Last Updated: March 17, 2023
The default business structure for a new small business is often a sole proprietorship. But as the business grows, there may come a time when the sole proprietor may want to formalize what they have built by creating a limited liability company (LLC).
This article addresses how you can convert a sole proprietorship to LLC, the advantages and disadvantages of owning an LLC, and the responsibilities of an LLC owner.
Sole Proprietorship vs LLC
A sole proprietorship (or sole trader) is an unincorporated business that one person owns. It is the easiest way to establish, maintain, and take apart (financially and otherwise), primarily because of the lack of government regulation. It allows small-scale business owners to try out the business venture. If it’s a small start-up business, it’s the only business structure that makes sense.
When mulling over an LLC ownership, keep in mind that the advantage (and disadvantage) of being a sole proprietor is that, as the owner, you pay personal income tax on the earned profits. But a business owner of a sole proprietorship is not exempt from liabilities incurred by the business. The owner’s personal assets and savings are at risk in case of legal challenges or if the business incurs debt.
This is where turning a sole proprietorship into an LLC comes into play. The main feature of a limited liability company is that it separates the owner’s personal assets from the business and, therefore, protects the property, ensuring that the business debt remains with the company. This business structure is between a sole proprietorship and a partnership, allowing for multiple owners (or LLC members).
The requirements for LLCs are minimal, and though they are encouraged to follow the same guidelines as some corporations, they aren’t legally required to do so.
An LLC also allows pass-through taxation, which means that the business does not need to pay taxes on its own. Instead, the tax on its income (or losses) can be passed through the LLC and recorded on the personal tax return of the person who owns an LLC. If there are multiple owners, the LLC is taxed as a partnership, with each member reporting losses and profit on their personal tax returns.
Another advantage of having an LLC is that it’s easier to get capital funding—such as obtaining bank loans and lines of credit—than with a sole proprietorship. An LLC is also a good choice if you wish to attract more serious clients, as some require that you operate as an LLC before coming on board.
|NOTE: Northwest Registered Agent (read our full review here) is thought to be a great LLC option. In addition, it offers a Free Registered Service Agent for one year, as well as IncAuthority, Swyft Filings, and MyCompanyWorks.|
Pros and Cons of an LLC
Moving from a sole proprietorship to an LLC is a smart move for a small business owner whose business is booming and who wishes to expand or bring in more partners. But it’s also essential not to rush into creating an LLC without considering the advantages and disadvantages.
- Ease of filing: The paperwork for an LLC is nowhere near as complicated as corporations. Much like a sole proprietorship, it’s straightforward.
- Limited personal liability: The LLC is a separate entity and offers protection for owners’ personal assets in case of a loss.
- Flexibility in membership and management: There is no limit to how many owners or members an LLC can have, which is a significant asset when considering whether you want to be a sole proprietor or LLC owner. An LLC can also choose to be managed by its members or designated managers from inside or outside the LLC.
- Easy cash distributions: LLC members can withdraw from the company profit account for their personal use rather than take salaries.
- Pass-through taxation on profit: Given that owners of an LLC put the business tax on their personal tax reports, the tax for the business is simpler to pay and could be lower than corporation owners.
- Member turnover can get complicated: A member change in the LLC will likely trigger a considerable amount of paperwork and other time-consuming actions, such as notifying institutions. Depending on the state, the LLC can also be forced to start from scratch.
- Limited liability has its limits: In certain instances, a judge can rule that an LLC owners’ personal assets are no longer protected, which is a serious risk called ‘piercing the corporate veil.’
- Misaligned tax burden: Just because an LLC allows for pass-through taxation doesn’t necessarily mean that the company will pay fewer taxes.
Convert a Sole Proprietorship to LLC
Creating an LLC has many advantages over a sole proprietorship. But it’s essential to note that requirements of forming an LLC vary by state. Therefore, it’s best to check out which state you want to create the LLC in.
Consider these eleven steps:
1. Choose a Name
Before submitting an official request, you need to choose a name for the LLC. LLC names have to comply with the state’s rules. For example, most states require that it ends with an LLC designator and that it’s unique, meaning that no other LLC or business entity in the state has that name.
2. Register an Agent
To convert this kind of proprietorship to an LLC, you need to choose a registered agent for the company that would accept legal papers on behalf of the LLC if it faces a lawsuit. A registered agent can be an outside individual, a member of the LLC, or a private service company. The National Registered Agent is considered by many to be the top registered agent solution in the US.
3. Company Management
How will the company be managed? The members of an LLC can agree to be equally responsible for managing the company, or they can appoint one person or more (including from outside the LLC) to manage it.
4. Create Operating Agreement
This is one of the most complicated parts of switching from a sole proprietor to an LLC. First, you need to create an operating agreement—a legally binding document outlining ownership percentage, voting rights, guidelines for distributing profits and losses, and the procedure.
5. Form an LLC
To formally begin the process of going from a sole proprietor to an LLC, you need to file articles of organization (or certificate of formation/certificate of organization) with the state’s corporate filing office, which is usually the office of the Secretary of State.
You should find an online form to complete the articles of organization on the Secretary of State’s website. You need the name of the LLC, the address of its registered agent, how the LLC will be managed, the names of LLC owners, and other basic information regarding the LLC ownership structure. You’ll also be asked to pay a fee to submit the articles, which typically costs around $100.00.
6. Cancel Sole Proprietorship
After you collect your money, pay all receivables and taxes, cancel your license, and close all bank accounts associated with your business, you need to close your business account.
