When a small business owner or an entrepreneur starts his business, choosing a Sole Proprietorship business structure often makes sense.
However, as the business is expanding, converting from a sole proprietorship to a Limited Liability Company (LLC) could be the best business decision.
Sole Proprietorship vs LLC
The following benefits and disadvantages of both business structures will help you decide whether converting your business will benefit you.
Disadvantages of Sole Proprietorship
- Unlimited liability, meaning that personal assets can be seized in case of bankruptcy or lawsuits against the business.
- Higher tax rates.
- Unexpected tax filings.
Advantages of Sole Proprietorship:
- The lowest start-up cost of the two options; $500 is the typical filing fee - Easier to manage single-handedly.
- Easy to set up.
- The owner has full control over the business structure and operations.
- A single person can typically handle all aspects of the company's daily activities.
Advantages of an LLC
- Limited liability to protect personal assets - Separate legal entity, meaning that lawsuits are filed against the LLC itself and not its owner - Less complicated tax filings than corporations or sole proprietorships. Typically taxed as a partnership or "pass-through" entity (check Ltd vs LLC).
- Less complicated taxation process.
- The ongoing cost is lower than a traditional corporation.
- Personal assets are protected in case of business failure.
Read More: Steps to Transferring Assets to an LLC
Disadvantages of an LLC
- There is no such thing as a standard form for an LLC, making it difficult to generalize how they operate and function.
- May be more complicated to set up and maintain than a traditional corporation.
- For federal income tax purposes, an LLC with two or more members is treated as a partnership unless the members choose otherwise (i.e., LLC is treated as a disregarded entity, corporation, or limited liability company), meaning that the LLC itself does not pay taxes and instead “passes through” any net taxable income to the members.
Top Signs It’s Time to Convert a Sole Proprietorship Into an LLC
When researching to see whether you should convert your business from sole proprietorship to an LLC, here are several signs that the time has come to switch:
1.) You have extra money to invest in your company. Sole Proprietorship is the simplest business structure, so it requires lower start-up costs than other types of businesses (however, it is not the least expensive). If you have extra money to invest in your company, converting it into an LLC will give you more freedom and flexibility.
2.) You plan on expanding or selling your business. An LLC protects personal assets, so this business structure would be beneficial if you plan on expanding the business or want to sell the business in the future.
3.) You are tired of managing your business on your own. Although Sole Proprietorship allows you to be fully involved with the day-to-day aspects of the company, this type of business structure can often become cumbersome and exhausting due to all of its responsibilities.
Instead, LLCs give a higher degree of autonomy and allow you to be more focused on the business while somebody else manages the day-to-day activities.
4.) You want a new tax status for your business LLCs to have several different taxation options, including being taxed as a Sole Proprietorship or a Corporation. Because there is no such thing as a standard tax form for an LLC, it is important to speak with your tax advisor about the best option for you.
5.) You want to raise capital from investors or other outside parties. To protect personal assets from being seized in case of bankruptcy, many lenders and investors require a business structure that includes limited liability.
6.) You want to form a business partnership with other individuals but do not want to be personally liable for their actions.
If you are forming a business partnership and do not want personal assets to be seized should your partner act improperly or criminally negligent, then it is best if the company is an LLC since owners of an LLC are only liable for the amount they have invested into the business.
7.) You want to avoid double taxation from LLC being taxed as a Corporation and then again as an individual on dividends from that Corporation. In general, LLCs are not subject to double taxation since they do not pay taxes at the entity level but instead pass through any net taxable income to the owners.
8.) You are tired of paying “self-employment taxes” on your net income in a Sole Proprietorship.
Since LLC members have no responsibility for debts or obligations in the event of insolvency, in general, they do not have to pay self-employment tax on their share of an LLC's business income.
After considering the benefits and disadvantages of both business structures, if you feel that converting your sole proprietorship to a Limited Liability Company will be advantageous for your small business, there are several steps to take to complete this transition.
Steps for Converting Sole Proprietorship to LLC
Knowing all that, the procedure for converting a business structure from a sole proprietorship t an LLC is reasonably similar in all states.
Here are the typical steps. However, you must know that there are slight differences from one state to another, so sole owners must study what they should do to make the switch legally.
1. Find Out If Your New LLC Name is Available
Your state government issues a list of all registered business names, and you must make sure your desired name is still available.
