When you begin generating business income for yourself, on the basis of self-employment, the law automatically considers you to be a Sole Proprietor. Unsurprisingly, then, Sole Proprietorships are incredibly common, providing the legal status for countless freelancers and solopreneurs.
As your business grows and your needs evolve, however, you may reach a point where you need to change your legal structure. The most common transition is from Sole Proprietorship to Limited Liability Company, or LLC. There are a number of reasons why Sole Proprietors might desire to make this change, but nine times out of 10, it’s out of a desire to limit personal liability risks.
For any business owner who’s thinking about shifting from Sole Proprietor to LLC status, it can be helpful to have a better grasp on the potential benefits of doing so; and, to better assess the steps required.
Sole Proprietorships vs. LLCs: What’s the Difference?
To begin with, let’s define our terms.
- When you go into business for yourself, you are automatically considered a Sole Proprietor. There is no initial administration or set-up required, other than paying your taxes and registering for any necessary business permits. When you are a Sole Proprietor, there is no distinction between you and your business. All business assets are yours, and all business losses and liabilities are yours, too. Also note that, by definition, a Sole Proprietorship involves just one person running the business and making managerial decisions.
- By contrast, the LLC is a legal structure that creates a whole new business entity. In other words, the business and the business owner are distinct in the eyes of the law, with a separation between business assets/liabilities and personal assets/liabilities. Because you’re creating a whole new legal structure, the LLC does have a bit more administration on the front-end. With that said, it’s much more straightforward than launching a Corporation.
Why Change from a Sole Proprietorship to an LLC?
There are plenty of reasons why you might decide to register your business as an LLC. Consider some of the most common ones:
Hiring Employees
The Sole Proprietorship structure is primarily for those who work alone. While you can bring staff on board, doing so can significantly complicate your tax reporting and accounting. Switching to an LLC will make it much easier for you to separate your business and personal tax information, which in turn makes it far more plausible to hire a team.
Tax Flexibility
When you’re a Sole Proprietor, you declare all business profits on your personal tax returns, and pay your normal tax rate. This can sometimes get a little expensive, and some business owners may long for more flexible options. LLCs allow you to continue getting taxed on a pass-through basis, but also to elect for the corporate tax rate if you deem it to be more advantageous. Tax flexibility is a common reason for Sole Proprietors to switch to an LLC.
Personal Asset Protection
With all of that said, by far the most common reason to switch to an LLC is for personal wealth protection.
Remember that Sole Proprietors do not enjoy any legal distinction between personal liabilities and business ones. As such, they face a high level of vulnerability to creditors and lawsuits. If a Sole Proprietor is sued, it is entirely possible that they could lose some of their personally-held assets, like money from their family’s bank account, even their car or house.
LLCs create a line of separation between personal and business liabilities, meaning that your personal wealth is shielded from creditors and lawsuits. This provides a high level of peace of mind and financial security. And ultimately, it makes the LLC the preferred business structure for entrepreneurs across the country.
Changing from a Sole Proprietorship to an LLC
There are a few steps involved in transitioning your business from a Sole Proprietorship to the LLC structure. Here’s a quick summary.
- Verify that the name of your business is available. First and foremost, ensure that the name you’ve been using for your business isn’t claimed by another local LLC. Most states have registries where you can easily check and make sure that your desired name isn’t in use. If your desired name is taken, there’s really nothing you can do except rebrand.
- Choose a Registered Agent. When you start an LLC, one requirement is that you choose someone to serve as your Registered Agent. Basically, this is someone who is legally designated to receive legal and tax documents on behalf of your business. (Common question: Can I be my own registered agent for an LLC? The short answer is that it varies from state to state, but in most states the answer is no.)
- File paperwork with the state. The next step is to file Articles of Organization with the Secretary of State. This is a very basic document, detailing the name and purpose of your business, the names of all partners, the name of your Registered Agent, and some basic contact details. You’ll also need to pay a nominal fee, which varies by state.
- Draft an Operating Agreement. While this isn’t a legal requirement, it’s certainly advised that you create a document outlining how managerial duties will be divided between your partners, and to denote how profits/assets will be allocated.
- Get an EIN. You’ll need an Employer Identification Number to handle payroll and to file taxes. Luckily, the IRS will give you one for free (assuming you’re a U.S. citizen).
Moving Forward with Your LLC
While Sole Proprietorship can be a great way to start your entrepreneurial career, switching to the LLC structure can ultimately bring many advantages, not least personal wealth protection. Start thinking about your business transition process today.