Many small businesses get their start as a sole proprietorship. After all, it’s the default business structure. If you’re a single business owner and never filed any official formation paperwork with the state, then you’re operating as a sole proprietorship.
There comes a time when a sole proprietor wants to formalize the business. Perhaps you realized that your side hobby is now a legitimate and blossoming business. Perhaps you realized that operating as a sole proprietorship puts your personal savings and assets at risk should your business incur any debt or be sued. Or maybe you want to take on a new client who requires you to operate as an LLC or corporation.
No matter the reason, the bottom line is it’s affordable and relatively simple to create a Limited Liability Company (LLC). And, there won’t be many changes in the way you operate your business. On the plus side, the LLC puts separation between your business and your personal assets and you’ll have more flexibility in how your business is taxed. You may even change your perception of your business and feel more motivation to see it grow.
If you’re interested in forming an LLC, here’s the general process. Note that specifics will vary by state, but these six steps will give you a general idea of what to expect.
Moving From Sole Proprietor to LLC
1. Research to Make Sure Your Business Name is Available in Your State
Let’s say that Jane wants to form an LLC for her business, Jane’s Candies. She needs to make sure that there already isn’t another business called “Jane’s Candies” registered in her state. To check the availability of a name, you can contact your state’s secretary of state office (some states offer an online searchable database). Another option is to have an online legal filing service do the search for you – and many sites will offer this basic search for free.
2. File Articles of Incorporation with Your State Government Office
The next step is to file specific paperwork, often known as Articles of Organization, with your state office. The document is straightforward and you’ll be required to provide information like:
- The name and address of your LLC
- Your LLC’s purpose. You typically won’t need to be specific here, and can even give a general answer like “The purpose of the Limited Liability Company is to engage in any lawful activity for which a Limited Liability Company may be organized in this state.”
- The name and address of your registered agent (this is the person designated to receive official papers for the LLC).
- An indication of your management: will your LLC be member-managed or manager-managed?
3. Create an LLC Operating Agreement
While the LLC is a great choice for those business owners looking for increased personal protection with less formality, there still is some paperwork involved. Some states require LLCs to create an operating agreement. This document is an official contract that spells out the management and ownership of the LLC. It can outline details like how much of the company each member owns, everyone’s voting rights; how profits and losses should be distributed among the members; and what happens when someone wants to leave the business.
The operating agreement can just be a few pages, and you can find some samples on the Web. Even if your state does not require an operating agreement, it can be an important document to help clarify verbal agreements and prevent misunderstandings.
4. Register with the IRS
When you form an LLC, you’ll need to apply for a new EIN (Employer Identification Number) with the IRS. This is most likely true even if you already had an EIN as a sole proprietorship. You can apply for an EIN here. The EIN is used for opening business bank accounts, filing taxes, handling payroll, and obtaining business credit.
5. Apply for a New Bank Account
If you had a business bank account for your sole proprietorship, you’ll need to close that account and open a new one in the LLC’s name (and with your new EIN number). Now that you’re an LLC, you’ll need to maintain a sharp separation between your business and personal finances. This will help shield your personal assets from the business – and has the added benefit of streamlining your business’ records for tax reporting.
6. Apply for Business Licenses and Permits
Don’t forget about any of the licenses and permits that are required to legally run your business – such as a professional license, reseller’s permit, or health department permit. Some states require that you reapply for a license when your business structure changes. You can contact your local office or a site like BusinessLicenses.com to find out about your specific licensing requirements.
That’s it. With those six basic steps, you’ve now formalized your business activities into a formal business structure.
If you’re wondering what comes next…you can opt to be taxed as an individual and still fill out the Schedule C and Schedule SE like you did as a sole proprietor. Or check with your CPA/tax advisor to see if there’s a better tax strategy, since you now have more options as an LLC than you did as a sole prop.
Lastly, you’ll need to maintain your LLC, or you could end up losing your personal liability protection. Check to see what your state’s maintenance requirements are, as you’ll typically be required to file an Annual Report (it’s a very simple form) and pay a nominal fee.
Best of luck on your business venture, and congratulations on taking this important step toward creating a solid foundation for your new business.
| Step | Description |
|---|---|
| Research Business Name Availability | Ensure your chosen business name is not already registered in your state by checking with the Secretary of State or using an online database. |
| File Articles of Incorporation | Submit paperwork (Articles of Organization) to your state office with details like LLC name, purpose, registered agent, and management structure. |
| Create an LLC Operating Agreement | Draft an official contract specifying management, ownership, voting rights, profit distribution, and exit procedures for members. |
| Register with the IRS | Apply for a new Employer Identification Number (EIN) from the IRS, even if you had one as a sole proprietor. |
| Apply for a New Bank Account | Close your sole proprietorship's bank account and open a new one in the LLC's name using the new EIN for financial separation. |
| Apply for Business Licenses and Permits | Verify and obtain any necessary licenses and permits required to operate legally, considering changes in business structure. |
| Maintain Your LLC | Regularly fulfill state maintenance requirements, such as filing an Annual Report and paying associated fees to maintain personal liability protection. |
Advantages of Transitioning from Sole Proprietorship to LLC
If you’re contemplating the shift from a sole proprietorship to an LLC, it’s important to understand the potential benefits. Here are some advantages to consider:
- Limited Liability: Operating as an LLC provides a crucial separation between your personal assets and your business. This limits your personal liability, protecting your savings and possessions in case of business debts or legal issues.
