ost new businesses begin as sole proprietorships, but this business type may not suit your needs forever. As your small business grows, your business needs will likely evolve. You may reach a point at which it makes sense to change your business entity from a sole proprietorship to an LLC. In the interest of your business’s long-term success, it’s important to understand why, when, and how to make the change.
Should you Transition from a Sole Proprietorship to an LLC?
When it comes to running your business day-to-day, you likely will not find much of a difference between operating a sole proprietorship and an LLC. The key differences between both business entities primarily involve liability, taxes, and relative ease of securing funding.
Pros and Cons of a Sole Proprietorship
A Sole Proprietorship is an unincorporated business that is owned and operated by one individual, the sole proprietor. In this structure, you, the sole owner, are your business. This means that you are entitled to all of its profits, but you also are liable for any debts, losses, and obligations – including any liabilities caused by your employees. For example, in the event you were sued, your personal assets could be appropriated to cover the loss. Typically this structure is the most simple and easy to operate if you run a business on your own, and if your business is relatively low-risk.
- Simple operational structure. With just one person at the top, you run your business without needing input or sign-off from a third party. This means you have complete control and flexibility to run your business as you see fit.
- Simpler tax filing and minimal paperwork. Out of all business structures, a sole proprietorship generally requires the least amount of paperwork and compliance requirements. Taxes are also simpler, as filing a separate business tax return is not necessary.
- Fewer business fees. State law requires LLCs and other business entities to register with the state in which they are organized or formed before they can conduct business – and they must also pay a yearly fee to maintain their registration. Sole proprietorships are not required to register and can save money on those fees.
- No liability protection: You are personally liable for all business debts, responsibilities, and losses. Creditors can also go after your personal assets to satisfy a claim if your business assets aren’t sufficient.
- No tax flexibility. While sole proprietorships and single-member LLCs can closely resemble each other with regard to taxes, where the business income gets taxed at the owner’s personal tax rate, LLC’s have the option to elect to be taxed as an S-Corporation or C Corporation and may save money. Sole Proprietorships cannot.
- More difficult to obtain funding and financing: In general, banks are reluctant to give loans due to higher turnover rates and smaller assets. Not only this, loans for sole proprietors are typically considered personal loans.
Pros and Cons of an LLC
A Limited Liability Company, or LLC, is a business structure governed by state statute that grants LLC owners personal liability protection from the responsibility for debts or other liabilities. In other words, members are not personally responsible for business debts and liability. Rather, the LLC entity is, and one of the best ways to protect your personal assets as a business owner is to transition your business to an LLC. Additionally, an LLC can be owned by one person (a single-member LLC), or by multiple (a multi-member LLC).
- Protection from company liability. Limited liability is a key advantage of an LLC over a sole proprietorship. Operating your business as an LLC limits your level of personal liability, in the event of legal issues or business debt. This means your personal assets are much more protected than they would be if you operate your business as a sole proprietorship.
- Formation flexibility. You can form an LLC as a single member, but you also can have an unlimited number of members. Members can also receive revenues (and write off forfeitures) that are larger than their individual ownership percentage.
- Tax flexibility. Unlike sole proprietorships, LLCs can elect to be taxed as a sole proprietorship, partnership, S-Corporation, or C-Corporation and may save money from doing so.
- Greater likelihood of securing a business loan. Compared to sole proprietorships, LLCs generally find it easier to take out small business loans. This is because loans for sole proprietors are typically considered personal loans by a lender.
- More complex organizational structure. While not nearly as complicated as an S-Corporation or C-Corporation, the ownership of an LLC is spread across its members (unless it's a single-member LLC). Most LLCs will also draw up an operating agreement, which defines each member’s ownership, voting rights, and profit share.
- More complex tax returns. If you choose for your LLC to be taxed as a corporation, your LLC must file separate tax returns from the owner’s tax return. Many states also have a franchise or capital values tax on LLCs, ranging from a flat fee to an amount based on the company’s revenue.
- State Registration and renewal fees. When you register your LLC for the first time, your state will require you to pay a fee. In order to maintain your LLC’s registration in that state, you will need to pay an annual or biannual fee (referred to as an ‘annual report’) in most states. While the state average in 2022 is $91, depending on your state, this annual fee may be much higher.
