Wasittha says, “Hello, Laura! I’m a big fan, and thank you so much for providing good financial information. I’m starting a local cottage business creating freeze-dried foods that I can operate in my kitchen. My startup capital is less than $5,000, and I plan to work alone. What’s the difference between having an LLC and a sole proprietorship, and which is better for protecting my finances?”
Thanks for your question, Wasittha! The business entity you choose is an important consideration that many small business owners, freelancers, and contractors need help with. I’ll explain the differences between having a sole proprietorship and an LLC and which option may be best for you as you launch and grow your venture.
Choosing a business entity
When you work for yourself, there’s a lot to do. You might need to create products, find clients, bill customers, search for outsourcing, or do a zillion other things. But one of the first tasks you should do is choose a business entity. Your entity determines your business structure according to the laws in your state.
Plus, you need to know your business entity and name before getting a business bank account, buying business insurance, and paying taxes.
Types of business entities
There are several primary business entity types and sub-entity structures to choose from. You typically register your business entity by filing documents and paying an annual fee to a state agency, such as the Secretary of State.
However, choosing a business entity can also be a passive decision, where you do nothing. If you don’t register your business with the state, you’ll automatically be a sole proprietor, which I’ll explain more about in a moment.
Since doing nothing is always easier than doing something, many small businesses start as sole proprietors by default. That’s not a bad thing. But it’s wise to make an informed decision by considering all your options.
Your business entity choice comes with significant financial and legal considerations, so it’s not something to take lightly. Each business entity has different pros and cons, including the complexity of formation and annual requirements. It affects the tax you must pay, what happens in a lawsuit, yearly paperwork, and the amount of personal exposure to risk.
Some business entities are considered separate from their owners for tax purposes and must file business tax returns. Others allow income to “pass-through” to the owner and get reported on your individual tax return.
So, there isn’t one best entity for a business, and it’s not a binding decision. As your business needs change, you can always change your entity. However, the most common entities for solopreneurs and small businesses are a sole proprietorship and LLC, so we’ll review their main pros and cons.
If you already have a business or you’re thinking about becoming self-employed, don’t miss legitimate ways to reduce expenses, cut taxes, and save more. Money Girl reviews seven ways that having a small business saves you money in the following episode. Listen below:
What is a sole proprietorship?
A sole proprietorship is the simplest business entity. It’s made up of one person or is co-owned by a married couple. As I mentioned, you don’t have to comply with specialized government requirements or submit any paperwork to be a sole proprietor. That allows you to focus entirely on launching your venture and creating revenue.
If you earn income on the side as a freelancer or contractor, you may have a sole proprietorship and not even realize it. The simplicity of a sole proprietorship can make it a good starting point for solopreneurs, especially if your industry or trade has few legal risks.
Pros of being a sole proprietor
Here are the main pros of being a sole proprietor:
- It’s convenient to start because you don’t have to take any formal action.
- It’s free because you aren’t required to register with your state.
- It gives you privacy because your business isn’t entered into public records.
- It’s simple to maintain because there’s no annual paperwork (such as meeting minutes) to complete.
- It’s easy to convert into another business entity, if you wish.
- It simplifies taxes because you include the business profit or loss on your personal tax return using Form 1040, U.S. Individual Tax Returnopens pdf file, and Schedule C, Profit or Loss from Businessopens pdf file.
Cons of being a sole proprietor
While the simplicity of a sole proprietorship sounds great, it comes with disadvantages to consider. A primary downside is that it exposes your personal finances to an unlimited amount of risk. For instance, if a customer, client, or other party sues your business, your personal assets–such as your savings, vehicles, and home–could be at risk.
Here are the main cons of being a sole proprietor:
- It makes you personally liable for the business’s activities and debts because there’s no distinction or legal separation between you and the business.
- It can be challenging to build credit for your business or obtain financing if needed.
- It may not have the same prestige as an incorporated business.
While many small businesses and solopreneurs start as sole proprietorships, they may change to another entity as they grow.
When I began working as a freelance writer and podcaster on the side of my day job many years ago, I wasn’t sure where it would go, so I maintained sole proprietor status for years. When I began working with large firms as a PR spokesperson and consultant, I decided to become a limited liability company or LLC.
RELATED: What’s the difference between a 401(k) and solo 401(k)?
What is an LLC?
An LLC is a business entity that exists separately from its owners, called members. An LLC and its members have liability protection from legal claims against the business. You can have unlimited members or a single-member LLC, making it a good option for solopreneurs.
LLCs are typically set up with an operating agreement that defines the company’s membership, management, and income distribution. But it can be a simple document and doesn’t require a formal annual meeting or minutes, as with a corporation, so record keeping is easier.
You must register an LLC with the state and file a report with a fee every year. I live in Florida, with a one-time formation fee of $100 and an annual LLC fee of $138.75.
