Key Takeaways
1. Sole proprietorship is the default business structure in the US, meaning there is no legal distinction between the business and its owner/operator.
2. LLCs, or limited liability companies, are regulated by state law in the US and are a flexible business structure for small businesses, allowing business profits to ‘flow through’ to the individual owners/members.
3. An S corporation or ‘S corp’ is a tax designation for corporations that can be particularly beneficial to small business owners.
4. The choice of sole proprietorship vs LLC vs S corp is a complicated one, depending on the goals of the business and the state that it is based in.
According to 2021 statistics from the US Small Business Administration, there are 32,540,953 small businesses in the U.S in 2022, with just over 80 percent having no employees (i.e. owner-operator businesses). This raises the question, what is the best kind of business entity or structure for a small business in the US?
For smaller businesses in the US, there are three key options: sole proprietorship, LLC, and an S corporation (‘S corp’. Each one has its own set of pros and cons, so it can be difficult to decide which is the best fit for your business. In this article, we will discuss the key differences between these three types of business structure. We will also help you decide which one is the best option for you.
What is the difference between a sole proprietorship and an LLC?
The biggest difference between a sole proprietorship and an LLC is that a sole proprietorship is owned and operated by one natural person, and there is no legal distinction between that person and their business. By contrast, a Limited Liability Company (LLC) has a distinct legal personality from its owner(s), and can have more than one ultimate owner.
A sole proprietor has total control over their business, but they also have unlimited liability for the debts and obligations of the business. An LLC, on the other hand, offers its owners limited liability protection: This means that the owners’ personal assets are protected from debts and liabilities of the LLC.
Another key difference between these two business entity types is how they are taxed. A sole proprietorship is taxed as a sole proprietor, which means that the owner pays taxes on their personal income tax return. An LLC, has more tax options than a sole proprietorship: It can choose to be taxed as a sole proprietorship (if one owner), a partnership (if more than one), or as a corporation. By default, the LLC is taxed as a sole proprietorship or partnership, so the tax differences with a sole proprietorship can be relatively minor.
In addition to limited liability, other potential advantages for business owners include:
- There is the option of an LLC to acquire outside investors (as ‘members’), whereas a sole proprietorship is limited to debt financing
- LLCs have international respectability and send a trust signal to potential partners that sole proprietorship doesnt.
On the other hand:
- LLCs cost money to set up
- Have ongoing compliance costs and
- Are treated differently in different states (requiring extra vigilance).
What is the difference between an LLC and an S Corp?
LLCs and S Corp are both popular business forms for smaller businesses in the US. They are both ‘corporate’ business forms (the business has a distinct legal personality from its owners). Both are potential ‘pass-through’ entities, allowing the income of the company to ‘pass through’ to the ultimate owners, un-taxed, to be taxed as personal income of that owner. One member LLCs are taxed like sole proprietorships, while multi-member LLCs are taxed like partnerships.
An S corporation or S corp, is not actually a distinct form of business structure or legal entity in the US. Rather, it is a special tax designation for corporations. A corporation has shareholders, who own the company and elect a board of directors to provide overall governance of the company. The board of directors then appoints officers to run the day-to-day operations of the company.
Some key differences between LLCs and S corps include:
- Number of shares/members. LLCs are allowed an unlimited number of members, while S corps may have no more than 100 shareholders.
- Nationality requirements. Non-U.S. citizens or residents are entitled to be members of LLCs. Non-U.S. citizens/residents may not be shareholders of S-corps.
- Status of owners. The shareholders of an S-corp must be natural persons. They cannot be owned by corporations, LLCs, trusts or partnerships. There is no such restriction on LLCs.
- Subsidiaries. There are restrictions on subsidiaries for S-corps (including foreign subsidiaries), but not for LLCs.
