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What to Consider When Deciding Between Forming a Sole Proprietorship or LLC

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Q: With starting a home-based vegan foods business, is it better to set up as sole proprietor or LLC?

A: I considered this question a few months ago when I started my own law firm.  Sole proprietorship is so simple and inexpensive and thus, so appealing.  But after researching the issue, I chose the LLC instead.  While my law firm might not be as tasty a venture as your vegan foods business, the issues we face in choosing our business entity are the same.

Here’s what you should consider:

Sole Proprietorship

The positive: There is no easier way to launch a business than as a sole proprietor -- basically, you just start working.

Related: Choose Your Business Structure

You ARE the business. Indeed, if you want to name the business something other than your legal name, you’ll need to file a “Doing Business As,” or DBA, name in the states in which you’re engaging in business. But that’s really all: It’s simple and inexpensive.  Even the taxes are easy: You pick up all the profits and losses of your business on your individual tax return, and you don’t need to file a separate return for the business.

The negative: A sole proprietor has zero liability protection. So, if someone gets sick from one of your vegan goodies, they can sue you personally. If they win, they will have access to all of your assets: your money, home and cars, among other assets.

If you were selling scarves instead of food, a sole proprietorship might be for you.  But any business with potential liability (that can’t be sheltered with insurance) should not be a sole proprietorship.

Limited Liability Company

The positive: The biggest benefit of the LLC over the sole proprietorship is that the LLC shelters you from liability.  A potential plaintiff would have to sue the LLC -- and if he or she wins, the person would generally be limited to the assets of the LLC (not your personal assets).  A single-member LLC is taxed in the same way as a sole proprietorship: The profits and losses flow through to your individual tax return.  But, unlike a sole proprietorship, you can add one or more partners.  While you give up the simplicity of filing your business’s profits and losses on your own tax return at that point, the LLC still gives you the benefit of pass-through taxation.

The negative:  An LLC is a statutory entity, which means that you’ll need to file a certificate of formation (this document has different names in different states) and pay filing fees to set up the entity.  This is a simple process: You can generally find the directions to file, along with a sample form, on a state web site. Or you can work with a filing company that will charge a fee to process the filing. 

Related: 7 Mistakes To Avoid When Choosing Your Business Entity

Here are a few more tidbits to consider when going down the LLC route:

Where to form the LLC

Once you decide to form an LLC, you need to determine which state will be your home base.  Often this is an easy decision: It’s where you’re doing business.  If, however, you intend to raise capital for your business, you should file the initial certificate of formation in Delaware, even if you’re not based in Delaware.   This is a more expensive process, because you’ll end up paying a couple of hundred dollars extra each year for someone to act as your local representative, (address) and you will need to request authority to do business in the other states in which you engage in business, costing even more money. The added expense may be worth it as Delaware is the state of choice for most investors. 

Being an LLC and raising capital

Often, you will hear that if you’re seeking venture capital for your business, you should set up a corporation.  While it’s true that venture capital funds tend to only invest in corporations (unless venture capital is imminent) there is a potentially significant tax cost to you if you start out as a corporation: You’ll lose out on all the losses from the start up phase that you can deduct on your personal return if you’re an LLC.  I always advise to start up as an LLC in Delaware where it is very simple to convert to a corporation right before the closing of a venture fundraise. 

Related: How to Choose the Best Legal Entity for Your Business