Interestingly, you can choose how you want to be taxed with an LLC. You can pay tax as a corporation or as a “disregarded entity,” which allows you to include pass-through income on your personal tax return. That means your business doesn’t pay taxes on its profits–instead you include them on your individual tax return.
Pros of having a limited liability company (LLC)
Here are the main pros of having an LLC:
- It’s recognized as a separate legal entity from the member(s), giving you unlimited liability for claims against the business and its debts.
- It gives you liability protection for claims against any other members.
- It has flexible organizational rules, requiring no formal officers or annual meetings.
- If you elect to be a disregarded entity, filing taxes is easy because you include any profits or losses from the business on your personal tax return.
Cons of having a limited liability company (LLC)
The main con for having an LLC as a solo or small business owner is the administration and registration cost, which varies depending on where you do business.
Also, separating your business and personal finances is important to simplify reporting and doing taxes as an LLC. While you’re not obligated to keep your personal finances separate as a sole proprietor, I highly recommend it for staying organized. If you don’t know which expenses were personal or business, you might forget to claim qualified expenses as business deductions and overpay taxes.
With an LLC, you should have a business bank account and sign documents and contracts on behalf of the business, not as an individual.
Recordkeeping is crucial when you’re self-employed. These eight rules will help you to stay compliant with the IRS and better understand your business now and in the future. Listen in the player below:
Should you have a sole proprietorship or LLC?
The answer to whether you should be a sole proprietor or have an LLC depends on factors like your type of business, potential risk of getting into a lawsuit, expected income, and business goals.
If you do contractual work as a consultant or freelancer with no employees, being a sole proprietor with business insurance may keep you safe and give you peace of mind. But it’s wise to create an LLC from the start if your business exposes you to certain risks, such as becoming a real estate agent or working in health care or food service.
So, what are the differences between a sole proprietorship and an LLC in Wasittha’s case, or – more so – which one is best? Since Wasittha said the business would create food products, creating an LLC would offer personal liability in the event of a lawsuit. I also recommend having business insurance based on the potential risks.
Since the needs of every business owner are different and the tax law varies by state, consider consulting a business attorney or a tax professional to discuss the issues that should affect your business entity, tax, and insurance decisions.
This article originally appeared on QuickandDirtyTips.com and was syndicated by MediaFeed.org.
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8 tax new tax benefits that rolled out last year
The much-awaited SECURE 2.0 Act of 2022 was signed into law on Dec. 29, 2022. The Act creates more tax savings for employers and employees, alike, and expands access to a work-sponsored retirement program to many employees.
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The new Starter K provisions allow employers that have never sponsored a retirement plan to set up a simplified 401(k)—named the “Starter K.” Under this new plan, employers will not be required to contribute, and employees will be automatically enrolled at 3% of pay. However, contribution limits are much lower for employees than a traditional 401(k). Beginning in 2024, employees can contribute a maximum of $6,000, with a $1,000 catch-up for those 50 or over.¹ In exchange for lowering the deferral limit, employers do not have to worry about annual ADP, ACP, or top-heavy testing.
The Starter K becomes a great option for a small business that cannot afford the administrative complexities and heavier price tag of a regular 401(k), but still want to give workers an opportunity to save for retirement. And especially in states that require an employer-sponsored retirement plan, the Starter K could be a great private alternative to the potentially somewhat clunky State-IRA options. The American Retirement Association estimates that 19 million additional workers will gain access to a workplace retirement plan with this provision enacted. Moreover, the plan will reduce racial inequity in the retirement space, as Black and Hispanic workers would see a a 22% increase in access to workplace retirement plans.
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Another of the more exciting provisions is the creation of Pension-Linked Emergency Savings Accounts (PLESAs), which are employer-sponsored accounts linked to a retirement plan, where non-highly compensated employees can withdraw more regularly and without penalty.
The account is to be set up as a designated Roth account and invested in highly liquid assets, such as a money market fund. Contributions must cease after the account balance reaches $2,500, and any additional savings goes to the Roth 401(k) account instead.
Participants can be auto-enrolled at 3% of gross income as an after-tax elective deferral. Employers need to match the funds with whatever 401(k) matching formula is used, and the match would be contributed to the 401(k) account. Participants can withdraw funds at least once monthly. They will also be able to replenish funds back up to the $2,500 cap at any time.
Not only do PLESAs have the potential to help alleviate the nationwide problem of households not having enough liquid emergency funds; they will also encourage retirement plan participation, since one of the main reasons for not participating is the fear of needing liquidity if an emergency were to occur.
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While not a new plan option, the new rules will now require all newly established 401(k) and 403(b) plans to include automatic enrollment, along with auto-escalation, as default features beginning Jan. 1, 2025. The initial auto-enrollment default must be between 3% and 10%, and the rate must increase every year by 1%, until the participant hits at least a 10%, and no more than 15%, contribution.
