Many determined individuals begin their entrepreneurial journey by operating their business as a sole proprietorship. It’s no wonder why. As a sole proprietor, the costs to start and legal formalities to maintain a business are less than when registering as other types of business entities. However, there are drawbacks to being a sole proprietor. The most significant downside is that the business owner is personally responsible for all debts and legal liabilities of the company.
It’s common for entrepreneurs to consider changing from a sole proprietor to an LLC as their business grows and evolves. Let’s walk through the right way to make this change legally.
Sole Proprietorship vs. LLC
Both are relatively simple business structures with some similarities but also notable differences.
A sole proprietorship is the default business structure when either an individual or a married couple starts a business. Business owners do not have to file formation documents with their state to become a sole proprietorship. In a sole proprietorship, the business is considered the same tax-paying and legal entity as the business owner. If a sole proprietor wants to operate the business under a name other than the owner’s legal name, filing a DBA is necessary to register the fictitious business name. Like all types of businesses, sole proprietorships must obtain the required licenses and permits to perform their business activities legally in their jurisdiction.
A limited liability company (LLC) is a registered business entity type formed under state laws. An LLC is a separate legal entity from its owner. From a tax perspective, by default, an LLC is considered the same tax-paying entity as its owner. A single-member LLC is the entity most comparable to a sole proprietorship. If an LLC has more than one owner, it is called a multi-member LLC.
Why Change from a Sole Proprietorship to an LLC?
Several reasons why sole proprietors might choose to form an LLC include:
- To protect their personal assets from the liabilities (debt, legal concerns) of the business.
- To have tax flexibility.
- To gain more credibility with potential clients and investors.
Personal Asset Protection
An LLC is its own legal entity. If someone sues the company or it racks up financial debt, the owner’s personal assets are protected. Note, however, the liability protection of the LLC structure may not cover actions by the owner that have endangered anyone or caused harm.
To maintain the limited liability protection of an LLC, the owner must follow all rules necessary to keep its “corporate veil” of protection intact. Several of those rules include:
- Keep all personal and business activity and finances separate.
- Not engage in reckless, dishonest, or fraudulent activity.
- Pay taxes and filing fees on time.
- Follow all compliance formalities associated with being an LLC.
Like a sole proprietorship, an LLC is, by default, considered the same tax-paying entity (“disregarded entity”) as its owner. Income and losses pass through to the owner’s personal tax return. Also, all profits from the business are subject to self-employment taxes (Medicare and Social Security).
Unlike a sole proprietorship, however, an LLC may elect to be treated as an S Corporation for tax purposes. In an S Corp, the owner must be put on the company payroll (rather than get paid through an owner’s draw, which is how sole proprietors and LLC owners usually get paid). An S Corp is still a pass-through tax entity with all profit and loss flowing through to the owner’s individual tax return. However, only income paid as wages to the owner is subject to self-employment taxes. Profits paid as distributions do not get hit with Social Security and Medicare taxes. The S Corp election is attractive to many LLC owners because it can help decrease their self-employment tax burden.
Having “LLC” behind a company name may make a more polished, professional first impression on customers, vendors, project partners, and investors than running a business as a sole proprietor. People may perceive a company with the letters “LLC” behind its name as more capable or professional.
8 Steps for Changing from a Sole Proprietor to an LLC
The process to form an LLC may differ from one state to another. Generally, however, the below steps represent the basic process entrepreneurs follow no matter where they establish their business. I encourage you to check with the Secretary of State office and your local government agencies to ensure you understand what’s required for your specific situation and location. Also, consider reaching out to an attorney and tax advisor for guidance on what you must do to officially change from a sole proprietorship to a limited liability company.
1. Check to See if Your Name is Available
States will not allow an LLC to be formed under a name already taken by another LLC or corporation in the state that offers similar products or services. That’s why it’s essential to check the business name’s availability before moving forward with business registration forms. Consider verifying the availability of your business name by contacting the Secretary of State and using CorpNet’s free Corporate Name Search tool. An attorney can help do a name search, too, for additional peace of mind. I also encourage doing a trademark search to make sure no one in another state has claimed the business name for use throughout the United States.
2. File Your Articles of Organization
After verifying that the business name is available for use, the next step in officially changing from a sole proprietorship to an LLC is to file a form called “Articles of Organization” with the state. The form is relatively simple—although the information requested may vary slightly from one state to the next. The fees to file the Articles of Organization also differ depending on the state.
