A Sole-Proprietorship being converted to an LLC can provide many benefits. It’s one of the more common entity conversions that I come across. Most of the time, someone will start a business on the side and have that business become more successful than they anticipated. It’s a good problem to have. On the other hand, it’s easier to start a business as an LLC than converting to one. Many people ask “What are the benefits of having an LLC instead of staying as a Sole Proprietorship?” The obvious answer would be the liability protection the LLC offers, but having an LLC opens up many options that aren’t available to Sole Proprietorships. Here are a few.
For a Sole Proprietorship, you’ll nearly always be taxed as if you’re self-employed. Any profits would be subject to self-employment taxes on top of the taxes you would owe on the profits. If you have a Sole Proprietorship, this might be a shock come tax time. Additionally, in the State of Texas, Sole Proprietorships are not subject to the Texas franchise tax. This does help, but not much.
For an LLC, the amount of taxes owed depends on how many members you have and how the LLC elected to be taxed. Generally, an LLC is taxed at the member level only. This means the LLC itself does not pay taxes except for the Texas franchise tax which is for most businesses under 0.50% of profit. If the LLC consists of only one member (a single-member LLC), the taxation is usually the same as a Sole Proprietorship. With two or more members, taxation is the same as well for each member.
After comparing the two previous paragraphs, one might question why having an LLC is beneficial for tax purposes. In comes S-Corp Taxation. It’s an interesting and fun tactic, but it isn’t for every LLC. Essentially, the LLC elects to be taxed as a corporation. Normally, corporations have double taxation which means the corporation is taxed on profits, as well as the dividends the shareholders receive. Yet, a corporation electing to be taxed as an S-corporation is able to have pass-through taxation, meaning only the shareholders are taxed while the S-corporation is not. There are certain requirements the S-corporation must meet to be taxed this way, and they usually limit the size of the corporation. The problem with corporations and S-corporations when compared to LLCs, is they are not as flexible as an LLC. Corporations have requirements of recordkeeping, reporting, corporate formalities, and have a lack of flexibility in management when compared to an LLC.
Now the fun part. An LLC can retain all the benefits of being an LLC when being compared to a corporation, but the LLC can elect to be taxed as a corporation. But you don’t want to stop there, because then you’d have double taxation. Instead, you then elect to be taxed as an S-corporation. But what does this do?
Remember earlier when we talked about self-employment taxes? This is where you have to pay your own Social Security and Medicare taxes, which is around 15%. Hence, the big shock for Sole Proprietors come tax time. The beauty of an LLC being taxed as an S-Corp allows you to receive some of your profit as a distribution, which is not considered employee wages, thus not requiring you to pay the 15% extra on top of your normal taxes. There is a caveat to this scenario. You’ll be required to pay yourself a reasonable salary, which includes paying the social security and medicare taxes. But if your LLC as a whole is making more than what a reasonable salary is, the rest of the profits can be distributed to the member(s) and not subject to the self-employment taxes. Again, this strategy is not for every LLC. There is extra paperwork and filings for this tax election, and it is important you speak with a qualified professional tax attorney and accountant in your State beforehand.
A Sole Proprietorship does not offer liability protection for the owner. If something goes wrong, your personal assets could be at risk. It’s that simple.
An LLC on the other hand, does provide some protection. Both members and managers of an LLC are not liable for the debts, obligations, and liabilities of the LLC. Now, this doesn’t mean you are are free to wreak havoc and not face the punishment. There is a term called “Piercing the Corporate Veil”. While an LLC is not a corporation, this term still applies. Essentially, courts can impose personal liability on the members or managers of an LLC in certain situations. The most common is the result of bad business practices. An LLC cannot be used as a tool to just prevent liability and let the member go wild. There has to be a separation between the LLC and the members of the LLC. To name a few examples, using LLC funds for personal use or not abiding by the rules the LLC implemented in the company agreement can be used by the court to pierce the veil. Another way to pierce the veil is through fraud and reckless business practices. So don’t take out a $3 million loan for your new company named “Banana Stand, LLC” and buy a yellow Lambo to drive around town hanging out with your friends.
Since this is more for small businesses and startups, this might be important for a few readers. A Sole Proprietorship has the edge sometimes when it comes to raising capital because of the lack of liability protections. Lenders may be more likely to loan money to a Sole Proprietorship because the owner will be personally liable for the debts, where an LLC would not be.
An LLC can still be loaned money, however there may be a long period where a relationship has to form and grow between an LLC and lender before a considerable amount of money can be received. An LLC can also raise capital through the issuance of membership interest in the LLC, an option Sole Proprietorships do not have. This is usually done in Private Placements, and fall under the Texas Blue Sky Laws and Regulation D.
Sole Proprietorships are real businesses. There is a common misconception about them that they aren’t held to the same standard and as widely accepted as the other types of business entities. Yet, they’re the most accepted, least complicated type of business.
LLCs are fairly new. Case law on LLCs is minimal. Not all businesses are able to form as an LLC, and laws vary between states. These are a few things a person should consider when creating an LLC.
There are many more differences between a Sole Proprietorship and an LLC, but these are some of the bigger categories of differences between the two and most discussed. Overall, an LLC does have benefits options that make it a better choice when compared to a Sole Proprietorship.
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