A sole proprietorship is the most basic method for carrying on business. It is not a formal business entity; rather, it consists of a single individual carrying on some commercial activity for a profit or loss. A limited liability company (LLC), on the other hand, is a formal business entity recognized under state law. Below we compare the primary characteristics of the two business forms.
Formation & Maintenance
Formal business entities, like an LLC, are recognized under state law. To form this type of business entity, an individual must file articles of organization with the appropriate state office (generally the state secretary of state). The state then issues a certificate of organization recognizing the existence of the entity. The entity is governed according to state law or a document drafted by the owners known as an operating agreement. This document will lay out all of the rights and obligations of the owners of the company. In comparison, a sole proprietorship exists or comes into existence whenever a single individual undertake a commercial activity with the purpose of generating a profit or loss. No formal filing is necessary. Further, the state law of business entities does not apply to the sole proprietorship. There is no formal maintenance requirements for the sole proprietorship.
A sole proprietorship ceases to exist as soon as the sole proprietor permanently ceases the commercial activity. The sole proprietor does not have to actively work in the business. She can simply hire individual to run the business. If she discontinues any actions in pursuit of a commercial activity the business dissolves. The default rule in an LLC, in most states, is that the LLC continues in existence when a member leaves. In any event, the operating agreement generally specifies under what conditions the LLC will continue to exists when a member leaves. If, however, all members exit the LLC, the LLC will dissolve and operations will be wound up.
Ownership & Control
The owner of a sole proprietorship can only be one person – the sole proprietor. If the sole proprietor awards any ownership interest to another person, the sole proprietorship automatically becomes a general partnership. The sole proprietor has the sole authority to control the business. Even if she hires individuals to manage her commercial activity, she still maintains complete authority of the business. The owners of an LLC are know as members. At the time of formation, the LLC will choose to be member-managed or manager-managed. A member-managed LLC is controlled by all of the members. A manager-managed LLC is controlled by managers hired by the members. If member-managed, the default rule is that all members have equal decision-making and control authority. This may be changed by the operating agreement. Third parties are still justified in dealing with any member on any business matter unless they have notice otherwise. If manager-managed, the managers have sole authority to run the operations of the business. The members are limited to the rights spelled out in the operating agreement. At a bare minimum, state law allows all members the right to vote for major decisions affecting the LLC.
Personal Liability of Owner
The sole proprietor is legally responsible or liable for any debts or obligation arising as a result of her commercial activity. This includes situations where an employee commits a tort or enters into a contract on behalf of the business. The sole proprietor is vicariously liable for these actions. This means that someone suing the sole proprietorship and receiving a judgment against it could seek payment from the sole proprietor. If the sole proprietor cannot or will not pay the judgment, the creditor could seek to have the sole proprietor’s assets seized and sold. This is known as execution against assets. Needless to say, this is a scary proposition for the sole proprietor.
The LLC provides limited personal liability for the owners of the LLC. If the employees of the LLC commit a tort or breach a contract, the wronged party can sue the LLC (and possibly the employee) to receive a judgment. If the LLC cannot or will not pay the judgment, she can satisfy the judgment by executing against the LLC’s assets. She cannot seek to collect the judgment against the members of the LLC. They have personal liability protection. This means that their personal assets are safe. Only the assets of the LLC are at risk. Having limited personal liability is one reason people form an LLC.
Compensation and Taxation
The profits or losses of the sole proprietorship are treated as the profits or losses of the sole proprietor. The sole proprietor uses the various schedules of her personal income tax return to report all revenues and expenses from the commercial activity. Thus, the sole proprietor is personally taxed on all profits.
The LLC may choose its form of taxation. It can either be taxed as a partnership or a corporation. If it elects corporate taxation, it will then elect whether to be taxed under subsection C or subsection S of the Internal Revenue Code. As a partnership or a S-corporation, all profits or losses flow through to the members of the LLC. That is, the LLC itself does not pay income taxes; rather, the members treat their share of LLC profits (whether actually distributed to them or left inside the business) as personal income. The tax rate will vary based upon how the profits are characterized, but that is the subject of another article. If the LLC elects C-corporation taxation, the LLC will pay taxes on all profits and all losses stay with the entity to defer future income. If the LLC distributes any profits to the members of the LLC, these are treated as dividends and taxed accordingly. Members working directly for an LLC taxed as an S or C corporation can work for the business and receive a salary. Members working for the LLC taxed as a partnership cannot receive a salary. They are compensated entirely from their draw of profits.
Law Trades and Business Formation
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