Virtually every business owner faces the question of whether to remain a sole proprietor or form a legal entity. Here are a few of the key factors to consider.
Formation Costs and Business Operations
A sole proprietorship is an informal ownership structure that requires very little in terms of formation or maintenance. When transacting business as a sole proprietor you must obtain the applicable city, county, and state licenses, but it is relatively simple and straight forward to properly start and maintain a sole proprietorship.
In contrast, more sophisticated entity structures such as a Limited Liability Company (“LLC”) or corporation have more stringent registration obligations. Additionally, they require internal corporate governance documents such as an operating agreement (for an LLC) or bylaws (for a corporation).
Liability Exposure as a Sole Proprietor
As a sole proprietor, you and your business are considered one and the same. Thus, as a sole proprietor, you are exposed to unlimited personal liability for all business liabilities and obligations. This means your personal assets may be at risk to satisfy an outstanding business debt or obligation.
Properly formed and maintained LLCs or corporations provide limited liability protection, so your personal assets are considered separate from the business assets. For example, if you form a legal entity with limited liability protection and the business defaults on a loan that you have not personally guaranteed, the creditor’s sole recourse would be to look for collection of the debt from the business assets. They cannot access the personal assets of the business owner.
Combining Resources
If two parties decide to start a business the legal classification is a “general partnership”. The risk of a general partnership is that both partners are liable not only for their own actions, but also for the actions of the other partner. To limit this risk, prudent investors seek out entities with limited liability protection to avoid this exposure.
Even if you intend to remain the sole owner of your business, life happens and circumstances change. By forming a strategy to limit your personal liability early on, you are creating a vehicle that is attractive to outsiders who otherwise might not consider your project.
Taxes
A single member LLC or an S-Corp is taxed as a “pass through” entity. A pass through entity essentially means the profits, losses, and other tax attributes flow through to the owner without any federal taxation occurring at the entity level.
The challenge in California is LLCs and entities that have elected to be taxed as an S corporation are treated differently when calculating the California annual franchise tax. A California entity that has elected to be taxed as an S corporation must pay 1.5% of the net income of the business as its annual franchise tax; a California LLC’s annual franchise tax is based on the company’s gross receipts.
This distinction can be crucial depending on the revenue of the business. In particular, if a business uses a lot of inventory but has relatively small margins, it can be more tax advantages for the business to elect to be taxed as an S corporation rather than as an LLC. For example, if a car dealership has a net income of $150,000, but gross sales of $1,100,000, if it elects to be taxed as an S corporation it would owe $1,500 in California franchise taxes. However, if it were a standard LLC, it would owe $6,500 in California annual franchise tax.
It’s always important to consult a tax professional when determining which legal entity to select for your business because, as the example above illustrates, you might owe varying amounts of taxes depending on which you select.
Other Considerations
In talking to clients we’ve found that some have really enjoyed a marketing bump by forming a legal entity. For example, if a prospective customer receives a proposal from ABC Inc., they might reasonably assume that it was produced by a shop of 5-10 people, even if it’s really one owner and occasional contractors supporting the business. In contrast, if a customer receives the same proposal from just ABC with no “LLC” or “Inc.” at the end, they might not view the business as a “real business.” Instead, they may assume it is a mom-and-pop shop or a fly by night operation that is not worth paying fair market rates.
Additionally, it should be noted that for liability protection to remain intact, it is important to follow corporate formalities when maintaining your entity. This means ensuring you always sign contracts on behalf of the company, and not in your individual capacity. It’s also crucial that you file your annual franchise taxes on time and that you send in forms such as the Statement of Information when they are due. This helps to ensure no one can claim “Well, Bob wasn’t really operating as an LLC and so we’d ask the court to not provide Bob with limited liability.”
As a sole proprietor there are a lot of factors to consider, and you’re strongly advised to seek out the opinion of a legal and tax professional before acting. Crafting a strategic plan for where you are heading is key to understanding if you’re exposing yourself to unnecessary liability, and if you’re missing out on an opportunity to best set yourself up for success down the line.
Disclaimer: This article discusses general legal issues and developments. Such materials are for informational purposes only and may not reflect the most current law in your jurisdiction. These informational materials are not intended, and should not be taken, as legal advice on any particular set of facts or circumstances. No reader should act or refrain from acting on the basis of any information presented herein without seeking the advice of counsel in the relevant jurisdiction. Bend Law Group, PC expressly disclaims all liability in respect of any actions taken or not taken based on any contents of this article.