LLC or sole proprietorship? USC expert answers your burning small business questions
The director of USC Gould’s Small Business Clinic addresses many of the major questions he hears from individuals looking to get their businesses off the ground.
Starting a business comes with a lot of questions, from whether to start an LLC or go the sole proprietor route, to protecting yourself as an independent contractor.
USC Gould School of Law Professor Michael Chasalow is the right person to tackle questions like those. Over the last 12 years, he’s directed the law school’s Small Business Clinic, which provides pro bono legal services to small businesses in Southern California. The bread and butter of the clinic is getting businesses off the ground, protecting existing entities from liability and planning for growth. Although the clinic is completely student-led, as the supervising attorney Chasalow is hands-on with every client who walks through its doors.
In the clinic, what are kind of the questions you ask to figure out which way a business might go in terms of forming an entity?
My first question is, “How many people are going to own the entity?” The reason that’s important is because if you just have one person, you don’t have to worry about dividing or allocating rights so you have more flexibility in what entity you might choose. Conversely, if you have multiple people, you have to go to the next question, which is, “Are they all being treated the same way?” Once I know they are not being treated the same way, I have to ask what are those differences and if we need to have a more complicated ownership structure to reflect the different ways the different owners might be treated.
You also get a sense for their goals, right?
I try to get a sense of the likely trajectory of the business. One of the questions I ask is, “If this is successful — not ‘win the lottery’ successful, but if this business achieves what you want it to — how much money will it make?”
Some people would want a business to make $200,000 a year and they would be thrilled. Some want a million dollars. Some want it to be like Google. Those different goals push us in different directions.
The first is like a mom-and-pop business. It’s, “I want to have my own business. I don’t want to work for anyone else, but this is never going to make me fabulously wealthy but will provide me with stability and income and I’ll be in charge.” Then we don’t have to worry about forming a corporation or going public. It’s likely that an LLC will meet the needs of the owners and the business.
If they want to be Google, we have to create a company that venture capitalists are going to want to invest in, which is a corporation.
Do entrepreneurs usually have this figured out early on?
Most of the businesses we see are starting small, so at least some growth is required. The real question is, on what scale? Some businesses won’t make money unless they are big. For example, it’s difficult to have an online dating service with only 500 users. With other businesses, the answer is “I don’t know” because they could envision a successful business on either a small or a big scale.
For example, let’s say someone wants to open a boba drink place. Maybe they’re going to have one store, although their hopes are that it’s many stores. But either would be OK. Then you have to plan a company that gives the business options in the future.
Let’s say you’re a sole proprietor. When should you shift to an LLC?
In general, most lawyers are going to recommend that all businesses operate under the protection of limited liability, so it is rare that we would recommend someone operate as a sole proprietorship and not form an LLC (or a corporation). LLCs protect the owners from claims against the business and few lawyers want to bear the risk of that liability by telling a client, “Don’t worry about it. I’m sure everything will be fine.”
However, when evaluating the degree of risk faced by an entrepreneur operating as a sole proprietorship, the big question is, “Are you in the kind of businesses that exposes you to liability?” For example, a graphic designer has much less exposure to potential liability than someone who operates a rock climbing business.
The most common reason that someone forms an LLC is limited liability and the protection an LLC provides for the owner(s) from claims against the business. However, there are two other reasons I see that lead people to form LLCs: tax benefits and credibility.
If I go to a yoga studio, I don’t care if they formed an LLC or not.
Tax benefits show up in different ways. Often, an LLC provides a vehicle for tax benefits that are not available or might be subject to greater IRS scrutiny in a sole proprietorship. Also, it is sometimes easier deducting certain expenses through an LLC — especially one that elects to be taxed as an S-corporation — than through a sole proprietorship. However, if the business is only making $5,000, you’re not paying enough in taxes to see meaningful tax benefits. Even though there are potential tax benefits in operating a business as an LLC, it is unlikely the owner will see those tax benefits until the business is making $40,000 to $50,000.
The third reason people form LLCs, which I just call “credibility,” is an interesting one. Some businesses, although not all, benefit from the legitimacy that other businesses associate with a formal entity. Of course, with some businesses, credibility is not an issue. If I go to a yoga studio, I don’t care if they formed an LLC or not.
But businesses that are doing businesses with other businesses (often called B2B) — such as business suppliers or vendors — often seem more established and professional if they’ve taken time to formalize their entity.
What if a sole proprietor has a low-liability situation but does hire other contractors?
If I operate as a sole proprietor, I can create liability for myself through my actions. But as soon as I hire other individuals to perform work, those individuals become agents of my business and have the power to create liability for me.
While workers can also create liability for an LLC, the LLC owner’s personal assets should have significant protection from most claims that arise out of the actions of the LLC’s workers. This would not be true in a sole proprietorship.