Employees can opt out or set their own contribution rate at any time, but this will ensure those who don’t take any action will automatically begin to save for retirement. There is an exception for small businesses with 10 or fewer employees, new businesses, church plans, and governmental plans. Plans established as of Dec. 23, 2022 are also grandfathered.
The Senate noted that auto-enrollment increases participation among younger, lower-paid employees and the racial gap in participation rates is nearly eliminated. No doubt that participation should significantly increase—however, given that auto-enrollment will be a requirement, there’s a chance the current $500 auto-enrollment tax credit for new plans will disappear as that incentive will no longer be needed. At Guideline, we believe that auto enrollment provides many benefits to employers and employees, which is why all eligible participants are automatically enrolled in their employer-sponsored 401(k) plan if they don’t either self-enroll or opt-out by the prescribed deadline.
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Increase in tax credits
Though auto-enrollment credit might eventually go away, SECURE 2.0 provides a wealth of additional tax incentives over the current ones.
The original SECURE Act, passed in 2019, increased the Retirement Plans Startup Cost Tax Credit to the greater of $500 or the lesser of either $250 for each eligible non-highly compensated employee (NHCE) or $5,000. The credit applies for up to three years and is limited to 50% of eligible startup costs, which include ordinary and necessary costs to set up and administer the plan, as well as educate employees about the plan.
Employers qualify for this credit if they have 100 or fewer employees, have at least one plan participant that is an NHCE, and have not sponsored a plan in the last three years.
SECURE 2.0 removes the 50% cap for qualifying businesses with up to 50 employees so that 100% of startup costs could potentially be covered. The maximum credit is still $15,000 over three years.
SECURE 2.0 also provides an additional credit for employer contributions, up to $1,000 per employee. Employers with up to 50 employees are eligible for the full credit, which is phased out for employers with 51-100 employees.
The new tax credit provisions, effective as of Jan. 1, 2023, significantly increase the benefits of starting a 401(k) plan for the smallest businesses and also provide monetary incentive for small businesses to start a safe harbor plan, which can make plan administration less of a burden in the long run.
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SECURE 2.0 turns the current Saver’s Credit into a saver’s match. Currently, individuals under a certain income threshold who save into their retirement account are eligible to receive a non-refundable tax credit of 50%, 20%, or 10% of their retirement contributions up to $2,000.
The new provisions require that this credit be deposited directly into a retirement account. The amount of the credit will remain the same based on prior requirements and again is phased out depending on income.
This provision is a clever way of ensuring that the saver’s retirement tax benefit is actually contributed towards their retirement and helps to boost retirement savings for those in a lower income tax bracket. However, it won’t be effective until after 2026—likely to figure out administrative challenges in how to deposit those funds.
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There is also good news for those paying off student debt. Starting in 2024, employers will be able to match payments employees make toward qualified student loans. The match must follow the same formula and vesting schedule as whatever is tied to the retirement plan, and the contribution will be deposited into the employee’s retirement account.
Employers will be able to rely on the employee’s certification that loan payments are being made. The student loan participants may also be tested separately from the rest of the plan for ADP purposes.
The new rules will allow employees with large student debt to still capitalize on any matching contributions offered by their company to help them keep on track for retirement.
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Catch-up contributions
The Act includes some nice adjustments for later-stage participants, beginning with an increase in catch-up contributions.
Starting in 2025, the catch-up contribution limit will increase to $10,000 for employees aged 60 to 63. The limit will be indexed for inflation every year, and—here’s the catch—all catch-up contributions will now be required to be Roth, unless the employee earns $145,000 or less annually.
Some have mixed feelings about this provision. On the one hand, employees nearer to retirement are allowed to save even more in a tax-advantaged way, but on the other hand, the immediate tax benefit gets taken away from them. Older participants generally prefer to save money on a pre-tax basis if possible, as the tax advantage of Roth contributions increases exponentially the longer you hold money in your account.
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Another favorable provision for later-stage savers is the required minimum distribution (RMD) age increase to 73, beginning on Jan. 1, 2023. The current RMD age is 72. The RMD age will also increase to age 75 in 2033. And starting in 2024 designated Roth contributions will no longer be included when calculating the RMD amount.
The late withdrawal penalty is also decreased to either 10 or 25% (down from 50%), depending on how soon the error is corrected. The provisions provide a logical adjustment to required distributions as life expectancy increases, allowing individuals more time to determine their best withdrawal strategy for tax purposes.
On the whole, we are excited about the new SECURE provisions and believe there will be an overall positive impact on the retirement readiness of American workers. Guideline looks forward to supporting the required immediate changes and adjusting our offerings in the future to accommodate the rest.
This article originally appeared on the Quickbooks Resource Center and was syndicated by MediaFeed.org.
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Featured Image Credit: DepositPhotos.com.
