A significant number of small businesses initially start operating as sole proprietorships. Many entrepreneurs opt to start as sole proprietors to take advantage of its little to no cost to start up, simplicity and the lack of formal requirements to begin operations. While sole proprietorships provide a variety of advantages, continuing to operate as a sole proprietor as a business grows can present significant risks. In this how to article, we’ll go over the risks present in operating as a sole proprietorship, the benefits that converting to an LLC can provide and walk you through the 7 steps to change your sole proprietorship to an LLC.Table of Contents:
- Why Convert to an LLC: Risks and Downsides to a Sole Proprietorship
- Benefits of Converting to an LLC
- How to Change from a Sole Proprietorship to an LLC in 7 Steps
Sole proprietorships are the most common form of business in the US, and for good reason. A sole proprietorship is the easiest way to get started as a business as they require no formal registration or up-front start-up costs outside of any required business licenses and permits. There are a wide range of advantages and disadvantages sole proprietorships provide as a business structure. However, as a business grows the advanatages provided by a sole proprietorship can start to be outweighed by the disadvantages sole proprietors can have in comparison to an LLC.
Once a business begins to gain traction and experiences success, many of the disadvantages of a sole proprietorship can become very hard to overlook. Furthermore, they can start to become active risks of the business that could result in some fairly serious issues. When it comes to sole proprietorships, there are 3 main areas that most business owners consider when thinking about converting to an LLC.3 Main Risks and Downsides of a Sole Proprietorship:
The lack of any formal registration requirements to start as a sole proprietor is one of the most attractive traits about operating as a sole proprietor. However, without the formal separation between the owner and business, sole proprietorships are exposed to unlimited personal liability risk. In the event that your business is unable to pay off debts or is sued, creditors and plaintiffs can attempt to seize a sole proprietors personal assets to recoup their losses. This means that your personal property like your home, car and even personal savings can be at risk.
Conversely, owners of a limited liability company enjoy limited personal liability protection from lawsuits emanating from outstanding business debts and other matters. Thus, converting sole proprietorship to LLC can be a great protection against going into personal bankruptcy if your business was to fail or be sued.
Additional reasons that compel entrepreneurs to learn more about how to change sole proprietorship to LLC is the difficulty in raising operating capital and building a business credit history. Unfortunately for most sole proprietors they are forced to rely on their savings, personal loans, or financial support from family or friends to get capital to grow and expand. This is because without a legal separation between the owner as an individual and the business there is much greater risk for a bank or traditional lender to consider. Generally speaking banks view sole proprietors are very small businesses that are much more risky and as a result they tend to only lend to sole proprietors who have a strong financial performance and have been in business for a number of years.
In contrast, LLCs have greater access to a broader selection of financing options such as business loans and lines of credit. Since an LLC is a separate legal entity, lenders have more confidence in the business and view the business as more credible. As a result, LLCs have an easier time getting financial support even when they are newly formed.
Although it is possible to find buyers for a sole proprietorship, the business is still hard to sell. The lack of a distinction between the owner and the business is a significant hurdle. Interested buyers are more likely to acquire assets like machinery and merchandise since the business is not a legal entity. However, the state of each asset’s title determines whether the business owner can sell the item. Financed items must be fully paid for before listing them for sale.
Operating as a sole proprietorship can have some significant risk and downsides to consider, which often lead to sole proprietors seek out a business structure that can work better for their needs. Most often, the go to business structure when moving from a sole proprietorship is an LLC. LLCs can help to mitigate the risks present for successful sole proprietors and provide a range of benefits. For sole proprietors thinking about converting, there are generally 4 benefits they should consider.4 Benefits of Converting to an LLC:
- Personal Liability Protection
- Easier to Secure Business Loans and Credit
- Flexible Taxation Status
- Easier to Sell the Business Downline
While a sole proprietorship makes no distinction between the owner and the business, LLCs protect owners from legal liability. This aspect plays a critical role in shielding the owners from the risk of lawsuits. Debtors and other third parties cannot seize the owners’ assets to recoup losses, even if a court of law awards damages.
