Feeling stuck within your current business structure and don't have ample room to grow? Learn how switching from a sole proprietorship to an LLC can help promote growth and flexibility within your business.
Updating your business structure could help you save on taxes while reducing your risk.
Most solopreneurs start as sole proprietorships. Of the four main types of business structures in the U.S., sole proprietorships make up 86.6% of small businesses without employees. One of the reasons sole proprietorships are so popular among new entrepreneurs is their simplicity. They are easy to form and allow owners to keep taxes and legal matters as uncomplicated as possible. As solopreneurs consider expansion, however, this simplicity becomes a double-edged sword. The straightforward rules of sole proprietorships leave little room for growth. At this stage, switching to a limited liability company (LLC) business structure can bring entrepreneurs flexibility, tax benefits, and asset protection.
But how do you know if it’s time to upgrade your business structure? Ask yourself these questions:
1. Are you worried about your personal assets?
With a sole proprietorship, you and your business are the same legal entity. This means that you are personally on the hook for the debts and liabilities of your business. Personal assets—such as your home or bank accounts—may be at risk to satisfy unpaid debts, legal judgments, or other obligations.
An LLC, on the other hand, is a separate entity from the business owner. LLC members are not personally liable for the company’s debts or legal liabilities. (Though, they are liable for their own conduct and any personal financial commitments to the LLC.) As is always the case with risk, each entrepreneur will need to determine what type of protection makes them the most comfortable.
2. Could you save money with a different tax strategy?
With sole proprietorships, you only have one option for how you are taxed, and your net business income is taxed on your individual tax return at your individual tax rates. You are also responsible for paying self-employment taxes.
LLCs, on the other hand, give their members the unique ability to choose how they are taxed. Solopreneurs can choose to be a pass-through entity, also known as a disregarded entity, which allows you to claim your business income on your personal return, just like you would in a sole proprietorship.
Alternatively, you can choose to tax your LLC like a corporation. For solopreneurs whose personal income tax rate is higher than the corporate tax rate, this can reduce your overall tax burden. This structure also reduces self-employment taxes for the individual since employers normally pay half of the costs for Social Security and Medicare taxes. Keep in mind, if you do elect to have your LLC taxed as a corporation, you won’t be able to change the status again for 60 months (five years).
Both sole proprietorships and LLCs can deduct business expenses from taxation, including costs for health and disability insurance, office supplies and utilities, and business vehicles and mileage. LLCs that are taxed as pass-through entities can also claim qualified business income (QBI) deductions. This deduction, which was established by the Tax Cuts and Jobs Act of 2018 and is available through 2025, allows self-employed individuals and small business owners to deduct up to 20% of their business income from taxes.
3. Do you plan to hire employees?
While sole proprietors can hire employees, operating as an LLC may make it easier to comply with employment and tax laws. Navigating employers’ legal requirements and payroll taxes can be difficult, especially for a growing business. Because LLCs separate the business’s operations and financials from the owner’s, it can make managing full-time employees more straightforward. Additionally, LLCs provide protection from potential disputes with employees.
4. Will you take on a business partner?
If a partner joins your business, your structure automatically changes to a general partnership. While you may be grateful for your partner’s help, their mere presence can alter your liability exposure significantly. In a partnership, you maintain full responsibility for the business’s obligations. This means that you could be held liable even if your partner did something without your knowledge or consent. Forming an LLC can help protect co-owners’ personal assets, while also preserving relationships and trust.
Ultimately, every solopreneur must decide for themselves which business structure is the right fit for their needs. Answering these questions can help you decide if switching to an LLC makes sense for you and your business.
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