To convert a sole proprietorship to a limited liability company (LLC), you'll file the same paperwork as you would if you'd created the LLC from scratch. You'll also update the following registrations, filings, and accounts to reflect the change:
- business licenses
- business permits
- trade name registrations
- bank accounts, and
- business contracts.
Running an LLC versus a sole proprietorship has its advantages and disadvantages. You should consider these pros and cons when determining whether an LLC is the right choice for your business.
Advantages of an LLC vs. a Sole Proprietorship
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.
Liability for Business Debts for Sole Proprietorships and LLCs
An LLC, and not a sole proprietorship, offers business owners limited liability protection, meaning the owners aren't personally responsible for paying the business's debts and obligations.
A sole proprietor is liable for business debts. 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's the same as suing the owner. The owner's personal assets like their car and bank account, are on the line to satisfy the debts of the business.
LLCs have limited liability protection for owners. An LLC is its own business entity, separate from the owner. The LLC doesn't 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 the owner's personal assets can't be taken to satisfy the LLC's debts. Creditors sue the LLC, not the owner, and the amount they can collect is limited to the assets of the LLC.
(For more guidance, read our article on when you're personally liable for your business's debts.)
Taxation of Sole Proprietorships and LLCs
When you own a sole proprietorship, you don't 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, like a sole proprietorship, is also taxed as a pass-through entity.
However, an LLC has more options when it comes to taxes. By default, after you form an LLC you'll 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 S Corporation tax status. You don't have the ability to elect other tax statuses with a sole proprietorship.
Disadvantages and Limitations of an LLC vs. a Sole Proprietorship
However, an LLC isn't an option for every company, and converting to that structure might mean you'll pay more taxes and fees than if you had stayed a sole proprietorship.
LLCs generally cost more than sole proprietorships. Converting to an LLC takes time and might cost you more money than continuing your business as a sole proprietorship. You'll owe the same federal taxes as a sole proprietorship unless you elect to be taxed as a corporation. However, your state might have filing fees, annual fees, and other state business taxes you didn't pay as a sole proprietorship.
Not every type of business can form an LLC. In some states, licensed professionals such as attorneys and accountants can't form LLCs. Instead, these professionals form professional companies. In states where professionals can form LLCs, the LLC might not protect their personal assets from malpractice claims.
Steps to Convert Your Business to an 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:
- Dissolve or cancel any trade names for your sole proprietorship. If you use a name for your business that's not your legal name, you probably had to register that trade name—also called a "fictitious business name" or "doing business as" (DBA)—with your state or local government. If you intend to continue to use the same trade name, then you should cancel your DBA. You'll claim your trade name as your business name when you file your articles of organization. If you want to register a different name for your LLC and keep your DBA (giving you two business names), then you'll need to update your DBA registration.
- Choose a business name. If you didn't already choose a business name as a sole proprietor, you'll need to choose a business name now. Make sure your LLC's name complies with your state's laws, which might mean changing or updating your current name. The name must be different from any business name already registered, which you can verify by using your state's business search tool. Many states require LLCs to include "limited liability company," "LLC," or another abbreviation in the name.
- Select a registered agent. A registered agent is a person or company who's assigned to receive your LLC's official documents and governmental notices on behalf of the company. You can list your name or use a registered agent service.
- File articles of organization with your state. To register your LLC, you'll need to file articles of organization—also known as a "certificate of organization" or "certificate of formation." You'll typically file this document with your secretary of state or a similar filing agency. Most states allow you to file this form online. You'll need to also pay the required filing fee.
- Draft an operating agreement. You should create an operating agreement for your LLC as soon as possible. An operating agreement is an internal document that outlines how you'll manage your LLC. Drafting an agreement about how you'll run your LLC when you're the only owner and manager might seem unnecessary. But having this organizational document will help establish that your LLC is a separate entity, which can help you maintain your limited liability status.
- Apply for an employer identification number (EIN). If your sole proprietorship used an EIN, you'll need a new number after forming an LLC. You can apply for one for free on the IRS website.
- Open or update your bank account. If you didn't have a bank account for your business previously, you should get one now. You can open a business checking account using your new EIN. If you already have an account, you should update or change your bank account information.
- Contact licensing and permitting agencies. Many states and municipalities require any business to obtain a general business license. Otherwise, you might be required to apply for licenses or permits depending on where you're located and what business activities you're engaged in. You should update your business information and verify that your registrations and licenses apply to your LLC. You might be required to file official paperwork to transfer some licenses and permits. You also could be required to re-apply under your new LLC.
- Update business information on all marketing materials. Your name probably already appears on your social media and on marketing for your business, such as on your website, business cards, and letterhead. You should add or update your business name so that your new LLC name appears on all existing and future communications and materials.
- Review your current contracts. You probably have contracts in place with vendors and customers. Check your contracts to see what the procedure is for changing your business name. You might just need to inform the other party of your business conversion and they'll update their records. Alternatively, you could have to formally assign the contract from you as a sole proprietor to your LLC.
Maintaining Your Limited Liability Protections
After you change your business to an LLC, treat it as a separate business entity, and not a sole proprietorship. If you blur the line between you and your company, you could lose your limited liability protection. Make sure you follow corporate formalities and keep your personal assets separate from your company's assets.
To treat your LLC as a separate entity, you should:
- draft an operating agreement
- file annual reports
- open a separate bank account for your business
- transfer ownership of all business property to the LLC, and
- list the LLC as the party on all new contracts.
The more steps you take to separate your business from yourself, the less likely it is you'll lose your limited liability protection. Limited liability is one of the greatest advantages LLCs offer. It's crucial that you maintain this advantage to protect your personal assets from being seized to pay your business's debts.