Last Updated on September 13, 2021 by DMEditor
Businesses go through many changes throughout their lifetime, and it is not easy to predict the form one takes. Some owners plan to scale up, something that never happens, while others designed to remain small end up becoming huge entities.
Most small businesses start as sole proprietorships, which is the simplest form a business can take, but not the best. The downsides of a sole proprietorship become evident when a business scales operations and has to be identified as an independent legal entity. At this point, the owners must change the structure from a sole proprietorship to a Limited Liability Company to allow the business to thrive and detach personal assets from that of the company.
In this piece, we will expound on the process required to change a sole proprietorship to LLC. Read on;
Table of Contents
- 1 An Overview of a Sole Proprietorship
- 2 Advantages of a Sole Proprietorship
- 3 Disadvantages of a Sole Proprietorship
- 4 Steps for Changing a Sole Proprietorship to LLC
- 5 Choosing an LLC vs. Sole Proprietorship
- 6 Frequently Asked Questions
- 7 Bottomline
An Overview of a Sole Proprietorship
This is an unincorporated business owned by one person. Here, the business is tied to you, and all the liabilities are tied to your ones. If someone sues the business, they are essentially suing you. In the eyes of the IRS, you and the business are identical on matters of tax. Technically, the business does not pay taxes; rather, you do it personally.
The formation of a sole proprietorship is not complicated compared to other legal structures since most things are tied to your record. As soon as you set up a venture and it turns a profit, you are a sole proprietor. Until you file the required paperwork to identify your business as a different legal structure, you are a sole proprietor.
However, there are a few things to be cleared before running a sole prop;
The IRS will not label your venture as a sole proprietorship unless you turn a profit. Assuming you like yoga and decide to teach some people as a donation. In total, you make just enough to cover your costs. Here, you are practicing a hobby, and unless you turn a profit, the IRS won’t regard you as a sole proprietor. If you start charging for each class and make some profit, you must report the income to the IRS as you become a sole proprietor by default.
All states have permits and licenses sole proprietors must hold to operate. This is also dependent on the niche you operate in. Specialized niches such as medicine, pest control, plumbing, and financial services require licenses specific to those areas. The business name on these licenses will be your name unless you want to file for a trading name which can be acquired by filing a DBA form.
While this is not mandatory, it is good to have a dedicated bank account for the business. It makes your life easier when filing tax returns, as you can easily separate business and personal transactions. When it comes to bookkeeping, you can have all business income and expenses in clean, separate accounts.
Common types of sole proprietors include;
This is a self-employed contractor who offers services on a contract basis with clients. They have the free will to pick the clients they do business with but are often subject to their clients’ processes when engaging with them. Think of it as a plumber, landscaper, or pest exterminator.
They can be self-employed like the contractors, but unlike them, they have some degree of autonomy in how the job is done. The establishment might be a bit sophisticated with a few employees and intellectual property with processes and basic business structures.
This is the traditional franchise operation, but it depends on the preferred method of operation dictated by the mother company.
Advantages of a Sole Proprietorship
The owner has the full decision-making authority
- Easy and quick to set up
- Free to start
- Simple to file taxes
- The IRS does not require you to file balance sheets
- Complete control over revenue streams
Disadvantages of a Sole Proprietorship
- No protection from business risks such as liability and lawsuits
- Hard to get bank loans since they mostly require businesses to incorporate
- Perceived lack of professionalism
- Self-employment tax
- Most businesses prefer working with incorporated entities
Steps for Changing a Sole Proprietorship to LLC
Check the Business Name
When you choose to switch from a sole proprietorship to an LLC, you must go through the process required to form one, which starts with checking if the business name you want to use is available. LLCs are independent entities, and they must be recognized by a unique name. The name you use might be already registered to another LLC, implying you need to find a new one.
Name checks are done at the secretary of state’s office and confirm with your specific one on the exact procedure. Most states have automated this process and provide an online database for the registered names, and you can complete this step quickly. Alternatively, you can contact a legal professional to help you get over this step.
Once you check and confirm that your business name is available, go an extra step to ensure it does not affect anyone’s trademark. This is done on the United States Patent and Trademark Office’s database, where you can conduct the search.
You must include the terms Limited Liability Company or a representation of the same on the business name to distinguish it as an LLC.
Usually, the name is automatically registered when you file the paperwork to set up the LLC but confirm the specific regulations surrounding this step with your state.
