Sole proprietorship is the simplest form of business, but it also has some disadvantages. So for this installment of the Small Biz 100, I’ll talk about some of the situations where you don’t want to be a sole proprietorship and what types of business you might want to form.
Important: I am not an attorney, and this is not legal advice. It is a compilation of information I’ve read about business startups.
Note: All of this discussion is specific to small businesses in the USA.
Note 2: More info on when TO be a sole proprietorship is in the Checklists for starting your first business post.
When not to be a sole proprietorship
If any of these factors apply, then it’s time to look at other forms of business:
Ownership – if you want to bring in a partner
Liability – if you have the type of business where you are more likely to be the target of a lawsuit
Taxes – if you are going to do so well financially that taxes are going to be an issue
Investment – if you want to be able to bring in other people in an ownership position
Selling – if you want to sell the business and make it easy to transfer to new owners
Other business structures
If any of those qualifiers applied, or you have other reasons, you can start your business with a different form. If you’ve already started your business, you can convert to another form at any time.
Above sole proprietorships, the two most reasonable forms are LLC or S Corp. These two share some benefits:
- Both offer some liability protection for owners (if the company is sued, you are not personally liable, usually).
- Both types can have multiple owners.
- Neither type requires a separate tax return.
- Both allow income to pass through to owners before taxation.
What does that “pass through” business mean? It means that the LLC or S Corp doesn’t file its own tax return and pay taxes. Instead, the income is passed through the company to the owners. Then the owners declare this income on their own tax returns. Of course, no matter what form of business you create, you are responsible for paying taxes on the income of the business. Sorry! No getting around it. You may be able to reduce your overall tax burden by allowing the new business to hire you as an employee. But if you are getting to that point, you have also gotten a tax advisor, right?
The requirements to form both an LLC and an S Corp are fairly similar.
- Both are treated as separate entities and require a new Employer Identification Number (EIN).
- Both require a written agreement to determine how they will operate.
- Both require filings to create them.
- Both require ongoing paperwork, such as official meetings and documentation. (The LLC takes less of this, if you ask me.)
LLC – Limited Liability Company
LLC’s are regulated by the states, and the rules vary. This means there is not one single guide for creating an LLC. I could tell you all about how I formed mine in Oklahoma, but it wouldn’t help you create one in Indiana. The general guideline is to check with your Secretary of State. They usually regulate these filings. You can also check in with your local Small Business Development Center, and they can give you the local scoop.
A few general rules apply nationwide. The owners of an LLC are called members, and the first filing is usually called Articles of Organization. You’ll also need to create the governing document, usually called an Operating Agreement. All the members have to agree to those operating rules. Some states allow one person to form an LLC on their own, and some states require a minimum of two people to start up.
LLC’s can be more flexible in terms of how they are taxed. An LLC can elect to be taxed like a sole proprietorship (probably best for one person LLC’s), a corporation, or a partnership. This is another place where you want to invest in some professional advice, to be sure you select the proper form.
S Corp – Subchapter S Corporation
Because the S Corp is regulated by the federal government, the tax rules do not vary from state to state. So if you plan to do business with locations in several states, go with the S Corp.
Corporations are still created in your individual state, usually with a filing at the Secretary of State’s office. Once you’ve formed the corporation in your state, you need to let the IRS know that you want it to be a Subchapter S Corp, by filing a form 8832 with the IRS. And you need to do that quickly, within 75 days.
General Partnerships and why I don’t like them
Few people choose to go into a general partnership anymore. Every partner is responsible for every debt and decision of every other partner. That unlimited liability is enough to scare most people away, especially since more attractive options like LLCs and S Corps can cover partners.
But sometimes people end up in a general partnership by accident. Just like the default form of a single person business is the sole proprietorship, the default form of a multiple person business is a general partnership. If you go into business with a friend, without putting any arrangements on paper, you just formed a general partnership. The good news? You can re-form as an LLC or S Corp at any time.
This article is part of the Small Biz 100, a series of 100 practical hands-on posts for small business people and solo entrepreneurs, whether in a small town, the big city, or in between. If you have questions you’d like us to address in this series, leave a comment or send us an email at becky@smallbizsurvival.com. This is a community project!
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Becky started Small Biz Survival in 2006 to share rural business and community building stories and ideas with other small town business people. She and her husband have a small cattle ranch and are lifelong entrepreneurs. Becky is an international speaker on small business and rural topics.
Very informative article! Although I’m not sure that “Taxes” and “Selling” are good factors to consider when considering a sole proprietorship because it is imposible to accurately predict them. However, you seemed to provide a wealth of knowledge in a pretty short post. Thanks for the refresher!
Ben, thanks! While most of us can’t predict taxes and selling when we first start our business, it’s quite possible that after some time, you’ll start to run into tax issues that would be better managed as an LLC or S Corp. Or, you’ll realize you are planning to sell in a few years or even sooner.
Luckily, in the US, it’s quite possible to create a new form for an existing business.
Thanks for taking time to comment!
Excellent summary of the various structures of business and when to choose each. I just formed an LLC for my business for tax purposes. Thanks for the great information!
Laura, thank you. Glad you found some value. Best of luck to you and your business!
Becky, this is good information about business structures. However, there is a return necessary for all entities. A Subchapter S corporation must file an 1120-S. This return requires no tax payment, but provides information to the IRS on the amounts passing through to the owners. Most states have reporting requirements as well. There is a real benefit to the Sub-S in that the income does not require self-employment tax payments.
J.R., thanks for offering this additional info. I’m glad you shared your expertise.
This was incredibly helpful. Thank you!
Both my lawyer and my accountant said that most people form LLC’s when they should REALLY be forming the Sub S Corp. I’m glad I have that advice and will do so sometime this year.
Patrick, know what you plan to do with your business, review the options and advice, and make your own decision. That’s my advice. Good luck!
Actually, I would rather trust my accountant and attorney than make the wrong choise. My “Make my own decision” choice would be wrong.
Patrick, thanks for coming back after a year for a follow up comment. I’m glad to see you back. As business owners, we are ultimately responsible for every decision.
This is great information but from my perspective as a tax/business attorney it is always prudent to sit down with an experienced and savvy attorney to get this right at inception. There are just too many variables and the facts of each particular situation really matter when it comes to choice of entity considerations. Also, in a state like PA, the state and local laws should be considered before any choice is made. Our state has something called a capital stock tax and our City of Philadelphia also has a Business Privilege Tax. Get legal help BEFORE you form any entity is my advice to your readers.
Steven, I appreciate your input. I agree that it is smart to consult a professional.
The complicating factor for rural, remote and small town businesses is access. You may have several attorneys in town, or none. You may be hours from the nearest attorney. Likely, you don’t have a local attorney who specializes in business and tax issues. That doesn’t mean it’s smart to go without help, only that it’s not as easy to find as it is in the big city.
Ultimately, it’s up to every one of us to do our homework, consult with professionals, and make our own decisions.
I just happened across this article about the supply of rural attorneys today: Small towns offer big opportunities for attorneys. They list 12 Nebraska counties that have zero attorneys presently.