Sole Proprietorship vs. Incorporation: What’s the Difference?

One of the decisions all new business owners face is how to set up their business structure. In the beginning, you can either take the easy route and operate as a sole proprietor or choose to incorporate your business. Let’s look at some of the advantages and disadvantages of both options.

[Read more: When — and Why — You Should Consider Changing Your Business Entity]

Sole proprietorship vs. incorporation

If you’re new to running a business, then you may not fully understand the difference between a sole proprietorship and incorporation. According to the IRS, a sole proprietor is an individual who runs an unincorporated business on their own. It’s the easiest and most common way to start a business in the U.S.

That’s because there’s no paperwork for you to fill out or dues to pay when you’re just getting started. As long as you’re the only owner, you’re automatically granted the status of sole proprietor without having to do anything.

In comparison, incorporation is the legal process of forming a company. You’re forming a business entity and creating a legal separation between your personal assets and the business’s assets. Most businesses either incorporate as an S corporation or a C corporation.

A corporation may be able to take advantage of certain business deductions that aren’t available to sole proprietors. However, both business models require a lot of paperwork to get set up.

[Read more: 6 Steps to Incorporating Your Business]

Pros and cons of sole proprietorship

Operating as a sole proprietor is the easiest and more inexpensive way to start a business. For instance, if you provide freelance services, then you may start out as a sole proprietor. You have complete control over your business, and all of the profits are yours to keep.

As a sole proprietor, you and the business are viewed as a single entity. Your business is considered a “pass-through business,” which means any income and tax liability passes through to you as the owner. For that reason, your business income won’t be taxed separately, which will make things much simpler come tax season.

However, there is no liability protection for sole proprietors. So as a business owner, you’re personally responsible for any debt the business takes on. And if one of your clients sues you, your personal assets could be at risk.

Pros and cons of incorporation

When you incorporate your business, you’re creating a separate legal entity. And one of the biggest advantages is the liability protection that comes with this.

When you incorporate, you’re not held personally responsible for any debts or lawsuits incurred by the business. If any legal claims are brought up against the business, then you’re not personally responsible for them.

When you incorporate your business, you may be taken more seriously as a business owner. Incorporating can also make it easier to apply for business financing in the future.

However, there’s a lot of work that comes with incorporating your business. You have to file your articles of incorporation, hold shareholders’ meetings and track corporate minutes. If you’re a new business owner, you may not be ready to commit to all of that.

Are there any alternatives?

What if you’re not ready to make the leap to an S corp or C corp, but you’re uncomfortable with the lack of liability protection that comes with operating as a sole proprietor? If you find yourself in this situation, you might consider setting up a single-member LLC.

This type of business structure is ideal for solo business owners who want a simple and straightforward business model. As a single-member LLC, you’re still considered a pass-through business, so you can continue to report the business’s income on your personal tax returns.

But unlike sole proprietors, single-member LLCs enjoy liability protection. So if the company is sued, goes into debt or goes bankrupt, your personal assets will not be at risk.

There is some paperwork involved in starting a single-member LLC, but it’s less tedious than incorporating as an S corp or C corp. You’ll want to check with your Secretary of State’s office to see what the requirements are where you live.

[Read more: Sole Proprietorship vs. LLC: Which Should You Choose?]

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