Sole Proprietorship to LLC: Ten key steps to make the change
Making the transition from a sole proprietorship to an LLC won’t happen overnight, but in the long run, it can be incredibly beneficial for your business. Here are ten key steps to consider when changing your business from a sole proprietorship to an LLC.
1. Seek Legal Advice
If you are having apprehensions about exactly how to change your business entity from a sole proprietorship to an LLC, do your research online or seek out legal advice. While this may cost upfront, it can assure that your transition is done in the most efficient and legal way possible.
2. Establish your Business Name
LLCs are established on a state-by-state basis, so it's important to ensure that your business name is available and does not infringe on any trademarks. You can check your name’s eligibility on your state's local website and will be informed of availability by the Secretary of State, then proceed to file by paying a filing fee. You also must dissolve your Sole Proprietorship or DBA where it was originally created.
3. Select a Registered Agent
A registered agent is the LLC’s point of contact for communicating with legal authorities, such as receiving and executing legal documents. You are able to act as your own registered agent or assign the role to an attorney.
4. File your Articles of Organization
When forming an LLC a crucial step is filing its articles of organization. These include detailed information regarding your business, such as your business name, registered agent and address, names of members, address of the principal place of business, and authorized signatures. Some, but not all states require a statement of purpose and the duration of time that your LLC will operate.
5. Register with the IRS
Based on elections made by the LLC and the number of members, the IRS will treat an LLC as a corporation, partnership, or as part of the LLC’s owner's tax return (a disregarded entity). Specifically, a domestic LLC with at least two members is classified as a partnership for federal income tax purposes unless it files Form 8832 and affirmatively elects to be treated as a corporation. For income tax purposes, an LLC with only one member is treated as an entity disregarded as separate from its owner, unless it files Form 8832 and elects to be treated as a corporation. However, for purposes of employment tax and certain excise taxes, an LLC with only one member is still considered a separate entity.
6. Apply for an EIN
Filing for a new EIN, employer identification number, will be your next step in the transition. This will be used for filing business taxes, opening a business bank account, facilitating payroll, and receiving credit for your company.
7. Open a New Business Banking Account
If you don’t yet have a business banking account, it’s vital to separate your business funds from your personal funds, particularly as the owner of an LLC. In fact, the right banking partner for your business can be a key factor in its continued growth and success. From features that speed up your cash flow or provide better visibility into your business finances to integrations with top business software, you’ll want to choose a business banking platform that simplifies and streamlines how you manage your business finances. Learn why Novo is one of the best business bank accounts for LLCs.
If you already have a business bank account, you may have to close the bank account associated with your sole proprietorship after all existing business associated with the account is finalized. On the other hand, if you are a Novo account holder, we make the transition smooth. We will help you update the EIN associated with your account, as well as your business name and type, as soon as you convert your business from a sole proprietorship to an LLC.
8. Apply for licenses and permits
When you make the switch from a sole proprietorship to an LLC, you will have to re-apply for any licenses or permits that are legally required for you to run your business. These vary based on industry and state regulations, but some examples include a professional license, health department permit, or reseller permit.
9. Contact your insurance provider
You will also need to connect with your insurance provider to inform them of your business entity change. Depending on your circumstances, you may need to adjust your existing insurance policy or purchase a different one altogether.
10. Rebrand your small business
Updating your remaining credentials is the last step of making the transition from a sole proprietorship to an LLC. If you’ve changed your business name, you may need to change your business letterhead, website, social media, business cards, and various other marketing materials or relevant contact information.
Transitioning from a sole proprietorship to an LLC can pave the way for future growth
As a small business owner, it can be overwhelming to take risks and make changes, but luckily there are many tools and resources available to better understand how to convert your business from a sole proprietorship to an LLC. Making the switch from a Sole Proprietorship to an LLC may just be the next step on your entrepreneurial journey that sets up you and your business for growth and long-term success.
This page is for informational purposes only and is not intended to be relied upon as legal, financial, or accounting advice. Please consult your own professional if you have any questions.