In the event that the debts or damages exceed the sole proprietor’s savings and combined assets’ value, the entrepreneur must declare bankruptcy. Switching to a limited liability company averts this extreme situation. Debtors can only seize the company’s assets, saving the owners from a dire personal finance crisis.
LLCs expand the number of business financing beyond personal loans and savings. Securing business loans from banks and other lenders makes it easier to build the company’s credit history. Many entrepreneurs convert sole proprietorship to LLC to improve access to operating capital. In many cases, business owners also manage to establish the company’s credit record, enabling them to access affordable loans from banks and other lenders.
A unique benefit that an LLC provides over sole proprietorships is flexibility when it comes to the business’ taxation status. Unlike many other entities, LLCs can select between 3 different tax statuses. By default, an LLC is a pass-through taxation entity, just like a sole proprietorship and partnership are. However, in addition to the default pass-through taxation status, LLCs can also elect to be treated as a C Corporation or S Corporation for tax purposes by the IRS. This provide LLCs with a flexibility that is not available as a sole proprietor.
Of the 2 elective tax status’, the most commonly selected is S Corporation tax election. This can be done by an LLC by completing form 2553 with the IRS. Essentially, the S Corporation taxation election allows a business owner to save on self-employment taxes by having the owner(s) become W-2 employees of the LLC, in addition to their ownership role. The IRS requires that the salary paid to owners under an S Corporation to be “reasonable”. By default, the entirety of the profits of an LLC are subject to self-employment taxation, which as of 2021 is 15.3%.
Under an S Corporation taxation election an LLC owner can pay themselves a reasonable wage, which will be subject to standard FICA employment taxation. However, any remaining profits of the LLC are paid to the owner(s) as dividends and thus are not subject to self-employment taxation. This can potentially save thousands for small businesses that are successful. If you want an in-depth breakdown of how an S Corporation can help in regards to self-employment tax we recommend that you speak to a licensed tax or finance professional for personalized advice.
Selling a limited liability company does not present the same hurdles faced by sole proprietors. Hence, you have a better chance of finding a buyer willing to pay a reasonable amount for the LLC. This benefit drives many small business owners to familiarize themselves with the dynamics of how to change sole proprietorship to LLC.
Converting a sole proprietorship to LLC encompasses several steps, such as choosing a registered agent, filing registration paperwork with the state government, applying for business permits, and obtaining an employer identification number (EIN).7 Steps to Convert a Sole Proprietorship to an LLC:
- Determine your LLC Name
- Choose a Registered Agent
- File LLC Formation Paperwork
- Create an LLC Operating Agreement
- Get an EIN from the IRS
- Open an LLC Bank Account
- Apply for Business Licenses and Permits
The first step to conversion is choosing the right name for your limited liability company. One of the benefits an LLC has is that you can operate under any name that complies with your state’s laws and regulations. This means that you can choose a name that doesn’t include your personal name, unlike a sole proprietorship. If you operated your sole proprietorship under a DBA you could attempt to use the LLC equivalent of that name.
To get started, you’ll need to complete a name availability check to ensure your desired business name is available for use. This check can normally be completed by visiting your state’s secretary of state website.
Pro Tip: If you find that your desired name is available but was used in the past you may want to consider using a different name. While you can use the name if it is available now, we recommend choosing a different name. If the business name was in use prior, you are very likely to encounter issues that can significantly delay the process of getting an EIN for the LLC.
One of the unique parts of the LLC formation and conversion process is the selection of a registered agent. Unlike sole proprietorships, LLCs must designate an individual or third-party organization as their “Registered Agent” when filing the LLCs official formation paperwork.
What is a LLC Registered Agent?
A LLC registered agent is an individual or entity that has been designated by an LLC to receive service of process, government correspondence and other compliance documents from the state on behalf of the LLC.
