At the owner’s capital gains tax rate, which is between 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 Corp.
What does this all mean? Generally, you need to have a minimum of $200,000-400,000 in profit to make C Corp taxation actually work in your favor.
Some people might take your business more seriously if you operate 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 in California, it can cost up to a few hundred dollars.You’ll need to file articles of organization with the California Secretary of State and you should also create an operating agreement.
You can also see our article, Entrepreneur’s Guide to the Costs of an LLC in California, for more information.
More Expensive to Maintain
Annual maintenance expenses will also come into play once your SMLLC is up and running. For example, if you hire a registered agent to accept court papers and other important documents on your LLC’s behalf, the annual cost is anywhere from $75 to $150.
You don’t need a registered agent when you’re a sole proprietor.
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 an $800 annual tax. This is the highest minimum LLC tax in the United States.
This annual tax isn’t imposed on sole proprietors. If you decide to form an SMLLC instead of working as a sole proprietor, you’ll need to allocate at least $800 annually to pay this tax.
Sole Proprietorships vs. SMLLCs in California
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).
Is an SMLLC Right for You?
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 can always start out as a sole proprietor and establish an SMLLC later, as your business grows.
No matter what, Collective can help along the way. We help you form and maintain your SMLLC so that you don’t miss any important documents or deadlines.
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.