As you continue to grow, it’s important to remember to keep your personal and business finances separate. This is one of the main advantages of having an LLC over a sole proprietorship.
As a business owner, choosing the right entity can be confusing. While you may start as a sole proprietor, you may find that switching to an LLC structure would be beneficial as you scale. Having the right business structure in place can help you establish credibility in the market and realize advantages you may not have initially considered. The more you grow, the structure of your business may change.
What’s the difference between a sole proprietorship and an LLC?
A sole proprietorship is the simplest business structure and not really a legal entity because you don’t need to register your business name to operate. The owner is directly tied to the company and is personally liable for all business debt. You’ll usually see freelancers, startups, and creatives in this category. Sole proprietors can also have private workspaces or brick-and-mortar establishments. The owner of the company is solely responsible for all wages and taxes of anyone they hire. There are a few advantages to using this business structure:
- Easy to form
This is the most inexpensive business structure you can form when starting a business. All you need is your EIN, any licenses, and permits. If this is something you’re just starting or a side job you’re trying to build, this is a good route to take.
- Name protection
In most cases, your personal name is also the name of your business. If you choose to have a different name, you need a DBA (Doing Business As) within your state.
You’re the boss and don’t have to answer to any partners or shareholders when it comes to making decisions on behalf of the company. By being a sole proprietor, you have flexibility in how you move.
While it’s easy to form a sole proprietorship, you won’t have liability protection, it’s harder to obtain business credit or financing, and you may have difficulty tracking your expenses.
An LLC (limited liability company) helps protect the personal assets of the owner from business debt or claims against the company. That means if the business is in debt with a creditor, they cannot go after the members of the LLC’s personal possessions, home, or car. The IRS classifies it as a pass-through entity because the income of the business passes through to the LLC members. Profits and losses are reported on their personal tax returns. Advantages of an LLC include:
- Easy to form
This is easy and inexpensive to form with your state. LLCs don’t have to have a board of directors, hold meetings for shareholders, or keep minutes of their meetings. That means less paperwork and more flexibility.
The LLC is a pass-through entity, which means it doesn’t have to pay income tax at the corporate level. This helps avoid double taxation. LLCs can also be an S Corp or a C Corp, which may be more beneficial.
LLCs are seen as being more credible than sole proprietorships because it shows you are willing to make the investment of legally registering the business and want to be taken seriously.
A few disadvantages of an LLC are that it costs more when forming the business and there are costs involved in maintaining legal standing like state fees and taxes. Additionally, you may have issues if you want to transfer ownership, and members must immediately recognize profits.
Switching from sole proprietorship to an LLC
If you’re considering switching your sole proprietorship to an LLC, there are three distinct advantages:
- Limited liability
There’s no getting around it – an LLC is a legal entity that stands on its own and is separate from the owner. That provides protection against any debt collectors. If you have employees, this protection is needed because you could personally become liable for something they did under a sole proprietorship.
- Flexibility in taxes
Once you convert from a sole proprietorship to an LLC, you can decide how you want to be taxed. There are multiple options, including a single-member LLC, partnership, C-corp, or S-corp.
It can be hard to obtain funding as a sole proprietor, especially when working with a bank or financial entity. As an LLC, banks see you as more credible and not so much of a risk as when the company is a sole proprietor. Investors also see LLCs as beneficial because they can negotiate shares for financing.
Steps for moving from a sole proprietorship to an LLC
If you’re ready to make the move, this can be complex depending on how things are set up. In most cases, there is a lot of paperwork and knowledge involved, so it is vitally important to use a business attorney or, if budget doesn’t allow, an online LLC service when making the switch. Some business owners are astute in these matters. If you feel confident in doing the process on your own, here are the steps for getting it done:
- Business name availability
First, you must check to see if the name is available. Do a search in your state’s database. If you feel as if this is something you want to trademark, it’s always best to do a trademark search as well. The worst thing you can do is start using someone else’s name on a national level and find out you can’t use it because it’s trademarked. Another reason why you need your own name is that you don’t want to confuse your customers. Staying away from the likelihood of confusion is key.
- Articles of organization
When forming an LLC, you must complete the Articles of Organization. This document has all the basics about your company. Each state has its own requirements, but they all include your business name, what the business does, your mailing address, the name and address of your registered agent, and information on your company’s owners, officers, and managers.
- Operating Agreement
While an operating agreement may or may not be required in your state, it is always good to have one in place. This legal document outlines the ownership of the company and all the duties of the members and managers. This comes in handy for major financial and working decisions. Additionally, if there are ever any discrepancies in business operations, everyone can defer to the operating agreement.
The EIN (employer identification number) is like the social security number of your company. It’s nine-digits and is used to open bank accounts, establish business credit, and pay taxes. This is the legal identifier of your business with the IRS. If you plan on having employees, you will pay their taxes through your EIN.
- Bank account
Once you have established the LLC and obtained the EIN, you should immediately open a bank account. This helps establish credibility and should be used for all incoming and outgoing financial transactions. You may already have a bank account from your sole proprietorship. Depending on your bank, you may have to open a different account, or they can change your information. If your bank requires you to open a new account, it’s important to close the old account and transfer all paperwork into the new business name.
- Licenses or permits
Depending on where your business is located, you may need licenses or permits for operation. It’s always a good idea to check with your local municipality to ensure you have the right permits and business licenses to legally operate within their boundaries. Each municipality is different, so what may be required in one may not be required in another. The best solution is to check and make sure before making any moves. Depending on the type of business you operate, you may also need a license from the state to do business. Knowing the regulations can keep you in compliance and out of potential trouble. If you already have licenses under the sole proprietorship, you should try and get them changed to your new entity or apply for new ones. You don’t want any more associations with your old business structure once you move to the new one.
As you continue to grow, it’s important to remember to keep your personal and business finances separate. This is one of the main advantages of having an LLC over a sole proprietorship. Consulting with a business advisor, attorney, or accountant can help put you on the right track to making sound business decisions.