- Tax Flexibility: LLCs offer flexibility in how your business is taxed. You can choose to be taxed as a sole proprietorship, partnership, S corporation, or C corporation, allowing you to optimize your tax strategy.
- Professionalism: Forming an LLC can enhance your business’s professional image. It signals commitment and dedication, potentially attracting more clients and opportunities.
- Continuity: An LLC can outlive its owner(s). If you decide to step away or pass on your business, the LLC can continue to operate, ensuring continuity for clients and employees.
- Access to Financing: Transitioning to an LLC can improve your access to business loans, credit, and financing options, helping your business grow.
- Operational Flexibility: While there’s some paperwork involved, LLCs generally have fewer formalities compared to corporations. This means less administrative burden, allowing you to focus on your business operations.
- Asset Protection: Shielding your personal assets through an LLC minimizes the risk associated with business-related debts or legal disputes, offering peace of mind.
- Attracting Partners: If you plan to bring in partners or investors, operating as an LLC can be more appealing to potential collaborators due to its flexible management structure.
- Legal Clarity: Drafting an operating agreement as required by some states helps clarify ownership, management, and profit-sharing arrangements, reducing the chances of misunderstandings or disputes.
| Advantages | Description |
|---|---|
| Limited Liability | Separation of personal assets and business assets protects personal savings and possessions. |
| Tax Flexibility | Choose from various tax structures (sole proprietorship, partnership, S corporation, C corporation). |
| Professionalism | Enhance your business's professional image, potentially attracting more clients and opportunities. |
| Continuity | An LLC can continue to operate beyond the owner(s), ensuring business continuity. |
| Access to Financing | Improved access to business loans, credit, and financing options for business growth. |
| Operational Flexibility | Fewer formalities compared to corporations, reducing administrative burden on business operations. |
| Asset Protection | Shield personal assets from business-related debts or legal disputes, providing peace of mind. |
| Attracting Partners | More appealing to potential partners and investors due to flexible management structure. |
| Legal Clarity | Operating agreement clarifies ownership, management, and profit-sharing, reducing misunderstandings. |
Key Considerations Before Transitioning to an LLC
Before making the shift from a sole proprietorship to an LLC, there are some important considerations to keep in mind:
- State-Specific Rules: LLC regulations can vary by state, so research the specific requirements and procedures in your state. This ensures compliance with local laws.
- Name Availability: Verify that your desired LLC name is available in your state. It should be distinguishable from existing business names to avoid conflicts.
- Business Purpose: Clearly define the purpose of your LLC when filing Articles of Organization. While it can be broad, it should accurately represent your business activities.
- Registered Agent: Designate a registered agent who will receive legal documents and official notices on behalf of the LLC. This individual or entity must have a physical address in the state.
- Management Structure: Decide whether your LLC will be member-managed or manager-managed. Member-managed means all owners (members) share in management, while manager-managed designates specific individuals to manage the business.
- Operating Agreement: Even if not required by your state, consider creating an LLC operating agreement. This document outlines the internal workings of your LLC, addressing issues like ownership, management, and profit distribution.
- Employer Identification Number (EIN): You’ll likely need a new EIN for your LLC, even if you had one as a sole proprietor. Apply for this through the IRS for tax purposes and business operations.
- Bank Accounts: Open a dedicated business bank account in the LLC’s name, using the new EIN. This helps maintain a clear separation between personal and business finances.
- Business Licenses and Permits: Review your local and industry-specific licensing requirements. Make sure you obtain the necessary permits to legally operate your LLC.
- Transitioning Clients and Contracts: If you have existing clients or contracts, communicate the transition to them and update contractual agreements if necessary. Ensure a smooth transition of services.
- Tax Implications: Consult with a tax advisor or CPA to understand the tax implications of transitioning to an LLC. Determine the most tax-efficient structure for your business.
- Annual Reporting: Find out your state’s requirements for annual reporting and fees. Failing to meet these obligations could result in penalties or loss of LLC status.
- Professional Advice: Consider seeking legal and financial advice during the transition process to ensure compliance with all regulations and to protect your interests.
LLC Computer Photo via Shutterstock
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