The Internal Revenue Service (IRS) requires that sole proprietors send a letter informing them of your decision. The letter needs to include the EIN, legal name and address of the business, and why the owner wants to close the account.
7. Obtain an EIN
Can I change my EIN from a sole proprietorship to an LLC? You cannot use the Employer Identification Number (EIN) from your sole proprietorship for your LLC. You must obtain a new EIN after the LLC is approved. The LLC needs to have an EIN even if it has no employees.
You can obtain an EIN by completing an online application from the IRS website. In some cases, an EIN Reference number can be displayed, which means there was an error in your application. You should also know the difference between TIN vs EIN.
TIN stands for a Taxpayer Identification Number. The primary difference between the TIN and EIN is that the TIN is used to identify taxable individuals in the US, and EIN is used to identify companies. (An EIN is a type of TIN.)
8. Transfer Assets
Here’s where making the change from a sole proprietorship to LLC transfer might get tricky. Since a sole proprietor owns the business’s assets, they can decide to transfer those assets to the startup LLC. The sole proprietor can treat the asset transfer as an equity contribution, a sale, or a lease.
If you’re making a change from sole proprietor to LLC, you can transfer assets by making a capital contribution, which is the equivalent of purchasing ownership interest. This is the quickest way to go about it, as it requires very little paperwork, and you would not need to pay any taxes. You can also purchase assets (which may involve some tax expenses) or simply assign assets to your LLC.
9. Open Bank Account
Opening a business bank account usually requires submitting articles of organization, the LLC’s EIN, and identification documents. The process of opening an LLC is not complete until you have a bank account for it because it officially separates your personal assets from the business.
10. Adapt Contracts
After kick-starting the process to convert a sole proprietorship, you will need to take care of all the contracts you had as a sole proprietor, including updating your current contracts with clients and vendors to add the LLC name.
It’s important to remember that you can only amend contracts if the terms of the agreements permit such a change. In some instances, you may have to ask the client for consent. If the contracts are not assignable, you will need to execute new agreements.
It’s best to have an attorney review the contracts before making any changes to avoid opening up the LLC to legal challenges, as well as corporate veil piercing.
11. Notify Public
In some states, potential LLC owners have more hoops to jump through. For example, Arizona, Nebraska, and New York have laws that require LLCs to publish notices in local newspapers.
|The main feature of changing a sole proprietorship to an LLC is that it allows owners to separate their personal assets from the business.|
|An LLC can have more than one owner. When applying for an LLC, you will need to name all business members and describe how they will be managed.|
|Don’t forget to cancel your sole proprietorship, close all bank accounts related to it, and pay taxes.|
|You cannot use the sole proprietorship number for your new LLC; you need to get a new one.|
|You will also need to open a bank account for your new LLC—not doing so defeats the very purpose of the LLC as a business structure.|
Responsibilities of the LLC Owner
With a new business structure comes new responsibilities. An LLC is a step further in business and, therefore, must follow specific laws and policies. LLC owners need to abide by the rules if they want to avoid piercing the corporate veil.
Can you pierce the LLC veil? The required behind the scene work that is needed to keep the LCC operating includes:
Being Mindful of Liabilities
The primary obligation of an LLC is to fulfill contractual obligations and pay the debt it incurs. In other words, they must comply with such responsibilities as performing properly under contracts, scheduling loan payments, paying wages, and compensating contractors, etc.
Other LLC responsibilities include:
- Drafting and maintaining formation documents.
- Keeping all personal and business finances separated.
- Obtaining and renewing all relevant licenses.
- Negotiating and signing contracts.
- Dealing with lenders and other financial institutions.
- Keeping complete and accurate records of all business transactions.
Following Rules of Operating Agreement
One of the main differences that stands out when comparing LLC vs sole proprietorship is the operating agreement. LLCs are legally obligated to follow the rules of the agreement.
Not much will change for an LLC owner who once operated as a sole proprietor if he is the only member. But if there are more LLC owners, then the business will be treated as a partnership, and all members will be required to pay federal and state income tax for the business on their individual tax returns.
There is, however, an exception to the rule in the instance where the LLC chooses corporate taxation. LLC responsibilities will then include paying taxes as a business entity.
Most states require annual or biennial reports that include basic information about the business, such as location, activities, and updates on membership change. An LLC typically needs to pay a fee to submit such a report.
If you’re having trouble with the nitty-gritty of switching from a sole proprietor to an LLC, it’s best to seek professional advice. You can find great deals at online legal options, such as LawDepot, JustAnswer, and US Legal Forms. Additionally, if you need help with taxes, there is plenty of software pieces for business tax you can find online, as well as budget-friendly tax solutions.
|NOTE: If an LLC business operated in a state other than the one where it was formed, it might require a formal qualification to do business as a ‘foreign’ LLC. The process is typically the same as applying for creating an LLC, as well as the rules.|
An LLC is a great choice for a sole proprietor who wishes to expand their company. There are plenty of advantages that this business structure brings, including multiple ownership, multiple locations, the ability to attract more clients, and, most significantly, keeping your personal assets separated from the business, which is not possible if you’re a sole proprietor.
Yes. A sole proprietor can turn their business into an LLC. In fact, in most cases, it’s recommended to do so if the owner wishes to make the business official. A sole proprietorship is the best option for those who seek to determine if their business idea would work. An LLC is the natural next step.
To convert a sole proprietorship to LLC, the sole proprietor must file a formal request, open a business bank account, create an operating agreement, and choose a name, manager, and a registered agent.
Owners of an LLC are called members. Depending on their operating agreement, some members can act as managers.