The Differences Between an LLC, a Sole Proprietor, and an S Corp.

By Jeffry Olson, J.D.

The Differences Between an LLC, a Sole Proprietor, and an S Corp.

By Jeffry Olson, J.D.

When starting a new business, the choices and decisions you have to make may seem overwhelming. Not the least of these decisions is the form of business you should choose for your new enterprise. If a new business has only one owner and a legal form of business is not specified, the business is, by default, a sole proprietorship. Popular choices for a more formal business entity include a limited liability company (LLC) and an S corporation, or S corp. Understanding these forms of business and the advantages and disadvantages of each can help a new business owner decide which form best suits his or her situation.

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Understanding an LLC

An LLC is a formal business entity that allows for the pass-through taxation, also known as flow-through taxation, of a sole proprietorship combined with the limited liability of a corporation. A business owner can create an LLC by filing articles of organization with the Secretary of State or other business authority. Creation of an LLC is simple, with many states offering the necessary forms online. The owners of the LLC, called "members," have limited liability for the actions of employees or fellow members if the LLC is properly created and operated.

One of the main drawbacks of an LLC is the difficulty of raising additional capital. LLCs do not use shares as corporations do. The most common method for raising additional capital involves adding members, which requires the existing members to give up some control of the LLC.

It can also be difficult to transfer an ownership interest in an LLC. Ownership transfers are often governed by the operating agreement. This process may make it difficult or impossible to sell outside the group of members, limiting the value of a member's ownership interest. This limitation can also be a positive, limiting the ability of other members to transfer ownership interests to outsiders.

Understanding an S Corporation

An S corporation is not a form of business itself. Rather, it is a corporation that has selected tax treatment under Subchapter S of the Internal Revenue Code. As such, owners, called "shareholders," benefit from flow-through taxation. At the same time, the S corporation provides limited liability for the shareholders.

The primary disadvantage of an S corporation is the level of formality required. As a corporation, S corporations must file official state and federal documents. These include not only articles of incorporation but also corporate minutes. S corporations must also hold regular shareholder meetings and pay additional government fees. If overlooked, failure to comply with the corporate formalities may result in a loss of liability protection in the future. Specifically, a court may elect to treat the business as a sole proprietorship for liability purposes.

Their Differences

When a small business begins operation without any formal legal filings, it is a sole proprietorship. A sole proprietorship has flow-through taxation, but it also has unlimited liability, which means that the sole proprietor's personal assets are at risk for any liability incurred, including by employees. An LLC provides the tax advantages of the sole proprietorship but limits member liability. The personal assets of a member are not at risk due to the liability incurred by employees or fellow members. The S corporation provides similar tax advantages and limits liability. However, it is more formal. In order to maintain corporate status and limited liability, the S corporation must meet state and federal requirements, including regular shareholder meetings and the appropriate documentation.

This portion of the site is for informational purposes only. The content is not legal advice. The statements and opinions are the expression of author, not LegalZoom, and have not been evaluated by LegalZoom for accuracy, completeness, or changes in the law.

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