The solo business owner has three main choices when it comes to choosing the entity which is the best vehicle for conducting his or her business: 1) the sole proprietorship, 2) a single-member LLC, and 3) a corporation. The focus today will be on the single-member LLC and the sole proprietorship.
When a Sole Proprietorship May Make Sense:
The sole proprietorship is the simplest and cheapest of all business entities to form. In fact, as soon as you commence business as a solo you will be operating as a sole proprietorship by default. For this reason, most all businesses start out as sole proprietorships. Accounting for taxes is also relatively simple for sole proprietors. For legal purposes the sole proprietorship is not considered separate and distinct from the owner, they are one in the same. Therefore, any income generated by the business is simply reported on a Schedule C of the owner’s Form 1040. However, because the owner and the business are legally considered one in the same the owner will be personally liable for any and all of the obligations of the business. This is the biggest drawback of the sole proprietorship and one must decide if the simplicity and cost savings of operating as a sole proprietorship outweigh putting the owner’s personal assets at risk.
When a Single-Member LLC May Make Sense:
For risk adverse solo business owners the limited liability afforded by the single-member LLC may outweigh the elevated formation costs and formality requirements that accompany forming a limited liability company. Unlike the sole proprietorship, the single-member LLC is considered a separate legal entity apart from the owner of the business. For this reason, the member (owner) of the LLC generally will not be held personally liable for any obligations created on behalf of the LLC. However, this limited liability is not absolute and the owner of a single member LLC must do everything in his or her power to ensure that the LLC is treated as a separate and distinct entity from the member. With the advent of online document preparation and do-it-yourself formation guides the costs of forming an LLC have diminished significantly. However, please keep in mind that the mere formation of an LLC does not by itself grant the owner liability protection. As mentioned above, the owner must expend time and energy ensuring that the formalities of operating as an LLC are met. This includes, but is not limited to, adequately capitalizing the LLC, keeping business and personal funds separate, following proper voting procedures, filing annual reports, and holding annual meetings and recording company minutes.
Generally the greater the risk of the business you are engaging in the more likely you will want to choose an entity which affords personal liability protection. If you are just starting out nothing prevents you from operating as a sole proprietor and later forming an LLC or corporation as the business grows or as you want to bring on investors. If you decide to operate as a sole proprietor it is a good idea to purchase an umbrella insurance policy to provide an additional funding source for any potentially incurred liability through the business. Please note that operating as a single-member LLC does have its drawbacks, most notably the lack of charging order protection. For a more in-depth article on single-member LLCs please visit our article, The Kansas Single Member LLC.