A common question amongst digital nomads is what company to set up: Sole proprietorship vs corporation.
In order to be able to answer this question, we need to weigh all the pros and cons of setting up a corporation as opposed to run a business from a sole proprietorship.
Sole proprietorship and corporations are by far the most common business structures for freelancers, location independent workers, entrepreneurs and Digital Nomads.
In fact, if you start a business and you are making money by invoicing your clients you will by default be classified as a sole proprietor unless you take formal steps to incorporate your business which will then result in a corporation.
Table of Contents
- Sole Proprietorship VS Corporation – Overview
- Sole Proprietorship VS Corporation
- Signs that You’re Ready to Incorporate a Company
- Sole Proprietorship VS Corporation Pros and Cons
- Conclusion – Sole Proprietorship VS Corporate
Sole Proprietorship VS Corporation – Overview
Let’s start this guide with some questions I frequently receive from digital nomads and entrepreneurs, from the main difference between sole proprietorship and corporation to the tax situation and more.
What is the Main Difference Between Sole Proprietorship and Corporation?
The primary distinction lies in structure and ownership. A sole proprietorship is an unincorporated business owned by one individual, where there’s no legal separation between owner and business.
A corporation is a separate legal entity, providing a distinction between the owners (shareholders) and the business entity.
How does Liability Differ Between Sole proprietorship and Corporation?
In a sole proprietorship, the owner has unlimited personal liability for business debts and obligations.
In contrast, a corporation offers limited liability protection, where shareholders’ personal assets are generally not at risk for business liabilities.
What are the Tax Implications of a Sole Proprietorship VS Corporation?
Sole proprietorships benefit from pass-through taxation, where business income is reported on the owner’s personal tax return.
Corporations face potential double taxation—corporate profits are taxed, and dividends paid to shareholders are taxed again on individual returns.
However, some corporations (S-corporations) can elect pass-through taxation.
Can a Sole Proprietorship Convert to a Corporation?
A sole proprietorship can transition to a corporation by filing articles of incorporation with the state, creating corporate bylaws, and issuing stock.
This process includes obtaining a new Employer Identification Number (EIN), and potentially changing business name and bank accounts to reflect the new corporate identity.
This conversion can offer benefits in liability protection and fundraising options.
Sole Proprietorship VS Corporation
Now that you have a better idea of what each of these mean, let’s go further in-depth for each, so you know which one to go for when the time comes.
Sole Proprietorship means that you and the business are the one and the same.
This is true from a legal and tax point of view. It basically means that business profits and losses pass through to your (the owner’s) personal tax return and you will have to pay taxes on that income.
The advantages of running your business as a sole proprietor are that it is one of the simplest and least expensive business structures. As stated above, if you don’t take any actions to formally set up a corporation, you’ll be deemed a sole proprietor.
In some countries, you might have to get registered as a sole proprietor and get a registration number, but that’s about it.
Further, you will be in complete control of your business and there isn’t an additional tax return that you will have to lodge.
The big disadvantage of a sole proprietorship is that you are personally liable for all business activities. This means that there is no legal separation between you and the business.
Therefore, if someone should decide to sue your business and they win, that they could potentially take all your personal assets (including your home, car, personal bank account, etc.)
If the disadvantages of a sole proprietorship, make you nervous then you might be better off organizing your business as a registered corporation.
Having a corporation will protect your personal assets in the unlikely event that your business faces a lawsuit or bankruptcy. Even if you’re the only owner of the business and have no employees, you can set up a single-person corporation.
A corporation is a separate legal entity from you and offers limited liability, which is one of the biggest advantages of a corporation. This means that if someone sues your business, they are limited to collect only from the business’ assets and your personal assets remain safe.
Besides the added legal protection that a corporation offers, another benefit might be that a corporation tends to be taken more seriously especially when dealing with outsiders such as potential investors, suppliers, and clients.
A corporation will also be taxed separately and can oftentimes access more tax benefits than a sole proprietorship.
However, one of the biggest disadvantages of a corporation is that the formal setup process can take up time and will be more expensive than that of a sole proprietorship.
Also, running a corporation can be a bit more time-consuming as you’ll have to make sure that your business and personal finances are separate which means you’ll need a business bank account.
This is important to ensure that you’ve got that legal protection in case someone decides to go after you.
So, how do you know when it is time to set up a corporation? Below we’ve listed a couple of factors that might help you when making up your mind whether to set up a separate business entity or not.
Signs that You’re Ready to Incorporate a Company
You Start Making Regular and More Money
When you are starting out your Digital Nomad journey oftentimes, you start with a little number of clients and you are just making enough to cover your daily costs. If that is the case, a sole proprietorship is adequate.
However, as soon as you start generating more income and your business is able to provide you with a bit of extra money in your bank account – that is when you might want to start thinking about formally setting up a corporation.
So, as soon as your initial project, side-hustle or hobby starts bringing in regular and steadily increasing income on which you can rely on, that is when it’s time to set up your corporation.
You Want to Hire People
You can hire people both as a sole proprietor and as a corporation. However, hiring people means that you’ll have much more responsibilities.
These include administrative tasks such as ensuring you get your employee’s tax identification number and social security number, complying with guidelines, and withholding correct amounts from every paycheck for tax obligations.
