Converting A Sole Proprietorship to An LLC: The Basics 2021
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Small businesses tend to grow. This is a good thing. However as you grow and potentially look to expand, you may realize that it's also time to change the structure of your business; that is to say, given tax advantages and legal implications, changing over to an LLC might be the direction in which your small company should be moving. Change of this kind does not have to be daunting. Below are seven steps that will help you more easily transform your sole proprietorship into an LLC.
Understanding Limited Liability Companies
First off, you might be wondering why you should change over to an LLC. If everything is running along fine then why rock the boat, right? What advantages could there be to an LLC? Tax advantages are huge here (we will touch upon those later/); additionally, you want to look at the element of risk. As a sole proprietor, your assets are on the line every day. This is because those of the business and your finances are essentially tied together in the eyes of the government. If for some reason, someone goes after the business and considers suing, your money is at risk; this could include your home and all such assets. With an LLC however, there is a distinctive difference between owner and business and thus in the event of legal action, you are shielded.
Also, think about the trajectory your business is taking—is it growing? As you do expand you may be taking on more clients, some that dictate your company has certain protections in place, such that is only possible with an established LLC.
As you set about changing over to an LLC, there are certain steps you're going to want to follow. Here, we've tried to compile a list off of which you can work.
1. Your LLC Name
Even if you currently have a name as a sole proprietorship, in changing to an LLC you are creating a whole new company. As it is a legal entity and separate from you as the owner, you are in essence building this new company from scratch. As such, you have to register the company with the state. This means that you need to utilize a name that doesn't already exist within your state. If the current name under which you are operating is available, then great; otherwise, you may need to choose something else.
2. File With the State
In a filing with the state, you will need to provide certain documents. One such document is what is called the "Articles of Incorporation," Each state has slightly different requirements when it comes to registering your LLC. A few things you will most likely need regardless of state are basic info regarding the company, name, and address of the person responsible for documentation for the company, purpose of your LLC, management structure of the business.
3. Create Your Operating Agreement
An operating agreement for your LLC needs to be created and thus filed. This outlines the various components of your business and how subsequently, it will be run. Such an agreement is comprised of the following:
- Organization How the various stakes are set up and how the company is structured in terms of the members involved.
- Management Which members can make changes/key decisions. How will changes be implemented?
- Capital Funding Where did the money come from to start the company and how does this affect the power structure within the organization.
- Asset Distribution How will assets be shared among members?
- Membership What happens when you want to bring in new members or get rid of existing ones.
- Dissolution If the company dissolves how will assets be allocated and debts settled.
Not all states will require this agreement, but it certainly can't hurt even if your state doesn't, to have one in place.
4. Register With the IRS
Taxation is one of the main reasons why companies do switch over to an LLC. They offer a great deal more flexibility than a sole proprietorship does. You can still maintain a pass-through status in which you can file business taxes on personal returns. But, you can also have your business taxed like a corporation would be. That is to say, the taxes are thus separated from those of the owners. Regardless of which you choose, you need to register with the IRS. You will also have to apply for a new Employer Identification Number (EIN/).
5. Set Up Your Bank Account
As again, the intent here is to separate your finances from those of the business, you now need to establish a bank account specifically set up in the name of the new LLC. The last thing you want to do with your LLC is to blur the line between personal and business finances. This could get you into trouble down the road. Plus, you want to ensure those liability protections are in place. If you currently have an account for the company, close this and open a new one using the EIN issued to the LLC.
6. Get Compliant
Becoming an LLC while not difficult does come with a new set of rules by which you have to adhere. This could entail certain licensing requirements and even ways in which you must operate. The best thing to do is to check with state and local offices regarding expectations and rules for LLCs. Not complying can lead to penalties and fines, and you certainly don't want that.
7. Tie Up Loose Ends
If there are any loose ends yet to be dealt with from the sole proprietorship, it's important that you get on that. You don't want any problems transitioning into the LLC. You might start by canceling any DBAs you have. Close bank accounts and just, generally speaking, ensure that everything is now contained within the umbrella of the LLC. Again, it's about ensuring that those relevant LLC protections remain valid.
Following these steps hopefully makes the process a bit easier for you as you move from sole proprietor to LLC. Keep in mind the following:
- Be sure to keep everything business related to include credit cards for example separate from your finances.
- Stay abreast of all relevant government rules and regulations about your LLC. If there are changes, be aware of them.
- Update your marketing materials—your new brand is that of the LLC, everything needs to reflect this change.
If you are in the process of expanding, now might be the perfect time to switch to an LLC. Just be sure to have everything organized and keep these steps in mind.