Sole Proprietorship vs. LLC vs. Corporation

A limited liability company operation agreement with pen
••• LYAO / Getty Images

When you form a business, you have a lot of decisions to make regarding its structure. Do you need to worry about liability? What about taxes? There's no substitute for asking for advice from a qualified tax professional, but you should still research on your own the structure that might be right for you.

Sole Proprietorship

A single owner of an unincorporated business essentially operates the business as an extension of herself. For tax purposes, the profits and losses of the business flow through to the owner's tax return. In other words, business profits are reported as earned income for the individual owner of the business.

Liabilities of the business also flow through to the owner. For example, if someone slips and falls on the business premises, the company damages a customer's property, or the company is unable to pay its debts, an individual or corporation can levy successful claims against the sole proprietorship—that is, the owner.

For home-based businesses or other small businesses, a sole proprietorship often is the best option because it is the least complicated.

Sole proprietors still can use a name different from their own in order to run a business. A DBA (doing business as) allows sole proprietors to use a business name rather than their personal name. The DBA cannot, however, contain terms such as corporation, incorporated, or LLC unless the business legally operates as such. For example, a sole proprietor selling widgets can name his business something like Widgets R Us, but he cannot name it Widgets Inc. unless he is legally incorporated.

Limited Liability Company (LLC)

Many sole proprietors turn to an LLC for some legal protection. The owners and any officers and directors are personally protected from the financial and legal liabilities of the company, including their own negligence in operating the business. Single-member LLCs often are treated by the IRS the same way as sole proprietorships. This means individuals attach their business income to their personal tax returns the same way they would as a sole proprietorship.

The steps and requirements for forming an LLC vary from state to state, so it is important to check with your local small business administration to find out precisely what you need to do. Typically, articles of organization and a membership agreement need to be filed with the state. These documents clearly outline who the LLC's members (owners) are, the LLC's address, its purpose, and the names of any nonmembers in key management roles. Fees for filing this paperwork may range from a few hundred dollars to more than $1,000, depending on your state's requirements.

The main benefit of an LLC is legal protection. Sole proprietorships may be fine for small home-based businesses, but when a business starts dealing with larger sums of money and multiple customers and clients, it's a good idea to separate the business from the individual—and forming an LLC allows for that.

Corporation

A corporation is owned by one or more stockholders and managed by a board of directors (which may consist of only one person) elected by the stockholders.

The directors appoint officers who run the day-to-day business of the company. The stockholders, directors, and officers of the company are protected from the liabilities of the company, including liabilities for their own negligence in operation of the business, except in certain extraordinary circumstances. In an ordinary corporation, the profits and losses do not flow through to the owners' tax returns. The corporation is a separate entity that files its own tax return and pays its own taxes.

Corporate federal income tax rates are not set in graduated tax brackets, and in many states, corporations also are subject to franchise taxes—a state corporate income tax, in essence.

Again, requirements for forming a corporation vary from state to state, but expect to be required to create corporate bylaws and to file articles of incorporation. Stock certificates must be issued to the owners, also referred to as shareholders, of the corporation, and a board of directors must be formed. It's common when corporations are first being formed for the owners to appoint themselves as directors, making them responsible for hiring managers and other staff. These documents define the business' purpose and location, much like the articles of organization for an LLC, but they also lay out rules for the board of directors, where and when it meets, and a plan of succession should there be a change in ownership.

Corporations typically need to register with the federal Securities and Exchange Commission in order to issue shares of stock, but smaller corporations with only a handful of shareholders can apply for an exemption from having to file. A corporation that plans to sell additional shares, though, has to register.

Forming a corporation generally is the best option if there are multiple owners all bringing significant investments to the business. And in order to raise additional capital by selling shares of stock, forming a corporation is required.