You might also have additional obligations such as having to pay for worker’s compensation.
You quickly realize that there are many obligations and this means that there are also more opportunities to mess it all up.
The more complicated it gets, the more you will want to protect yourself. That’s why as soon as you are starting to think about hiring people who could potentially sue you, you should make sure that you protect your personal assets by establishing a corporation.
With a corporation in place, employees can only seek recovery from the corporation’s assets.
You Want to Save Taxes
Another valid reason for wanting to set up a corporation is to access certain tax benefits.
We’ve discussed before that sole proprietorships are the same as you. This means, that if you run your business through a sole proprietorship, all your income will be taxed at your personal income tax rate.
By contrast, if you set up a corporation the corporation will lodge a separate tax return to your personal one and will be taxed at the current corporate tax rate.
Tax rates are oftentimes lower than personal income tax rates which means you have to give less to the government if you run your business through a corporation.
Also, in many countries, if you run your business as a sole proprietorship you have to pay self-employment taxes which are likely to include your own Social Security contributions and potentially Medical Care taxes on all of the business’ income.
With a corporation, you only have to pay these taxes on the salary that you pay yourself.
Lastly, many countries even have lower tax rates for small corporations and grants available to new start-ups through which you could receive further tax benefits.
You Want to Attract Big Clients
If you’re hoping to land a big client or you are working together with big companies, you have to keep in mind that they prefer to work with corporations.
To put it simply, a corporation makes your business more attractive to prospective clients. Oftentimes large companies won’t even consider working together with you unless you are a corporation.
On the other side, you also have to consider that working together with large companies might expose you to more risk as those companies would have the money to potentially sue you if you don’t comply with certain agreements.
As such, you definitely want to make sure that you have a corporation that will protect your personal assets.
You Need to Raise Money
Oftentimes when your small business starts growing, you might need a business loan from the bank or money from investors. In both cases, whether you are dealing with the bank or with private investors, they both prefer working with corporations.
Corporations are in fact less likely to default on loans and have higher success rates compared to a sole proprietorship. Corporations also present the potential lender with the lowest risk.
That’s why this could be the appropriate time to start thinking about setting up a corporation in order to create more credibility and trust around your business.
Whatever your reason may be for wanting to set up a corporation we are able to help you with the formal process of incorporating a business.
Sole Proprietorship VS Corporation Pros and Cons
Let’s now talk about the pros and cons of both sole proprietorship vs corporation for you to make an informed decision before actually starting.
Sole Proprietorship: Pros and Cons
- Simple to Establish: Minimal paperwork and legal formalities.
- Full Control: Owner makes all business decisions.
- Tax Benefits: Income is taxed once on the owner’s personal tax return (pass-through taxation).
- Fewer Regulations: Less government oversight and regulatory requirements.
- Direct Receipt of Profits: All profits go directly to the owner.
In a sole proprietorship, one significant drawback is the issue of unlimited personal liability. This means the owner is personally responsible for all business debts and legal matters.
If the business incurs debt or faces lawsuits, the owner’s personal assets, such as their home or savings, can be at risk.
Another challenge for sole proprietors is limited funding options. Raising capital can be more difficult, as sole proprietorships typically don’t have access to the same range of financing options as corporations.
Securing loans may also be challenging, as lenders often perceive a higher risk in sole proprietorships. This can limit the business’s ability to expand or invest in new opportunities.
Lastly, sole proprietorships may suffer from a perception of less credibility. Compared to a corporation, a sole proprietorship might be viewed as less professional or established, which can affect business relationships.
Corporation: Pros and Cons
- Limited Liability: Shareholders’ personal assets are protected from business debts and lawsuits.
- Increased Credibility: Often viewed as more established, aiding in business relationships.
- Easier Access to Capital: Can raise funds through the sale of stock.
- Perpetual Existence: Continues to exist even if ownership changes.
- Tax Flexibility: Potential for tax benefits, especially for S-corporations with pass-through taxation.
The formation of a corporation involves a more complex and costly process compared to a sole proprietorship. Establishing a corporation requires substantial paperwork, adherence to legal formalities, and often entails higher initial setup costs.
This complexity can be a significant barrier for some entrepreneurs, especially those looking for a quick and straightforward start.
Another aspect to consider with corporations is the increased regulatory requirements. Corporations are subject to more government oversight and regulations than sole proprietorships.
This includes periodic filings, maintaining corporate records, and adhering to both state and federal regulations. These requirements demand more time and resources, which can be a burden for business owners.
Lastly, in a corporation, especially one with multiple shareholders, the owner often has less control over business decisions, which is something to consider.
Conclusion – Sole Proprietorship VS Corporate
In conclusion, the choice between operating as a sole proprietorship vs corporation depends largely on individual business needs, financial goals, and risk tolerance.
Sole proprietorships offer simplicity and direct control but come with unlimited personal liability and less opportunity for raising capital.
Corporations, on the other hand, provide limited liability protection, potential tax advantages, and easier access to funding, but they require more paperwork, formalities, and can involve double taxation.
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NOTICE: The content of this article is not to be considered as a legal opinion or tax advice. Wanderers Wealth does not hold itself out as a legal or tax advisor. If you want to receive a legal opinion or tax advice on the matter in this article please contact us directly and we will refer you to a legal practitioner.