Small businesses have fluid needs, and yours is no different. As a sole proprietor considering expansion, you could examine making a few changes, including how your business is structured. If you read our guide on finding the best type of entity to run your small business, you’re aware of the potential tax and legal advantages limited liability companies provide.
But change can be intimidating, especially when it means overhauling your whole business structure. Luckily, we have put together a list of the 7 steps to changing your sole proprietorship to an LLC.
Why You Should Consider Running a Limited Liability Company
Before we jump into these steps, let’s briefly consider why you should consider a change to your business entity type. Other than the tax flexibility it provides—which we will get into later—there are internal and external factors that could make creating an LLC appealing to you (or even necessary).
As an owner, you may become weary of the risk you’re taking as a sole proprietor; your personal assets and finances are at an increased threat because they’re not distinguishable from your business. If your business is sued, for instance, the plaintiff could be entitled to your money. In an LLC, however, the company is treated as a separate entity from you and will keep you personally shielded from liability.
Business growth is also a common reason owners make the switch. As your business expands, you take on more clients. And depending on your industry, some may require your company to have certain liability protections before they work with you. Adding more to your plate could also make it time to add additional owners or, in an LLC’s case, members, to the team to help run your company.
If you currently have any of these challenges with your business, it’s time to make the switch.
We will guide you through the 7 steps to show you how easy and beneficial it is to change your sole proprietorship to an LLC.
1. Name Your LLC
You may be thinking “I already have a name for my business, why do I need another one?” However, it’s a common misconception that you can “convert” your sole proprietorship to an LLC. What you’re actually doing is creating a new company. A sole proprietorship runs as a single entity with you, the business owner. An LLC, however, is legally a separate type of business entity and therefore must be made from scratch.
Don’t worry, this doesn’t mean everything you accomplished as a sole proprietor is thrown away. All you’re doing is finding a name that is available in your state and filing it with the appropriate office. This will be the name you use to set up and conduct your business from here on out.
2. File Your LLC With the State
Unlike sole proprietorships, LLCs require different forms to be supplied to the appropriate federal agency. First, you need to submit what is usually referred to as the “Articles of Incorporation” with the state you’re doing business in. Guidelines vary by state, but there are generally a few things they will need:
- Basic company info (name, address, etc.)
- The name and address of the registered agent of your company, who will receive and handle all documents related to the State
- The general purpose of your LLC
- The management structure of your company
3. Create an LLC Operating Agreement
The next step to changing your sole proprietorship to an LLC is to create and file an Operating Agreement. LLCs must have this document in place to outline different parts of the business and how it will be run. The contents of an Operating Agreement change depending on your industry and ownership, but there are generally 6 key factors to include:
How the business was created and how ownership stakes and power are structured between all members of the company.
How the business is managed. How organizational changes are made and, if applicable, which members hold the power to do so.
- Capital/ Funding
An outline of how money was raised to fund the business and how that may translate to power within the company. Some companies also draw up how they will raise funding through investments and loans and how that can change the company structure.
- Asset Distribution
This section provides a structure of how members will divide and share financial and physical assets.
Contingencies put in place to follow when adding or subtracting a member from the LLC. This can be important to consider if you plan to bring on multiple members as your business grows.
Finally, you want to determine the circumstances that would necessitate it and what will happen in case the company dissolves. The allocation of assets and settlement of any outstanding debts can be included in this section.
Although some states do not require an Operating Agreement, it’s important to have one in place to make sure your company has a set structure in which it will run.
4. Register Your LLC With the IRS
One of the main reasons you may decide to change your sole proprietorship to an LLC is the flexibility they provide for taxation. LLCs can be “pass-through” business entities like sole proprietorships and partnerships that allow you to file business taxes on your personal return. You can also, however, elect to tax your company like a corporation, having the business’s taxes done separately from you and other members. Doing taxes this way can have advantages for you, including certain write-offs, deductions and lowered tax rates for eligible businesses.
Either way, you will need to register your new LLC with the IRS. Since the business will now be considered a separate entity from yourself, you will have to apply for a new Employer Identification Number (EIN). Doing so will create the new entity for the IRS to acknowledge, and you can then select which tax classification is right for you.
5. Set Up Your LLC’s Bank Account
Running a limited liability company means you need to separate yourself as an owner from the entity that is your business. You need to keep your personal finances clear from those your business generates. This is important for compliance purposes, as muddying the financial waters between you and your small business can void the liability protections that made you change to an LLC in the first place.
If you had a business account for your sole proprietorship, you will need to close that out and apply for a bank account for the new company using your new EIN. Doing so will help protect your personal finances and assets in case the business incurs debt or is sued. Banks can have different fees for business accounts, so make sure to shop around to find something suitable for you.
6. Make Your LLC Compliant
Depending on your state, changing your sole proprietorship to an LLC can bring a whole new set of rules and regulations you must adhere to. These range from licensing policies to the way your company is run. Failure to comply could leave you and your business open to penalties handed down by state or federal agencies.
This can mean a lot of bureaucratic red-tape for you to jump through. There may be new requirements for licensing and permits your business needs. Some states even require companies to reapply when changing what type of business entity they’re run as, so check in with your county or state office to find out if there are any additional boxes you need to check off to stay up to date.
Look into any other regulations your state may have for LLCs. They can provide rules for your company’s record keeping, meeting requirements and other operational and reporting procedures. The last thing you want is to divert your attention from growing your small business to handle a menial compliance error.
7. Tie Up Loose Ends With Your Sole Proprietorship
Once your new LLC is approved, it’s time to wrap up all business with the sole proprietorship. If you do not, you may run into problems if any work you’re doing with the LLC gets tangled up with what remains of the old business.
If applicable, cancel your old DBA with the same government office you had originally filed it with. Close all old bank accounts, convert any files or invoices and make sure everything you do from here on out is under the umbrella of your brand new LLC. Failure to do so could diminish all liability protections you sought from your new business structure and get you into legal trouble with local government.
Things to Remember When Creating an LLC
Outside of these steps, make sure you understand what it means to run an LLC. We have touched on a couple of these above, but there are a few key bullet points to keep in mind when making the change:
- Maintain the “corporate veil.” You MUST keep all company property, finances, accounts, credit cards, loans and other business separate from your own.
- Although LLCs offer certain liability protections for owners, you’re still responsible for your own actions. If you run the business improperly (dodging taxes, defaulting on loans, etc.), you can and will be held personally accountable.
- Continue to keep up with changing rules and regulations that your business needs to follow within your state.
- Update all of your branding. Your website, marketing, advertising, business checks and business cards should all be updated to fit the new marketing strategy.
There you have it. You know the process, and you know what to look for. Now it’s time to put these 7 steps into motion and take the next action in growing your small business.