How to Change from Sole Proprietorship to LLC

by Jennifer Kiesewetter in
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TLDR

  • When you launch your startup, you may choose to operate under a sole proprietorship structure, one of the U.S's most accessible and most popular business structures.
  • New founders often use this structure as a stepping stone to a more formal entity, such as a limited liability company (LLC) or a corporation.
  • A sole proprietorship is an unincorporated business owned by one person. When a startup is a sole proprietorship, there is no legal distinction between the founder and the business, making the founder personally responsible for all debts and liabilities of the startup.
  • A partnership is a business arrangement between two or more people who share decision-making, profits, and liabilities. Two types of partnerships exist: general and limited.
  • A limited liability company (LLC) is another popular business structure, as it’s easy to form but gives the founders similar protections as a corporation. This limited liability helps to protect the founders’ personal assets in the event of a lawsuit against the startup.
  • A corporation differs from a sole proprietorship or a partnership in several ways. First, corporations are distinct legal entities, with rights, obligations, and liabilities separate from the founders. Corporations pay their own taxes, they can be sued, and they can enter into legal contracts as a separate, legal entity.
  • Because a corporation is its own legal entity, it protects its founders and shareholders from legal action directed at the startup.

When you launch your startup, you may choose to operate as a sole proprietorship structure, one of the most popular business structures in the U.S. With 23 million U.S. sole proprietorships, new founders often use this structure as a stepping stone to a more formal entity, such as a limited liability company (LLC) or a corporation.

This article will address how to transition from a sole proprietorship to an LLC when you’re ready to take the next step with your startup.

What is a Sole Proprietorship?

A sole proprietorship is an unincorporated business owned by one person. When a startup is a sole proprietorship, there is no legal distinction between the founder and the business, making the founder personally responsible for all debts and liabilities of the startup.

Although there is no legal distinction between the founder and the sole proprietorship, the founder may still need to register their startup locally or at the state level by applying for a business license or other required permits.

Advantages

In addition to being easy and inexpensive to form, sole proprietorships offer additional advantages. For example, taxes are easy to file on your sole proprietorship startup as any business income is added to your personal income and reported on your personal tax returns.

A sole proprietorship gives the sole founder complete control over the business, with no partners or shareholders. It’s also easy to register your sole proprietorship with a “doing business as” (DBA) name, allowing you to brand your business. Finally, just as it’s easy to create, a sole proprietorship is also easy to dissolve since it is an unincorporated entity.

Disadvantages

Like all business structures, a sole proprietorship is not without its disadvantages. For example, it isn’t easy running a business by yourself. As you grow and expand, you’ll need partners and employees to help you get to the next level.

Additionally, because you and your startup are one and the same, you are responsible for all business liabilities, meaning you are solely responsible for every amount owed by your startup. Courts will not distinguish the startup from the owner, so if you find yourself in a dispute over amounts owed and the court rules against your startup, you are personally liable for the disputed amount plus any court costs and fines.

As a sole proprietor, you also may find it challenging to raise money or secure lending from banks or other financial institutions. In addition, as there is no formal business structure, investors and lenders may be reluctant to give you money.

What is a Partnership?

A partnership is a business arrangement between two or more people who share decision-making, profits, and liabilities. Two types of partnerships exist: general and limited.

In a general partnership, all partners manage the business, assuming responsibility for decision-making and obligations. In a limited partnership, general partners run the company, and limited partners serve as investors with no managerial responsibilities. Because limited partners only serve as investors, they are also not subject to any of the startup’s liabilities.

Advantages

One of the main advantages of a partnership is the potential tax benefits. For example, for general partnerships, the partnership itself does not pay taxes. Instead, the profits and losses are “passed through” to the founders. This avoids double taxation — once at the business level and once at the founder level.

Additionally, with partnerships, you can access more expertise with each partner, allowing you to fill knowledge gaps. Another benefit is sharing financial responsibility with a partnership instead of taking it all upon yourself as you would with a sole proprietorship.

Disadvantages

Now, let’s look at some disadvantages of partnerships. First, although sharing responsibilities for the startup’s liabilities can be positive, it can also be a disadvantage. For example, if your partner incurred a cost, you’ll also be liable for the expense. You also lose your autonomy in a partnership since you now “share control with a partner, and important decisions would be made jointly.”

