Sole Proprietorship vs. LLC Discussion Regarding Liability: Which Should You Choose?

The sole proprietorship is the most common form of business structure in the United States, while theSole Proprietorship limited liability company (LLC) is a relatively new business structure. There isn’t a right or wrong form of business structure. The type of structure that would be best for your business activities depends on lots of factors.

The whole sole proprietorship vs. LLC discussion is about liability. But, it may not be the type of liability you’re thinking of. Any discussion of the sole proprietorship vs.  LLC issues with an attorney will center on the liability exposure created through conducting business.

Attorneys rarely discuss which personal liabilities you have and how to protect your business from those liabilities. Your small business may easily be the most valuable asset you have. It’s just as important that you protect the business from your personal liabilities as it is for you to protect your home from the business liabilities.

Recently, I am seeing more folks lose wealth because they lose their business through personal creditor problems than those who lose their personal assets because of business problems. This issue has to be addressed in the sole proprietorship vs. LLC discussion, but is seldom if ever addressed.

The Corporate Shield in the Sole Proprietorship vs. LLC Discussion

The sole proprietorship vs. LLC discussion on corporate shields is pretty short if you are discussing the corporate shield protection offered by a sole proprietorship. There is no corporate shield protection in a sole proprietorship. In fact, there isn’t even any protection for the proprietor (you) if you are conducting your business activities as a sole proprietor.

The corporate shield is a creation of Congress to protect the personal assets of people who are willing to take the risk of starting a small business. It requires specific actions to be taken when you start your business. A sole proprietorship, however, can be started without any formal action.  Therefore, for the sole proprietorship vs. LLC discussion a sole proprietorship does not provide liability protection.

The primary argument in the sole proprietorship vs. LLC discussion for using LLCs centers on the corporate shield protection offered by an LLC. Please note that an LLC has the exact same corporate shield as a “corporation.” Many people believe that an LLC does not provide as much protection as a corporation. This is wrong. The corporate shield is the same. In fact, an LLC actually offers much better protection than a corporation does.

Many people have been told that an LLC doesn’t require the “corporate formalities” that a corporation requires in order to actually get the corporate shield protection. That’s not actually true.

Some state statutes say that the LLC can’t be “set aside” because the owners don’t follow the corporate formalities. Technically, that’s true, but practically, there is another side of the coin.

Whenever there’s a lawsuit, you’ll be sued personally along with your LLC or corporation. The first argument will be whether or not to dismiss the suit against you personally. The Plaintiff (the guy suing you) will make the argument that your company is a sham. He will say that it is your alter ego.

Basically, what the Plaintiff is saying is you didn’t treat the LLC or corporation as a real company, and you just conducted business as if the company wasn’t really there. If the judge can’t see that you really intended to do business as a company, then he won’t have any choice but to hold you personally liable in the suit and let the company creditors chew on you personally because the Plaintiff was able to “pierce the corporate veil.”

The way you show the judge that you really intended to operate as a company is to show him you followed all of the corporate formalities. When you demonstrate that you really treated your LLC or corporation as a true company, then he will follow the laws associated with the company structure and let you stand behind the corporate shield.

Corporate formalities include things like keeping the books separate. If you co-mingle personal money and business money, your asset protection goes out the door, no matter what the code says about having an LLC follow formalities.  We have included a complete list of corporate formalities in our Advanced and LLC Wizard Packages.

Double Asset Protection in the Sole Proprietorship vs. LLC Discussion

The concept of protecting business assets from personal liabilities is very foreign to most people. The thought never crosses their mind. A sole proprietorship can’t give you any protection from what happens in the company, and it can’t give your company protection from what happens to you.

An LLC can protect you and your personal assets with the corporate shield, plus it can protect your business assets from your personal liabilities. In many ways the LLC is a more powerful asset protection tool than a corporation. So what exactly are these personal liabilities?

Personal liabilities are the liabilities that you encounter that are not related to the business. Examples include illness, divorce, bad real estate investments, injuring someone, and credit card debt. The list goes on almost forever.

This double asset protection is a big deal when you think that almost two thirds of bankruptcies are caused by medical bills incurred just because somebody in the family got sick. Get the eBook I have written, Double Your Asset Protection,  and learn the fine points of double asset protection. It will protect the way you make your money.

Lawyers concentrate on protecting the assets of an individual. Wouldn’t it be better to protect the way you earn your money? The sole proprietorship vs. LLC discussion in the area of asset protection is settled. Use an LLC if there is any liability associated with your business activities. Use an LLC to protect your business from the problems you face in your personal life.

Tax Considerations in the Sole Proprietorship vs. LLC Discussion

Your little business is your most important tax shelter. The good news is an LLC with one member will be taxed exactly like a sole proprietorship. A single member LLC can choose to be taxed as a sole proprietorship, S corporation, or C corporation.

If no filings are made with the IRS, then a single member LLC will default to a sole proprietorship tax structure. Of course, taxes have to be filed each year. In fact, quarterly taxes may have to be filed.

An LLC taxed as a sole proprietorship is called a “disregarded entity,” because the IRS disregards the entity and looks at the single member as a sole proprietorship. If a tax return is needed, the member’s Social Security number should be used. The member will file a Schedule C with his or her 1040 tax form. All of the business income will simply flow through to the member’s 1040 form on the Schedule C.

The short story in the sole proprietorship vs. LLC discussion involving taxation is a moot issue. Both the sole proprietorship and the single member LLC can have the exact same tax treatment. The IRS disregards the LLC and says for tax purposes the LLC exists as a sole proprietorship.

But, don’t even think for a minute that an LLC taxed as a disregarded entity has any less asset protection power. The asset protection power of an LLC is the exact same whether it is taxed as a sole proprietorship or as a C corporation or an S corporation. Liability structure and tax structure have nothing to do with each other.

Costs in the Sole Proprietorship vs. LLC Discussion

It’s really easy to say that you need an LLC. However, in some states an LLC can be very expensive to set up and maintain. Do not fall victim to the sharks that are trying to get you to do your LLC in one state or another. Where you should file your LLC is another long discussion, and there are lots of factors to consider. Cost is a factor, but only one factor.

If you’re in California, for example, your annual fees are on the order of $800 per year. Yet Arizona has no annual fee. Regardless, you must be registered in the state where you are doing business (whether as a sole proprietorship or an LLC). So, if you are doing business in California and you or your LLC is a resident of Arizona, you’ll still have to pay all the fees in California. If you want to avoid the fees, don’t do business in California. Please don’t be a sucker for the “deals” to form your business in specific states to avoid fees in another–this is a case where if it sounds too good to be true, it definitely is.

If there are high expenses for an LLC and the liabilities are low in your business activities, then just go with a sole proprietorship. Low liability activities include things like reselling garage sale items on eBay, being an artist or a seamstress, working an MLM, or working as a secret shopper. If you have employees, you have liabilities no matter what you’re doing, and you need an LLC.

The Bottom Line in the Sole Proprietorship vs. LLC Discussion

The bottom line is easy. For most business activities, you should use an LLC. The liability exposure just isn’t worth risking the wealth you’ve worked your whole life for. An LLC can give you asset protection. You can’t get any asset protection out of a sole proprietorship. The taxation is the same any way you compare in the sole proprietorship vs. LLC argument. LLCs are easy to set up and maintain, if you know what to do.

Updates for clarity and grammar made May 1, 2014. Video added June 3, 2014.