Although you can represent yourself as a registered agent, experts strongly recommend hiring a commercial registered agent. Doing so ensures that your documentation is handled professionally. You count on the agent to forward your limited liability company’s ‘service of process’ promptly.
A well-chosen agent is always available to handle your legal documentation processing requirements. A reliable agent eliminates the risk of missing some critical legal documents that have a bearing on your company’s operations. For more information on who serve as a registered agent and why you may want to hire a commercial registered agent visit our guide on the topic.
Once you select a unique LLC name and determine who will be your registered agent, you’re ready to formally register your LLC. LLCs are formed by filing Articles of Organization with your secretary of state’s office. In addition to filing the legal paperwork to form the LLC, you’ll need to submit a filing fee as well. These fees vary quite a bit from state to state and range from $40 to $500. While the required information contained in the Articles of Organization do vary depending on the state, generally they include:
- Street address of your business premises
- The unique limited liability company name
- Registered agent’s name, physical address, and contact information
- Contact details of individual owners
- Operations start dates
You’ll want to make sure that you have this information compiled prior to starting the filing process. In addition to this, you may want to consider using an online formation service such as Legal Zoom or IncFile to help complete the Articles of Organization filing. These online service providers can assist in the process and charge fees anywhere from $39 to $500 for a more comprehensive service.
While these fees will be on top of the state filing fee, it can easily be worth the peace of mind you can get from having an expert complete the process for you than the headache you can encounter if your filing was not done properly. Online formation providers can be a more cost effective way to get professional assistance when compared to paying for the assistance of a lawyer that will often cost anywhere from $500 to $1,500 in comparison.
While not required by law, we recommend that every LLC take the time to create an operating agreement. This legal document outlines ownership percentages, initial investments, how profits will be distributed and the functions performed by individual members of the business. The benefit of creating the agreement is that you prevent disagreements about roles and the degree of ownership for each member.
One of the main reasons to create an operating agreement is to avoid the default rules that LLCs are subject to in your state. Often times the default governing rules that an LLC is subject to are not ideal and thus creating an operating agreement can override these default rules. An operating agreement is also incredibly important to ensuring that your LLC maintains it limited liability status. While an LLC provides limited liability protection, if you don’t take the formal steps to operate your business as a separate entity from yourself as the owner, you could lose this protection. Having a well written and detailed operating agreement can go a long way, in conjunction with ensuring that you keep business and personal expenses separate to maintain your limited liability status.
Obtaining an employer identification number (EIN) is another critical step when looking to convert sole proprietorship to LLC. An EIN is a very important ID number that is used by the IRS to identify businesses for tax filing and employment purposes. The IRS issues EIN numbers for free via the online EIN Assistant.
If you are a single-member LLC you are not required to obtain an EIN, however it is another step that can help to prove that your LLC is a separate entity from yourself. On top of this, having an EIN can also help to protect your privacy as you can provide your EIN rather than your personal SSN for identification purposes. Lastly, you will need an EIN to complete the next step in the process, opening a business bank account.
Opening a business bank account for your LLC is a key step in ensuring that your business is separated from you as an individual. By separating your personal finances from company operations it ensures that can maintain your limited liability status and will make the bookkeeping process much easier.
By opening a business bank account for your LLC, you find it easier to access operating capital from various sources, including banks, investors, and partners. The account ensures that you can budget and build a corporate credit history more effectively.
When converting a sole proprietorship to LLC, one of the final steps is applying for business licenses and permits. Municipalities and states issue wide-ranging permits and licenses to maintain regulatory compliance for businesses involved in particular activities. Examples of state and local authorities’ licenses include signage permits, professional licenses, health, safety permits, and liquor licenses.
Depending on your industry, you may require one of the few permits and licenses issued by the federal authorities. Although this requirement typically applies to businesses in a handful of industries, it is vital to identify the full list of permits needed for your business. Since the process can be quite confusing and difficult, we recommend using a business license research service to help you save time identifying all of the relevant business licenses and permits that your business will need to remain compliant with the law.