If the name is already taken in your state, you will have to choose another one or apply for an assumed name certificate.
2. Assumed Business Name Certificate
If you have found a business name still available, you will have to apply for an assumed name certificate.
Most states require filing this type of certificate with the county clerk's office or a state agency such as the Division of Corporations.
The process for obtaining this certificate depends on your location. In general, however, there must be a statement from each of the members of your LLC that they are doing business under a fictitious name.
Once this is established, you will be required to apply for an assumed name certificate.
3. File Articles of Organization with the Corporations Division of Your State
After you have obtained your assumed name certificate, it’s time to file articles of organization with the division of corporations in your state.
Articles of Organization documents can ask for:
- The name of the LLC.
- The purpose of the business entity.
- How many owners are in the company?
- The address where official business documents are mailed.
The filing fee for articles of organization will vary depending on the state (anywhere from $10 to $300).
4. Get a Federal Tax ID Number
After establishing a business name and filing your Articles of Organization with your state, it’s now time to register for a federal tax identification number.
Regulations for business licenses may vary by state, industry, and locality.
There are several ways to get one:
- Register on the IRS website using your Employer Identification Number (EIN) or SSN. You can have it mailed to you or pick it up in person at an IRS office.
- Apply for a federal ID number on paper by filing Form SS-4 with the Internal Revenue Service.
5.) Prepare an Operating Agreement
Prepare and submit articles of organization to your state division of corporations and a signed operating agreement (if applicable).
An operating agreement is an internal document that outlines how business decisions will be made, what percentage of ownership each person has, and any other special rules that apply to your LLC.
6.) Set Up a Business Bank Account
After you have established your business name and filed your Articles of Organization with the Division of Corporations in your state, it's now time to open a bank account.
A business bank account must be opened using the exact name on all official documents associated with your LLC.
7.) A Quick Word About Books and Records
As a sole proprietor, you may or may not have kept business books and records. Even if you haven't done so, it is wise to start keeping records of your income and expenses so you can prove a history of business transactions.
The complexities of a traditional corporation can be confusing. Converting from a Sole Proprietorship to an LLC may ease administrative burdens, simplify tax filings and limit your liability for business obligations.
How Long Does It Take To Convert From a Sole Proprietorship to an LLC?
It usually takes a few weeks to convert from a Sole Proprietorship to an LLC.
You need to take several steps to complete the transition, such as drafting articles of organization for the LLC, opening up an LLC bank account, obtaining necessary licenses or permits, and distributing profits year-end.
How Much Does It Cost to Form an LLC?
The cost of forming an LLC will vary from state to state. In general, you can expect to pay a minimum of between $50 and $500 initial filing fees to form your LLC and around $100 annually to maintain your LLC.
If you hire a lawyer (legal fees) or use a professional service provider to form or maintain your LLC, these costs will increase.
Do I Need an Attorney to Form a New LLC?
No. You can form a Limited Liability Company without hiring a lawyer. You only need to submit thef organization and operating agreement articles and have an overall understanding of the LLC laws.
How Many People Are Needed to Form a New LLC?
The number of people required to form an LLC will vary depending on the state where you are filing your articles of the organization.
You can have multiple-member LLC or a single-member LLC owner.
What Is an LLC’s Registered Agent?
A registered agent is a person or business designated to receive important legal documents sent by the state on behalf of the LLC.
This person should be located in your LLC's state of residence. However, if you don't have a physical address in your state, you can still designate a registered agent-based beyond its borders.
What Is a Written LLC Operating Agreement?
An operating agreement is a legal document that outlines the ownership and operating procedures of your Limited Liability Company.
This operating agreement allows you to create financial and working relations among business owners ( LLC members) and between members and managers.
Having this document in place is important if a dispute or lawsuit arises.
How to Change Sole Proprietorship to an LLC...
In conclusion, forming an LLC is a simple and inexpensive structure for your business.
It helps you reduce and eliminate risk by shielding you from lawsuits, creditors, and the government.
As discussed above, it also provides you with tax benefits that sole proprietorships or partnerships cannot enjoy.
For example, you can deduct expenses against income to lower or even eliminate tax liability.
The key to remember is that all businesses should have some sort of business structure to protect the owner(s) from personal liability, no matter how big or small.
If you are currently a Sole Proprietorship and are looking for these benefits, it might be time to consider converting your business to an LLC.