Doing Business as a Sole Proprietorship v. LLC: Considerations for Small Business Owners

Many small business entrepreneurs confront the issue of whether to start out as a sole proprietorship (“DBA”) or form an entity for their business such as a limited liability company (“LLC”).  In this blog article, the ladies of Smith Shapourian Mignano LLP discuss some important factors that small business entrepreneurs should consider when determining whether to do business as a sole proprietorship versus an LLC.

Set Up

Setting up your business as a sole proprietorship is simple and straightforward.  As a small business owner, you simply need to:

• Choose a business name available for use, after performing a federal and state name search;
  
• File a Fictitious Business Name Statement with the appropriate county recorder;
  
• Obtain licenses, permits, and zoning clearance, if applicable; and
  
• Obtain an Employer Identification Number.
  

Setting up your business as an LLC is likewise relatively simple and straightforward, especially for single-member LLCs.  In California, you must register your LLC with the California Secretary of State’s office by filing Articles of Organization.  In addition, during the formation process, you will need to:

• Choose a business name available for use, after performing a federal and state name search;
  
• Draft an Operating Agreement tailored to the single-member or multi-member California LLC;
  
• Prepare an initial Statement of Information for filing within 90 days of formation of the LLC;
  
• Obtain licenses, permits, and zoning clearance, if applicable;  
  
• Obtain an Employer Identification Number; and
  
• If you have been operating as a sole proprietorship prior to forming an LLC, draft a Founder IP Assignment Agreement (for assignment of your domain and website, existing trademarks, patents etc.), or a Transfer of Assets and Liabilities Agreement, if there are more assets to transfer from your sole proprietorship to your LLC (such as a commercial lease, insurance policy, capital, etc.).
  

Where there are two or more owners of your LLC, an Operating Agreement becomes quite crucial as this document spells out each member’s duties, capital contributions, and rights to profits.  For more information on this document, please see our previous blog article on the importance of an Operating Agreement here.

While setting up an LLC requires more upfront time and money (in legal fees and filing costs, for example) than a sole proprietorship, there are important benefits to forming a business entity such as an LLC for your business.

Personal Liability

Unlike a sole proprietorship, an LLC exists as a legal entity that is separate from its individual members or owners.   

Unlike a sole proprietor or general partner in a partnership, an LLC owner is not personally liable for the business liabilities or debts of the LLC.  While an LLC owner may forfeit his or her capital contribution to the business if the LLC fails, an LLC owner is not personally liable for the LLC’s debts or legal liabilities.  So, the LLC owner’s personal assets, such as his or her home, car, or individual bank account, are not at risk.  There are limited exceptions to this rule, such as in cases where there exists:

• Personal guarantees on a loan to an LLC;
  
• Overdue taxes, in which case the IRS or California Franchise Tax Board may go after personal assets of LLC owner(s);
  
• Negligent or intentional acts (“torts”);
  
• Breach of fiduciary duty (which requires more than just an honest mistake or poor judgment, and is usually reserved for serious indiscretions like fraud); and/or
  
• Absence of a boundary between the LLC and owners, allowing courts to “pierce the corporate veil.”
  

Taxes

For federal tax purposes, there is not much difference between organizing your business as a sole proprietorship versus an LLC.  A sole proprietor’s income is taxed on an individual income tax return.  LLCs receive “pass through” treatment, which similarly allow allocated profits to be taxed on each member’s individual income tax return.  

In California, however, there is a minimum annual franchise tax of $800, which is due shortly after forming an LLC.

Profit Sharing

Especially where there are two or more business owners, an LLC may be the more appropriate choice in terms of setting up profit sharing.  An LLC provides owners with a flexible structure to determine how profits are allocated under the applicable Operating Agreement.  LLC members are not necessarily limited to their proportion of ownership, and may agree to divide up profits in a different manner.  However, LLC’s may not distribute profits when it endangers solvency, or when liabilities are equal to or greater than assets.
In sum, for small business owners, the decision to go about business as a sole proprietorship versus an LLC is certainly one worth considering.  Smith Shapourian & Mignano, LLP is available to answer any questions or concerns you may have regarding forming an LLC for your business.  Feel free to contact us for a consultation.

This blog does not constitute solicitation or provision of legal advice, and does not establish an attorney-client relationship. This blog should not be used as a substitute for obtaining legal advice from an attorney licensed or authorized to practice in your jurisdiction. You should always consult a suitably qualified attorney regarding any specific legal problem or matter in a timely manner, as statutes of limitations may bar your claim.