When figuring out your “choice of entity,” you first want to make sure it even makes sense for you to form an LLC. Sometimes, remaining as a sole proprietorship makes the most sense.
Here's some background. If you don’t form an entity and you’re the only owner, you are, by default, considered a sole proprietorship in the eyes of the government. They’re automatic, meaning there’s no need for state filing and registration, unlike LLCs, corporations, and nonprofits.
So if you open a lemonade stand on your sidewalk, you’re a sole prop. (If you have more than one owner, by default you’re considered a partnership, but almost no one does this).
Limited Advantages for Sole Proprietorships
So why would you want to be a sole proprietor rather than establishing a formal entity?
Easy to Form
In a sole proprietorship, one person owns and manages the business. They’re easy to form--they’re automatic, unless you want to sign contracts in a business name. In that case, you would need to file a fictitious name registration (a.k.a. d/b/a, or “doing business as”) with the state.
For example, if you were a sole proprietorship and you wanted to call your startup “Techy” and sign contracts on behalf of “Techy,” you’d file a d/b/a with your state saying you’re doing business as “Techy.” Otherwise, you can only sign contracts using your personal name.
So, they’re cheap, couldn’t be easier, and automatic. Seems great to be a sole prop, right? Sometimes, but for most businesses, establishing a formal entity is a smarter move. Let’s learn factors to consider when thinking about whether to become a formal entity.
When LLCs are Better than Sole Props
If any of these factors apply, then forming an entity usually makes sense:
Your business has any potential liability
The best way to think of this is to ask yourself, “Could any potential customer sue me for something related to my business? If you create products, could the customer somehow harm themselves or others with the product?
If you sell services, could you be sued for malpractice? Or be sued for not performing the services correctly?
Do you drive anywhere for your business? If so, and you get in an accident, then the other party involved in the accident could sue your business since driving somewhere for business purposes makes that claim available for that other party.
Your business has more than one owner or has employees
If this is true, then definitely form an entity. Without an entity, you could be personally liable for the other owner’s or your employee’s actions.
You want your business to continue on if something bad happens to you.
The fact that there’s no distinction between you and your business means there is no continuity of life—meaning your business ceases to exist when you can no longer operate it. So the owner’s death or incapacitation (due to an illness or otherwise) discontinues business operations. If Max dies, Max’s Studio will cease to exist.
You’ll seek investment
Because sole proprietorships are designed for single owners, they also can’t take on investors. How could you? You don’t have an interest in a company to sell to anyone. So you couldn’t issue equity or stock to raise capital.
For example, Max’s friend is interested in joining the business. He wants to invest and become Max’s business partner. By law, Max would not be able to take in a business partner and remain a sole proprietor. If he’s thinking of selling some of his company’s shares to raise capital, he would need to switch to a different business structure.
Similarly, you can’t pay your employees with equity compensation because there really is no equity.
Your state has low fees for forming an entity
Especially if your state has low fees, then entities make a lot more sense. What constitutes “low fees?” It’s a balancing act, but here’s an example.
Let’s say you moonlight as an artist and sell occasional paintings on Etsy. You generate approximately $2,000 in revenue each year. And you’re the only owner and you have no employees. If your state charges you $500 to form an LLC or a corporation, and you have to pay another $500 each year as an annual fee, then setting up an entity probably doesn’t make as much sense.
But, if your state charges you $50 to form an LLC and has no annual fees, then there’s virtually no downside to forming the LLC or corporation and it creates more credibility for your business.
You sign contracts on behalf of your business
If you sign contracts in your business, entities can provide liability protection if you breach the contract (or don’t breach but are sued anyways).
One caveat: entities do NOT provide liability protection when you commit a tort, which means you took or did not take an action that injures someone else. If your employee or other owner committed a tort, then it provides protection for you. But if you personally harm someone, you’re still liable for that harm (this is where insurance is valuable).
All this being said, forming an entity helps make your business feel more “official”—which is a great intangible benefit.