There are many variables when making the decision to start a business. I often tell my clients that a sole proprietorship means that your actual person is responsible for all of the liability aspects of the business. All profit/ loss will be included in personal tax return.Tax liability is included with your personal taxes, and all legal responsibilities are your direct liability as well. you are only responsible for paying personal federal, state, local and Federal Insurance Contributions Act (FICA) taxes. You are not required to pay any specific business taxes or unemployment taxes. There is no required annual state filings to complete, unless there’s specific industry filings required by your industry.

Some benefits still present themselves as far as writing off some of your personal expenses as business expenses in order to decrease your overall tax liability. (Business use of home and personal vehicle if used at all during your business hours).

You also don’t need any licensing unless required based on the industry of the business. There is no required state paperwork, unless you plan to have employees or contractors

Utilizing self-employed retirement plans like Simplified Employee Pension Individual Retirement Accounts (SEP IRAs) for higher deductions, writing off regular business expenses such as marketing costs, writing off business travel costs, writing off costs to entertain clients and more.

However, with the Sole Proprietorship, you also have the following Cons:

  • Although becoming a sole proprietor is a lot more economical for a new business, It looks and feels better to the consumer when they can recognize they are doing business with a registered business.. It also enhances your market credibility. Under a trade name. Now this could be easily resolved by creating a “Doing Business As” Name (DBA) with your state’s department of revenue or the secretary of state, but this will require fees for establishment and ongoing fees to continue to use the DBA name.
  • There’s no liability protect against commercial debt, lawsuits and other obligations. This means you can be sued personally for commercial activities, putting your personal assets at risk.
  • Being a Sole Proprietorship, also Limits the amount of capital you could raise through investors. This could limit the amount of funds available to grow, develop, and sustain your business.
  • Unfortunately, its also difficult to obtain financing through lending institutions. For most lenders a Sole Proprietorship presenting a loan request, will be categorized as a “personal loan” rather than a “Business Loan”, which brings all sorts of caps in terms of approval amount potential.

Incorporating your business

Choosing to incorporate brings both advantages and additional costs. It will be up to you to determine if those advantages are worth the additional costs that you will have to pay. Incorporation entity choices include the following:

  • Limited Liability Company (LLC)
  • C-Corporation
  • S-Corporation

Incorporating as an LLC separates your personal assets from lawsuits, creditors, etc. It also avoids the potential double taxation that occurs with C-Corporations. With the LLC, you will have the following benefits:

  • A higher level of market credibility.
  • Liability protection against commercial debts, lawsuits and other obligations. This means, as long as you set up your LLC properly without any co-mingling of personal/commercial assets and properly fund your LLC with working capital, your corporate veil should remain in place and you can’t be sued personally for commercial activities.
  • It’s much easier to generate equity and debt financing due to having an actual incorporated business as well as an established business credit score. This will avoid many potential equity partners and financial institutions from categorizing your request as a personal loan rather than a business loan, which brings all sorts of caps in terms of approval amount potential. It also opens you up to all sorts of commercial debt financing options including loans, leases, factoring, trade credit and more.
  • You can combine the “best” of the incorporation worlds, by electing your LLC to be taxed as a Sole Proprietor (which is the standard election), an S-Corporation or a C-Corporation. Electing to be taxed as a sole proprietor just means all profits/losses flow to the owner’s individual tax return like normal. Electing to be taxed as an S-Corporation means the profits/losses flow to the owner’s individual return, but you have the chance to reduce FICA taxes by establishing a “reasonable salary” and receiving the remaining profit amounts as dividends, with only the “reasonable salary” being taxed under FICA.
  • And of course, you will enjoy all of tax benefits of being self-employed.

With an LLC, you have the following drawbacks as well:

  • State-related paperwork will be required, including any specific industry licensing.
  • Annual state filings (and the associated fees) will be required as well, including any specific industry licensing fees that are required.
  • Besides paying personal federal, state, local and FICA taxes, you might also be required to pay State Business Taxes and Unemployment Taxes.
  • Costs for completing the tax return of an LLC is much higher than that of a Sole Proprietorship.

Is Incorporation Always the Best Choice?

Life is all about making choices and choosing to incorporate or not incorporate your business can be a very important one. Asset protection consultants routinely market to business owners stating that incorporation is always a “good idea”, but I do not believe this to be true. Some entities are actually better suited for a Sole Proprietorship as the additional costs and taxes of an LLC do not provide any significant benefits over operating as a Sole Proprietor.

Also, understand that with the concept of an LLC providing “liability protection against commercial acts of your business”, a savvy attorney is going to try to find any loophole he can in your current setup to break the corporate veil. This could be your lack of providing funding to your business, this could be your co-mingling of personal/business affairs, or more.

In addition, some states don’t look too favorably on sole member LLCs, as often the question comes up in legal proceedings as to whose interests are you being protected against if technically, you are the only member of the LLC? So it gets tricky, make sure to sit down with your trusted CPA and business attorney to map out the right route for your business.