On other other hand, potential benefits of the S corp include:
- Taxation. A one-member LLC, under default tax arrangements, requires the member to pay full self-employment taxes, as they are passed through to the member as in a sole proprietorship. However, in a one-shareholder S corp, it is common for the operator to be an employee on a ‘reasonable salary’, paying employment taxes only on that salary. Further profits from the S corp can be passed through to the operator without requiring being subject to employment taxes;
- Flexibility. Shares in an S corp are more easily issued and sold than ‘membership’ of an LLC, usually making it easier to acquire capital for the LLC.
Sole proprietorship vs LLC vs S corp: Which should you choose?
Deciding which business structure to choose for a new venture can be a daunting task. There are many factors to consider, and the wrong choice can have far-reaching implications. Three of the most popular choices for small businesses are sole proprietorships, LLCs, and S corporations. Each has its own benefits and drawbacks, so it’s important to understand the differences before making a decision.
Sole proprietorships are the simplest and most common type of business structure, both in the US and internationally. They are the ‘default’ businss form, are easy to set up and require little paperwork. The biggest downside of a sole proprietorship is that the owner is personally liable for all debts and obligations of the business. This means that if the business fails, the owner’s personal assets could be at risk.
LLCs offer greater flexibility than sole proprietorships in terms of ownership and management. They also provide limited liability protection for the owners, meaning that they are not personally responsible for the debts of the business. However, LLCs are more expensive and complicated to set up than sole proprietorships, and are subject to more extensive, ongoing compliance requirements.
S corporations are similar to LLCs in terms of liability protection, but they have a few key differences: S corporations can only have shareholders who are natural persons, and they must file special paperwork with the IRS. They also face stricter limits on their activities than LLCs. Despite these disadvantages, S corporations offer several tax benefits that may make them the best choice for some businesses.
Ultimately, there is no one-size-fits-all answer when choosing a business structure. The best decision will depend on your business’s specific needs and your risk tolerance when setting it up. Understanding your business’s ecommerce valuation can be crucial in making informed decisions during this process
Consider alternative business entities and structures with Horizons
For overseas expansion or employee hire, it may not be necessary to set up a formal business structure such as an LLC or S corp. Horizons hiring solutions allow you to hire anywhere in the world, without setting up a business entity.
Get in touch with one of our hiring specialists today to find out more.
Frequently asked questions
A sole proprietorship is a business that is owned and operated by one person. The owner is personally liable for all debts and obligations of the business, and the profits of the business are taxed as personal income. Sole proprietorships are easy to set up and require little paperwork.
This is the default set-up for independent contractors in the US.
An LLC, or limited liability company, is a type of business structure that offers limited liability protection for its owners. LLCs are allowed to have an unlimited number of members, and can be managed either by the members themselves or by appointed managers. They are more expensive and complicated to set up than sole proprietorships, but offer greater flexibility in terms of ownership and management.
An S corporation, or S corp, is a type of business structure that offers limited liability protection for its shareholders. S corps can only have shareholders who are natural persons, and they must file special paperwork with the IRS. They also face stricter limits on their activities than LLCs. Despite these disadvantages, S corporations offer several tax benefits that may make them the best choice for some businesses.
The biggest advantage of an S corp over a sole proprietorship is that the shareholders are not personally liable for the debts of the business.
There is no easy answer when it comes to choosing between an LLC and an S corp for tax purposes. The reason is that a single-member LLC can elect to be taxed as a sole proprietor, or as an S corp. As long as one’s income is high enough, generally it will be better to elect to be taxed as an S corp: That way a certain amount of the business’s profits can be taken as owner’s drawings/distributions, and not be subject to full self-employment tax.
The tax burden of sole proprietorship and an LLC can be similar, as in an LLC, all the income can be passed through to a single owner and taxed as personal income. However, an LLC is ‘limited liability’, meaning that the owner or owner’s personal assets are protected in case of business insolvency.
On the other hand, sole proprietorship is a simple, default, business structure, not requiring active steps on behalf of the owners for establishment. An LLC must be duly incorporated and meet all compliance requirements in the states in which it operates.