It’s for these reasons that’s it’s critical to choose your partners wisely.

What is an LLC?

A limited liability company (LLC) is another popular business structure, as it’s easy to form but gives the founders similar protections as a corporation. This limited liability helps to protect the founders’ personal assets in the event of a lawsuit against the startup. LLCs also provide flexibility in their taxation, as they can be taxed as a sole proprietorship, partnership, or S-corporation.

Advantages

LLCs are popular because of their flexibility and limited liability. For example, like partnerships, LLCs are pass-through organizations for tax purposes, meaning that the LLC itself is not taxed as a separate entity. Instead, the LLC’s members determine if they want to be taxed as follows:

And, of course, a primary benefit of an LLC is the limited liability, meaning that the founders are not personally liable for the LLC’s debts, lawsuits, or bankruptcy.

Disadvantages

Like other startup formations, LLCs have their own disadvantages as well — although not many. For example, the primary drawback is the payment of self-employment taxes. Because the LLC is not taxed at the corporate level, and the profits and losses are passed through to the founders, the founders are also responsible for paying their own self-employment taxes, consisting of Social Security and Medicare taxes. To understand how these taxes impact you financially, you should talk to a knowledgeable accountant or tax attorney.

How Does a Corporation Differ from a Sole Proprietorship or Partnership?

A corporation differs from a sole proprietorship or a partnership in several ways. First, corporations are distinct legal entities, with rights, obligations, and liabilities separate from the founders. Corporations pay their own taxes, they can be sued, and they can enter into legal contracts as a separate, legal entity.

Because the corporation is its own legal entity, it protects its founders and shareholders from legal action directed at the startup.

Two types of corporations exist C-corporations and S-corporations. First, a C-corporation is taxed on its profits. Then, when a C-corporation pays dividends to its shareholders, those individual shareholders must pay income taxes on the dividends. This is known as “double taxation.”

An S-corporation passes profits and losses through to its shareholders, similar to partnerships and LLCs. Because of this, S-corporations avoid double taxation on corporate income, as all income is passed through the shareholders, requiring reporting of the “flow-through of income and losses on their personal tax returns and are assessed tax at their individual income tax rates. This allows S-corporations to avoid double taxation on the corporate income. S- corporations are responsible for tax on certain built-in gains and passive income at the entity level.”

How to Change from a Sole Proprietorship to an LLC?

If you began operating your startup as a sole proprietorship and you’re ready to convert it to an LLC, there are several steps that you’ll need to follow to achieve the transition successfully.

Check the Availability of Your Startup’s Name

First, you should check the availability of your startup’s name. When converting your startup from a sole proprietorship to an LLC, you want a unique business name. First, you need to confirm that the name you want is not registered to another active business in the state in which you’re operating. To check the availability of your startup’s name, visit your state’s secretary of state website to see if your chosen name (or one similar to it) is already in use.

If your startup’s name is available, then make sure it conforms with your state’s naming requirements, such as using “LLC” in your business’s name. Typically, you will not need to register your startup’s name, as that will be done when you convert your sole proprietorship to an LLC. However, it’s always a best practice to check with your state on its specific rules.

File Your Articles of Organization

When converting to an LLC, you’ll need to complete your state’s articles of organization, which is the official form used to create your LLC. Many states have sample forms that you can use, helping to make sure you include all of the appropriate language in your filing.

Typically, these forms require you to include your startup's name and address along with the founders' names. You’ll also need to identify a registered agent who can receive legal papers on the startup’s behalf. Finally, you’ll need to pay a filing fee, which differs from state to state.

Once you file your startup’s articles of organization, you’ll need to check with your local state rules to confirm whether you need to publish notification of your new LLC in a local newspaper.

Get Business Licenses and Permits

Once you file your LLC’s formation documents, you should check with your local and state governments to see if any additional licenses or permits are required for operation. For example, one of the most popular licenses is a business license.

Apply for a Business Bank Account

Finally, you’ll want to apply for a new business bank account after receiving your federal employer identification number. A separate business account helps you segregate business funds and expenses from your personal financials, allowing you to create a record of your startup’s income, expenses, and debts. Your accountant will thank you come tax time.

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