Examples of the information you might expect to have to provide in Articles of Organization include:
- Name and principal address of the business
- Purpose of the business
- Name and address of the business’s designated registered agent
- The LLC’s management structure (Single-member LLCs are usually “member-managed.” However, they may be “manager-managed” instead if the owner would like to appoint another individual to handle day-to-day operations, such as at a retail store.)
3. Create an LLC Operating Agreement
An LLC Operating Agreement is a document that provides details about an LLC members’ rights and responsibilities, distribution of the LLC’s income, and other rules and provisions about the LLC’s internal operations. Even when an LLC is owned and operated by a single owner, an LLC Operating Agreement has value because its existence helps protect the limited liability status of the LLC. It strengthens the all-important corporate veil that separates the business’s debts and assets from those of its owner. For that reason, even in states that don’t require LLCs to have an operating agreement, creating one and maintaining it at the principal place of business can be beneficial.
4. Obtain an EIN
An employer identification number (EIN) is a tax ID number issued by the IRS. Any business, even a sole proprietor, must obtain an EIN if it has employees on its payroll. All LLCs, whether or not they have employees, must apply for an EIN. When converting from a sole proprietorship to an LLC, the business owner must obtain a new EIN for the LLC (even if the business owner had an EIN as a sole proprietor).
5. Open Business Bank Account for Your LLC
Sole proprietorships may not use their existing business bank account (assuming they established one!) for their limited liability company. After the state approves the Articles of Organization and the LLC has its EIN from the IRS, it will need its own bank account, checks, and credit accounts that reflect the LLC’s official name. Banks can provide guidance on moving existing business funds from a sole proprietorship bank account to an LLC bank account.
6. Determine if You’ll Have to Reapply for Business Licenses and Permits
Some states and local licensing agencies will not transfer business licenses and permits from a sole proprietorship to an LLC. Research your state and local government’s rules (which are usually available on their websites) so that you don’t miss applying for what you need to operate your business legally as an LLC. CorpNet’s business license research services also can help you identify which licenses and permits can or cannot be transferred to your LLC.
7. Decide How You Want Income Taxes Treated
As I described earlier in this article under “Tax Flexibility,” an LLC’s profits will be passed through to its owner’s personal income tax return (on Schedule C and Schedule SE). The LLC itself does not file a return because it is considered a disregarded entity for tax purposes. This offers simplicity. However, it means that all of the business’s profits are subject to self-employment taxes (Social Security and Medicare), which could result in a high tax burden for the owner. Alternatively, to decrease the self-employment tax burden, an LLC may request S Corporation election (by filing IRS Form 2553). As an S Corp, the LLC still receives pass-through tax treatment. However, only the owner’s wages and salaries are subject to Social Security and Medicare taxes. At income tax filing time, an LLC taxed as an S Corp files IRS Form 1120S. Also, the LLC member(s) must report their share of the profits on their individual Form 1040, and on Schedule K-1 in Form 1120S.
The tax option that will be most advantageous to you will depend on the specifics of your situation. I recommend talking with your accountant or a trusted tax advisor for guidance when making this critical decision.
8. Keep Up With Business Compliance Requirements
An LLC’s compliance obligations will depend on the state’s rules governing the LLC entity and the local regulations that apply to the business.
Examples of the possible ongoing responsibilities to stay in good standing include:
- Filing annual reports (sometimes these are biennial or on some other schedule)
- Maintaining a registered agent
- Reporting and paying taxes
- Renewing business licenses and permits
- Holding an annual meeting and recording minutes
- Keeping business and personal financial records and activities separate
Failure to stay on top of these tasks may result in fines, penalties, loss of liability protection, and even administrative dissolution (forced closing) of the business. Remain vigilant about tracking your deadlines and carrying out your responsibilities on time. If you need some assistance, consider using CorpNet’s free Compliance Portal to monitor approaching deadlines.
Make a Smooth Transition With CorpNet’s Help
If you’ve done your due diligence and have decided that switching from a sole proprietor to an LLC is the right move for your business, contact CorpNet. We’re here to ensure that all of your business formation and compliance filings are completed accurately and promptly. Our filing experts have helped nearly countless business owners in all 50 states form their LLCs, and they can help you, too!
CorpNet.com is a document filing service and CANNOT provide you with legal, tax, or financial advice. The information provided is for general educational and informational purposes only. It should not be considered legal, financial, or tax advice. Please consult a licensed attorney, accountant, or tax advisor to address your specific legal, tax, and accounting questions or concerns.