The pros and cons of each business structure
If you first started your business on the side while keeping a full-time job, or you performed freelance work that didn’t require much liability protection, a sole proprietorship likely suited your needs.
But as a business grows, so too does the need to keep your business and personal finances and affairs separate. Transitioning to an LLC is often a natural progression because an LLC can limit your level of personal liability should your business ever be on the hook for a sum of money.
Before we jump into the process of transitioning from a sole proprietorship to an LLC, let’s take a look at how the two business structures differ.
- There are very few (if any) ongoing requirements for sole proprietors
- Separating business and personal assets isn’t legally required when you’re a sole proprietor, but we do advise that you avoid commingling business and personal finances
- You aren’t required to pay unemployment tax on your own income, although you do need to pay the tax if you have an employee
- The downside is that sole proprietors are subject to unlimited liability in the event of losses, debts, and liabilities—meaning that if you were sued, for example, your personal assets could be used to cover the payments
Limited Liability Company (LLC)
- Members’ assets are usually protected if the business is sued or incurs debts
- There can be no mixing of business and personal assets as an LLC. If assets are mixed, members are no longer protected by limited liability (this is referred to as piercing the corporate veil.
- Most states will charge LLCs franchise fees and taxes. Since these vary by location and are charged in addition to state and federal income tax, changing to an LLC is not guaranteed to lower your tax bill.
Further reading: Sole Props vs. LLCs (Main Differences)
How to transition a sole proprietorship to an LLC
Transitioning your business’s legal structure from a sole proprietorship to a limited liability company will take some time.
When you’re ready to go through the process, use this checklist to work through each step.
Step 1: Consider professional assistance
There are many moving parts required to establish an LLC, so you may want to get some assistance. If you do want help, there are online legal services you can sign up for, or you can hire an attorney. An online service will guide you through the setup process, and it’s the less expensive option. Alternatively, hiring an attorney will give you more specialized assistance, but it will cost you.
Step 2: Choose a name for your LLC
While LLC name requirements vary by state, all states require that the business name reflects the LLC status. Choose a name that includes ‘Limited Liability Company,’ or an abbreviation of it (LLC).
Step 3: Designate a registered agent
Your registered agent will be the LLC’s main point of contact for communicating with the state and other legal authorities. You can choose to function as your own agent or designate your attorney to take on this role.
Step 4: File the articles of organization
An LLC’s articles of organization include pertinent information about your business, including business name, address, registered agent, the names of members, and more.
Step 5: Register with the IRS
When it comes to taxes, an LLC can be treated as either a corporation, partnership, or as a disregarded entity (income is included on the owner’s individual tax return). You can stick with the default IRS classification or elect a different option using Form 8832.
Step 6: Re-apply for licenses for your new LLC structure
Regulations for business licenses vary by state, industry, and locality. The Small Business Association Licenses and Permits Tool can help you determine what you need.
Step 7: Talk to your insurance company
You’ll need to get in touch with your insurance provider and notify them that your business structure is changing. They can also advise you on whether you’ll need to purchase a new business insurance policy.
Step 8: Update your bank information or open a new account
In many cases, you’ll need to open a new business bank account for the LLC, but at the very least, you’ll need to update your business bank information to reflect your new LLC status.
If you do open a new account, be sure to close the old one (after all checks and purchases have gone through). While you’re waiting for those payments to clear, stop using the account and change the banking information for any automatic payments that you make. Also, be sure to inform clients of your new business name so that they can issue payments to your LLC.
Further reading: Form 8832 and Changing Your LLC Tax Status