File Articles of Organization
This is a form that captures the details of your LLC, and it must be filed with your secretary of state. All states have varying requirements for filing one, but it is a short a simple document.
Some of the everyday things you will have to indicate include the name of the LLC, physical address, and name of owners, among others. There is a fee for submitting this form, with the average being $100. An essential aspect of this is the nomination of a registered agent. This is a legal entity that you charge with the responsibility of receiving legal mail on behalf of your business. It can be a third-party entity or an owner of the LLC.
Write an LLC Operating Agreement
While the secretary of state does not require this, it is a vital document that outlines how the LLC will conduct its business. It comes in handy when a dispute needs to be resolved, or the owners decide to close the LLC. It maps out how the business will be managed and states the powers the owners have. It also states how profits and losses will be divided, voting power, and the rights and responsibilities of the different members.
An operating agreement is fundamental if more than one person owns the LLC since these situations require allocation of powers between the members. It reduces conflict between members but strives to create one even if you have a one-member LLC. This is because you might scale up and decide to sell shares or bring in new owners, and it is vital to have a standard operating agreement that the new members can refer to.
Announce the LLC
Some states will ask you to announce that you are forming an LLC through a public notice. This can be done in the local newspaper or through any other media outlets specified by the secretary of state. In some cases, you need to announce forming the LLC severally and submit written proof to the secretary of state before they approve the application.
Get a Bank Account
You probably had a bank account for your sole proprietorship, but this won’t suffice as you need to get a new one. An LLC is a new legal entity, and it has the right to own property and has a bank account. This step is vital since you can separate personal and business funds. It also comes in handy when filing for taxes since you get a sharper view of the company’s financial activity.
Apply for an Employer Identification Number with the IRS even if you already had one for the sole proprietorship.
Get the Applicable Licenses and Permits
You might have a license for the sole proprietorship you run, but an LLC is a different entity altogether. In most cases, the requirements for you to hold a personal license to offer a service are different from an LLC’s requirements. This way, you might have to apply for new licenses or transfer the existing ones to your LLCs name if this is possible.
The six major steps required to change a sole proprietorship to an LLC have been mentioned, and they are not all that different from the steps required to form a new one. Essentially, a sole proprietorship is not a legal entity, so you are simply forming a new one when you switch to an LLC.
Choosing an LLC vs. Sole Proprietorship
Before you decide to change a sole proprietorship to an LLC, it helps to go over some of the critical differences that will determine what is best for you.
One aspect that sets the two apart is the formation phase. A sole proprietor is easier to set up than an LLC that requires some money and a relatively longer legal process. The local government can clear all the sole proprietorship legal work. Luckily, the LLC formation process has been automated and can be completed online, depending on the state you reside in.
Financing is the other key difference that can help you select the best entity to conduct business with. Most small businesses require you to keep a separate job and then bootstrap the finances to help the business get up to its feet. But there is a limit to this as businesses need huge loans to scale up operations. In addition, sole proprietors find it hard to get formal financing from these institutions since they are tied to the owners.
Both an LLC and sole proprietorship file taxes through the owner’s returns, but an LLC has more flexibility, which can be leveraged to get some tax savings. LLCs can elect to be taxed as an S-Corp or C-Corp, but they will need to meet specific requirements to attain the status.
Frequently Asked Questions
Answer: If you had an EIN for your sole proprietorship, you could write a request to the IRS to transfer it to the newly formed LLC. However, it depends if you already had a bank account for the sole proprietorship. If you had an account, you would have to open a new one for the LLC using the EIN.
Answer: The process of changing a DBA to an LLC is not all that different from the one used to change a sole proprietorship to an LLC. It all starts with the name check, filing articles or organization, getting an EIN, appointing a registered agent, and getting the necessary licenses required to conduct business.
Answer: A DBA is a type of sole proprietorship since it gives the business a professional name, but it doesn’t enjoy the benefits of an LLC. However, it is easier to deal with other businesses and generate funding for an LLC compared to a DBA. Read our full DBA vs LLC comparison here.
The steps required to change a sole proprietorship to an LLC have been mentioned, and it is prudent to understand the point you must make the change. Understand that if you have a new business, legal protection against liability is critical, a reason why you should not delay forming an LLC.
It can make your business appear more professional and stable to partners and other businesses you will deal with. A sole proprietorship is as easy as it gets, and you have the authority to make all decisions, which are attractive when starting.