To convert a sole proprietorship to a limited liability company (LLC), you’ll file the same paperwork as you would if you had created the LLC from scratch. You’ll also update sole proprietorship registrations (including business permits, licenses, and trade name registrations), bank accounts, and contracts to reflect the change. Becoming an LLC offers you a number of benefits, including protecting your personal assets from the debts of the business and adding credibility to your business by communicating to vendors and customers that you own a formally registered company. However, an LLC is not an option for every company, and converting to that structure might mean you will pay more taxes and fees than had you stayed a sole proprietorship.
As soon as you begin doing business by yourself (and in some states, with your spouse), you have a sole proprietorship. In the eyes of the law, the sole proprietorship and the owner are one and the same. When the business owes a debt, so does the owner. If someone brings a lawsuit against a sole proprietorship, it is the same as suing the owner. The owner’s personal assets like his car and bank account, are on the line to satisfy the debts of the business.
An LLC is its own business entity, separate from the owner. The LLC does not exist until the owner forms it with the state. The LLC owns property and enters into contracts. This business structure provides limited liability protection for the owner, which means that owners are not personally responsible for the debts of the business. Creditors sue the LLC, not the owner, and the amount they can collect is limited to the assets of the LLC.
When you own a sole proprietorship, you do not file a separate business tax return, nor do you pay corporate tax. You report the business income and losses on your personal tax return. An LLC has more options when it comes to taxes. By default, after you form an LLC you will continue to pay taxes as a sole proprietor, and you can continue to avoid corporate tax. However, you can file paperwork with the IRS to elect C Corporation or an S Corporation tax status.
Converting to an LLC takes time and might cost you more money than continuing your business as a sole proprietorship. You will not owe additional federal taxes unless you elect C Corporation tax status. However, your state might have filing fees, annual fees, and other state business taxes you did not pay as a sole proprietorship.
Not every type of business can form an LLC. In some states, licensed professionals such as attorneys and accountants cannot form LLCs (instead, they’re typically organized as professional companies). In states where professionals can form LLCs, the LLC might not protect their personal assets from malpractice claims. For more information, see Forming a Professional LLC.
To change your business from a sole proprietorship to an LLC, you must create an LLC according to the laws of your state, and update your sole proprietorship registrations and accounts. The steps include:
After you change your business to an LLC, treat it as a separate business entity, and not a sole proprietorship. If you blur the lines, you could lose your limited liability protection. Proper maintenance of your LLC means following corporate formalities (such as filing annual reports and creating and following an operating agreement), and keeping your personal assets separate from the company’s assets. To keep your personal assets separate, transfer ownership of all business property to the LLC, list the LLC as the party on all new contracts, and open a separate bank account for the LLC.