Switching from Sole Proprietor to LLC and Why It Is a Smart Move

Switching From Sole Proprietor To LLC

Switching from sole proprietor to LLC (Limited Liability Company) is a smart move for both you and your business.

Most small businesses start off as sole proprietors, but as they grow with time, they usually switch from a sole proprietorship to an LLC.

People often change the legal status of their business from a sole proprietorship to an LLC when looking to formalize their company, which has flourished into a full-fledged, large-scale business.

It protects them and their personal savings and assets from risk in case the business is sued or falls into debt.

Once your business reaches a certain size, most financial advisors will tell you that the switch should be made. It is a logical next step for your business and is quite simple as well.

Steps of Switching from Sole Proprietor to LLC

Step 1: Check the Availability of Business Name

The first thing you need to do when you are switching from a sole proprietorship to an LLC is to check the availability of your business name. You have to ensure that the name you are willing to move ahead with is not already taken by someone else.

You will need to contact the secretary of state office of your state to find out whether your intended business name is already registered in your state.

Some state offices offer an online database where you can carry out your search. You can also approach an online legal filing service to do the search for you. Many service providers can do that for you without charging a fee.

Once you know that your preferred business name is not registered in your state, you can move on to the next step.

Step 2: File the Articles of Organization

After you have made sure that the business name is available, you can start the official paperwork. The paperwork, known as the articles of organization, is filed with the government office of your state. It is a pretty straightforward document.

You will be asked to provide the following information during this process:

  • The name and the address of your LLC
  • The purpose of your LLC. You are not required to provide any specifics. A general answer will suffice
  • The name and address of the person who will be receiving all the official papers for the LLC (the registered agent)
  • You will have to specify your management structure; member-managed or manager-managed

Step 3: Create an LLC Operating Agreement

Although switching from sole proprietor to LLC does not involve extensive formalities, there is still some highly important paperwork that is needed. An LLC operating agreement is a requirement of many states.

An LLC operating agreement is an official contract that states the details of the ownership and management of an LLC, the ownership percentage of each member, the voting rights of every person involved in management/ownership, the distribution of profits and losses, and the details of what happens when someone is willing to opt out of the business.

The operating agreement is usually a few pages long. It is a wise decision to have this document prepared even if your state doesn’t ask for it. It clearly documents all the important aspects, clarifies verbal agreements, and above all, prevents misunderstandings that may arise in the future.

Step 4: Register with the IRS

Since an LLC is an entirely independent entity, the EIN (Employee Identification Number) of a sole proprietor will not be applicable. You will need a new EIN for your LLC. This is done by registering your LLC with the IRS. The EIN is used to open business bank accounts, filing taxes, obtaining business credit, and handling payroll. You can do this conveniently through the IRS’s website.

Step 5: Open a New Bank Account

Now that you are no longer a sole proprietor, you cannot continue with the bank account you opened as DBA or a sole proprietor. You have to close the old accounts and open a new one for your LLC with the new EIN.

Once you form an LLC, you will have to keep personal and business finances strictly separate. This is important because it shields your personal assets from your business, which makes the streamlining of your business records for taxation purposes simpler.

Step 6: Change All Basics

Now that you have a new EIN, you will have to change all the basics related to your business. This includes: vendor accounts, mailing addresses, accounts payable, and every account that is registered with any government department or agency.

Step 7: Apply for Business License and Permit

You cannot run any business legally without valid permits and licenses. You will require a professional license for your business, a permit from the health department, and a reseller’s permit. The requirements of some states are more critical than others. Some states will want you to reapply for a license whenever there is a structural change in your business.

You can take help from a local office or any professional service providers for the issuance of these licenses and permits.

Step 8: Complete the Transition

Now that you have everything sorted for your LLC, including the EIN, bank accounts, permits, and licenses, you can finally complete the transition. You will have to change your letterheads, business cards, website, telephone listings, and all the relevant contact information. You will also need to track down all the lists where the sole proprietorship was listed and replace it with the LLC information.

Step 9: Choose Taxation Strategy

Taxation is something that you just can’t miss. You don’t have any taxation strategy options to choose from as a sole proprietor. But, things change when you switch from sole proprietor to LLC. You can choose to be taxed as an individual and continue filling out Schedule C and Schedule SE. Also, you cab check with your tax advisor to evaluate other tax strategies that may better suit you.  

Why Is Switching from Sole Proprietor to LLC a Smart Move?

LLC and Inc. Type of Business Models

Before you get yourself into the hassle of switching from sole proprietor to LLC, you should understand why it is such a smart move.

  • A sole proprietorship is not a legal entity. While you get all the profits, powers, the authority to make decisions, and the rewards, you are also responsible for everything and have to bear all the risks and losses. Switching to LLC makes your business a legally distinct entity. You get personal liability protection, greater funding potential, and more tax options.
  • In a sole proprietorship, all the legal and financial issues affecting your business will affect you because you are your business. You have to bear the debts and losses of the business. But when you switch to LLC, you are separating your personal and business finances completely. For example, if someone sues your sole proprietorship and the damages are greater than what you have in your bank account, you may have to sell off your personal assets like your house and your car to pay off the damages. But with an LLC, your personal and business assets are separate. Even if your LLC is sued, your personal assets and bank accounts are off-limits. This is the “limited liability” aspect of a limited liability company.
  • Switching to LLC gives you tax flexibility. A sole proprietorship has only a single tax option. You fill out a Schedule C or C-EZ or a Schedule SE if the net profit is greater than $400. However, switching to LLC will give you additional options that can help you save on taxes.

A single-member LLC is taxed in a similar way, but they are not bound to keep the default tax status. An LLC will have an option to be taxed as a corporation. You will then have the option to choose an S-corp election.

The difference between the two is in self-employment taxes. In a sole proprietorship, all of the income is considered as self-employment income. Hence, all of it is subject to tax. In an LLC, some part of your income is subjected to self-employment tax. This allows you to save part of your income.

LLC Business Model Benefits
  • The funding options are more diverse for an LLC. If you are a sole proprietor, you have multiple funding options like debt financing and equity financing.
  • Debt financing is the funding that you have to return. It comes in the form of bank loans and credit cards.
  • If you own a sole proprietorship, you will get low bank loans and credit card limits. But, when you are an LLC, the loan limits and business card limits are higher.
  • Equity financing is when you ask for funding in exchange for a part of your company’s stock/shares. This is not possible in a sole proprietorship, where you are the only owner and member of the business.
  • An LLC does not have to conduct annual meetings or maintain extensive records.
  • An LLC offers management flexibility. In a sole proprietorship, the management structure is fixed. While in an LLC, there is no formal structure, and there are more choices with regards to how the business is run.

The adaptable business model of an LLC makes switching from sole proprietor to LLC a fairly smart move that benefits not only your business but also you as an individual. It offers increased protection to your personal assets and finances, which is what you need if your business is flourishing beyond expectations.