This is one of the first things any business has to decide but it can have a huge impact on the business and personal impacts for the owner.
A sole proprietorship simply means you are making money as an individual, not a separate legal entity. If you register with your state this way, you usually have to keep the name the same as your personal name or include your personal name (such as John Doe Handyman), or you have to register a DBA (doing business as) so it’s legally established that you’re operating under a different name.
The real problem with a sole proprietorship though isn’t the name, it’s the lack of legal protection for your personal assets. As a sole proprietorship, you are personally liable for all the financial obligations of the business. For example, if you damage someone’s home or hurt or kill someone, that would be on you personally. Most people can’t afford to suddenly drop tens or hundreds of thousands of dollars over an honest mistake and certainly don’t want to even if they can.
If this happens, every single personal asset you own is now at risk. Yes, your personal checking account, savings, retirement, your shared home that shelters your family, it’s all at risk. You could literally end up walking away with no money in the bank and no more house (and still owing more). Yes, this has actually happened to people.
An LLC (limited liability company) is a separate legal entity from you personally. This creates a wall between your personal assets and the business. Obviously, this is much better than being a sole proprietorship. In Virginia, it only costs $100 per year to be an LLC. That’s a lot of protection for only $100. And considering that a sole proprietorship doesn’t offer a single advantage over an LLC, it’s a no-brainer.
This does assume however that you keep your personal and business finances separate. This should be done no matter what type of business it is. Even as a sole proprietorship, a separate checking account for all the business activity makes the bookkeeping really easy and much more accurate. Making deposits into your personal account, paying for business expenses out of your personal accounts, and even just making personal purchases from the business account pierce the veil of the LLC meaning your personal assets are now at risk again because you let the business and personal finances co-mingle.
You can still pay yourself, but it should be done routinely in a clear way. For example, you may establish a specific minimum balance for your business checking account to cover expected cash flow and pay yourself everything above that at the end of the month. For a simple example, let’s say you want to keep at least $10,000 in your business checking account and at the end of the month you have $17,000. So you write yourself a check for $7,000 and deposit that into your personal checking account. That’s fine (and you should immediately set aside 25% or more for your estimated tax payments).
I don’t recommend being a corporation unless there are specific reasons why you really need to do it that way which are beyond the scope of this article. An S-Corp is fine because it’s still taxed as a pass-through entity and you can be an S-Corp with the IRS and an LLC with your state. However, C-Corps are subject to double taxation. This means the business is taxed directly AND then the remaining profit is taxed again by the individual owner(s).