Updated: Jan 31
So, you have been busy starting your business, planning every aspect of its operations, designing a website, and developing a marketing strategy for your social media platform but have you considered the effect that a business legal structure can have on your personal wealth and on the income taxes that will need to be paid? There are several options for business legal structures. Some legal structures offer protection for your personal assets, shielding your personal property, such as your home, money in your bank account, and your investment portfolio, from creditors and lawsuits. Yet, other business legal structures do not protect your personal assets. When it comes to personal liability protection for its owners and taxes, each type of business legal structure has its nuances and tax implications.
Ultimately, the type of legal structure you choose will determine whether your personal assets are shielded from creditors and other legal claims and how much taxes will be owed on your business profits.
Here are the two most common business legal structures selected by solo entrepreneurs with an introduction into each structure’s nuances when it comes to whether it does or does not offer personal asset protection and how it is taxed:
A sole proprietorship is the simplest of entity classifications. Sole proprietorships are easy and inexpensive to form and are often the entity of choice for individuals starting a new business. In many cases, individuals seeking to operate a business as a sole proprietorship only need to register the business with their local city or town for a small fee. In some cases, they may even be able to avoid having to register their business and can avoid paying the fee if, for example the owner is using his or her legal name as the name of the business which is routine with sole practitioner certified public accountants and attorneys.
So, a low cost to establish a business as a sole proprietorship makes it an attractive option if cost management is a significant concern but what is the drawback? The drawback is that a business classified as a sole proprietorship is not considered to be a separate entity from its owner. Consequently, a sole proprietorship does not afford the individual owner personal liability protection from claims resulting from the business’s operations. Thus, entrepreneurs need to carefully consider their potential exposure to litigation in their select industries.
Does this mean that if I operate my business as a sole proprietorship, I will have zero protection regarding my personal assets? Not necessarily, other strategies can be employed to help limit your exposure to the ability of creditors and persons with other legal judgements against your business to lay claim on your assets. Although, in most cases it would be more cost-effective to simple choose another form of legal structure rather than employing other strategies; however, there is a notable exception for individuals practicing in certain professions. It is also important to note that the different strategies, which can be employed to protect your personal assets, come with additional exposure to tax return filings and potentially additional taxes.
How are sole proprietorships taxed, and what are some of the key advantages and disadvantages? Since sole proprietorships are not distinguished from their owner, the income or loss generated by the business is reported on the business owner’s individual income tax return. This provides an advantage from the perspective that the business owner does not need to file a separate tax return for the business entity required of other business structures with an exception allowed for single member limited liability companies. Sole proprietors report their business income and the amounts paid in cash, by check, or on a credit card to cover business related expenses and some other special deductions allowed on the IRS Schedule C, Profit or Loss from a Business, which accompanies the IRS Form 1040, U.S. Individual Income Tax Return.
Another advantage is that a business classified as a sole proprietorship may be able to avoid paying a minimum tax which is assessed by their home state on companies operating in the state; the rules vary significantly from state to state so it is essential to review the rules of your state.
A significant disadvantage, depending on the individual circumstances, could be that the overall tax burden may be higher when compared to other available entity structures. Another disadvantage could be limits imposed on certain deductions.
Limited Liability Companies
Solo entrepreneurs contemplating establishing a business as a sole proprietorship should consider the limited liability company (LLC) business legal structure. Limited liability companies are established under state laws and the businesses are registered with the state. Those seeking to establish an LLC will be required to submit some form of articles of organization with the state and will need to pay a fee. Laws regulating LLCs vary from state to state so it is important to research the home state's laws.
So, why might an entrepreneur prefer an LLC over a sole proprietorship entity structure?
The most significant advantage that an LLC has over a sole proprietorship is that the LLC protects the owner’s personal assets. As a result, creditors or persons with other legal claims against the business cannot access the owner’s personal property to satisfy what is owed to them. Since the LLC entity structure shields the solo owner’s assets, creditors and others with legal judgments against the business, they will only be able to pursue settlement against the assets held by the LLC. Other reasons to consider an LLC if you are a sole business owner is the relative ease of organizing, and the relatively low cost of establishing the entity.
It is important to note that establishing an LLC with multiple members may involve some complexity as the members devise an agreement that will govern the entity and work to address other vital issues.
How are LLCs taxed, and what are some advantages and disadvantages? An LLC with one owner is classified for tax purposes as a single-member LLC. This classification entitles the LLC to special treatment under the tax code by allowing the owner to disregard the LLC and report the income and deductions from the business on their personal tax return. As a result, a single-member LLC can report its income and deductions in the same manner as a sole proprietorship, allowing for the advantage of filing a single tax return. A single-member LLC may elect to be treated as a corporation for tax purposes. If the LLC is treated as a corporation, it will file the IRS Form 1120, U.S. Corporation Income Tax Return; the LLC may also elect to be treated as a Subchapter S corporation.
LLCs with more than one member may be treated as a partnership or a corporation, entity structures regulated under specific tax laws. An LLC with multiple members classified as a partnership would file the IRS Form 1065, U.S. Return of Partnership Income. Subchapter S corporations and partnerships are also allowed under the tax code to pass-through business income and deductions to their owners. Another advantage of an LLC structure is that the members may have the opportunity to select the tax reporting avenue that will allow for the least tax burden.
A couple of disadvantages related to LLCs are the routinely imposed state minimum tax liability and the annual filing fees required to retain the entity status in good standing. Additionally, LLCs classified as partnerships or corporations must file tax returns at the entity level. Their owners must also file personal income tax returns reporting their share of taxable items from those entities.
In closing, when considering the options of legal entity structures for one’s business, one must understand the potential liability exposure in the selected industry and the tax implications of operating under the legal structure. Research should be conducted related to the propensity for litigation in the industry. For example, if the industry is prone to accidents resulting in injuries to employees or product malfunctions resulting in injuries to consumers, or if the industry is highly regulated due to environmental impact concerns, the business should select a legal structure that shields the owners from personal liability which would protect their assets.
This same logic can apply to service-based companies. For example, suppose one is operating a financial consulting firm that provides asset management services to wealthy individuals. In that case, the potential for litigation is high due to stock market volatility which can negatively impact clients’ portfolios. Furthermore, the tax implications demand equal consideration as the entity structure will determine the tax reporting requirements, what party will be required to report the taxable items, the treatment of taxable transactions, and the amount of taxes owed.