In layman’s terms, you mean you don’t want to lose your personal finances or assets due to a business dispute?
Right. If I operate my business as a sole proprietorship and there is a substantial claim against the business, I could lose my house and personal assets. However, assuming that the business is operated through an LLC and that LLC is properly formed and operated, then that LLC provides protection for the business owner’s home and other assets, even if there is a claim against the business.
Of course, this “protection” is not free. Whenever you form an entity, there are costs and hassles.
Whenever you form an entity, there are costs and hassles.
LLCs cost money to form, pay yearly fees to the state (the minimum fee is $800 in California), and the owners need to follow certain rules to treat the LLC as separate from the owner’s personal assets.
Still, I think that almost all businesses should form an entity that provides limited liability protection. While it is important to recognize that some individuals are not ready to form an LLC (or a corporation), it is important to distinguish between being too early in the process to form and not wanting to spend the money. Operating a business comes with several costs. If the business can’t afford those costs, it might mean — painful as it is — that the entrepreneur needs to reevaluate the underlying business itself.
That kind of leads me to my next question, which is how sole proprietors can protect themselves if they don’t have an LLC. One way is contracts. Necessary?
The unfortunate truth is you should have a contract for all of your business dealings. A lawyer should look it over. It should be tailored to your business to maximize its protection. People leave things out and make mistakes. Many people want a form so they can just fill in the blanks, but that’s not how contracts work. Even if your attorney only changes 10% of the form, that 10% is often very important.
I’m a big promoter of having a formal contract to document the deal. It provides protection but it also prevents misunderstandings.
I also want to be clear that a contract is not a substitute for forming an LLC. An LLC and a contract provide different protections, and I urge clients to form an LLC (or a corporation) and have a strong contract.
Do emails constitute a contract?
If you have a written or even an oral exchange that documents offer and acceptance, then you likely have an agreement. The question is: What is the agreement and what are its terms?
The problem with a contract that is created by an email chain is that you are likely to wind up fighting not just about whether there was an agreement but what it includes.
A good contract addresses what could go wrong and how can it be handled.
Consider a simple example: You’re a graphic designer and I say, “Will you please design a logo for me? I’ll pay you $1,000,” and you say yes. You then design a logo, and I don’t like it. What should happen? We might have a contract, but the contract didn’t address any of the issues that might arise. Do I need to pay for the logo I don’t like? Do you need to redesign the logo at additional cost and expense to you? What if you redesign the logo, and I don’t like that one either?
A good contract would address the contingencies that come up in a business and be clear about which party bears which risks and burdens. A good contract addresses what could go wrong and how can it be handled. A contract that was created by an email chain is unlikely to address many of the important issues. So, it doesn’t provide the protection that many would hope.
And it costs money to have an attorney go over this stuff, so that’s another hurdle.
I often hear from people who say, “I can’t afford to do a business if I have to do these things.” It’s hard to hear and it’s sad but it doesn’t mean there’s a good way to proceed without incurring the costs.
In my mind, the costs are worth it because if you find yourself in a lawsuit you lose in two ways — I call it money and a stomachache. The people I know who have contract disputes — it becomes financially and emotionally burdensome. You’re not sure if you’re going to get paid. You worry about your reputation. It weighs on us, and we want to avoid that too.
There’s a lot of talk, especially in California, about the rights of independent contractors versus employees. If freelancers feel like they’re in an iffy situation, what are some things to know?
Most new business would prefer to treat workers as independent contractors (who get 1099s), so that the businesses can avoid employee costs and taxes (such as Medicare, social security and unemployment), but it isn’t necessarily up to the employer or even the individual providing services.
The distinction can be very tricky. The law focuses on the nature of the work performed and how that work fits into the employer’s business. The traditional ‘test’ for whether someone qualifies as an independent contractor turns on how much control the employer exercises: if the employer just requires a particular result, then the worker can often be treated as an independent contractor. If the employer has the right to control the ‘manner and means’ by which the worker accomplishes that result, then it is likely that the worker must be treated as an employee.
There was a recent California Supreme Court decision that added additional confusion to this test. It added another category so that if a worker performs a task that is the same type of work performed by the business (e.g. drivers that deliver for food delivery services such as DoorDash or Postmates; barbers that cut hair for a salon; or journalists that write for a paper) that worker must be treated — at least for some purposes — as an employee, even if the employer does not exercise control over the performance of the work. These rules can be very complicated and expensive to comply with, and businesses need to be careful that they have proper guidance or they can get into trouble. On the other hand, some freelancers may have more rights and be entitled to more money than they thought, so they might want to look into their rights as well.
More stories about: Business Strategy, Gould School of Law, Law