There are numerous classifications for business types, and while companies often consider all of their options when first starting their business, business needs can adapt and grow over time. As a result, what once served your needs when you were a single person starting in your garage may no longer be the best solution for you as you employ hundreds of people and operate in dozens of countries.
Determining which business type is best for your company requires an intimate understanding of the differences between each and assessing which solution would be the most beneficial.
Continue reading to learn the fundamental differences between a sole proprietorship and a limited liability company (LLC), what an LLC's primary benefits are, why changing to one may be a wise decision for your business, and how you can change your sole proprietorship to an LLC.
The primary differences between a sole proprietorship and LLC
Sole proprietorships and LLCs are two of the most common business types. Understanding the fundamental differences between the two is essential to determining which solution is right for your business.
What is a sole proprietorship?
A sole proprietorship is a type of unincorporated business with a single owner. Many small businesses begin as sole proprietorships because of the ease of establishment.
Businesses that are commonly sole proprietorships include:
- Freelancers like writers, designers, and consultants
- Retail stores owned by a single individual
- Artists who independently sell their wares
When an individual begins a business or sells their services, they are immediately registered as a sole proprietor. Additionally, because this type of business is typical for self-employed individuals, the business's and individual's finances are interconnected. This is essential for sole proprietors to keep in mind, as it means they will be held personally accountable for any debts their business accrues.
What is a limited liability company (LLC)?
On the other hand, an LLC is an established business entity separate from an individual proprietor. LLCs are established under state law and are appealing to many business owners because of the amount of flexibility that they provide. However, the requirements for establishing an LLC vary by state, and business owners will need to familiarize themselves with their state's requirements to establish an LLC where they live.
A single individual can start an LLC, called a single-member LLC, or multiple individuals can, at which point it is called a multi-member LLC. Members of LLCs own specific percentages of the company and typically share profits based on the percentages they own.
Remember that some businesses, like insurance agencies, cannot legally be considered an LLC, so you'll want to ensure your business is eligible for this status before transferring your sole proprietorship.
What are the key differences?
Sole proprietorships have significant differences for business owners, and understanding these differences will help you determine whether you want to change your business structure.
- Liability: The primary difference between a sole proprietorship and an LLC is the amount of personal liability the business owner faces. With a sole proprietorship, the business owner is financially liable for the business's debts. In contrast, an LLC provides the business owner with limited liability that protects their finances if something happens with the company.
- Ease of startup: A sole proprietorship is significantly more straightforward to establish than an LLC, and individuals can immediately start operating their business as a sole proprietorship as soon as they receive business permits. Meanwhile, an LLC requires significantly more organization and must be registered by the state in which it operates and the IRS.
- Taxation: Single-member LLCs and sole proprietorships are taxed similarly unless otherwise requested. However, LLCs can choose how they are taxed, and multi-member LLCs can choose to be taxed as either a C corporation, an S corporation, or a partnership.
- Ownership: A sole proprietorship is always owned by a single individual who assumes total liability for the company. On the other hand, an LLC is owned by one or more individuals who own certain portions of the company and are not personally liable.
Understanding these differences can help determine whether switching from a sole proprietorship to an LLC will benefit your business.
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Why change a sole proprietorship to an LLC?
Consider the following reasons why you may choose to convert a sole proprietorship to an LLC:
- Reduce personal liability
- Reap tax benefits
- Enter a co-ownership arrangement
- Increase credibility
- Scale your business
Major benefits of changing to an LLC
Changing your benefits from a sole proprietorship to an LLC can significantly benefit your business.
- There are significant tax benefits: Taxation is one of the primary benefits of an LLC. Because business owners can file their taxes as a partnership, S corporation, or C corporation, you could afford your significant tax savings each year, specific to your business needs, by switching to an LLC.
- Improve your business's credibility: Because sole proprietorships are considered a less formal business type, many investors and potential business partners may be unwilling to get involved with your business at this stage. Furthermore, remember that a sole proprietorship is, by definition, a single owner, which means you cannot enter a co-owning arrangement. Forming an LLC offers your company credibility, which may make your business more appealing to investors.
- Financing: LLCs have an easier time with funding than sole proprietorships because they can offer a stake in the company in exchange for investment money. This can be essential to business growth, particularly in the early stages of your company.
- Reduced liability: By changing your business to an LLC, you remove all personal risks associated with business ownership.
- Profit sharing flexibility: Because you can dictate your business details in an LLC operating agreement, you can distribute the business's profits amongst owners however it is laid out in this agreement.
How to change a sole proprietorship to LLC?
If you've decided to change your sole proprietorship to an LLC, consider partnering with a professional to ensure that all documents are filed correctly and that you meet all requirements to transfer your business type successfully. You will need to know how to change from a sole proprietor to an LLC with the IRS and your state.
Follow these steps if you're converting a sole proprietorship to an LLC:
Select a business name
Whether you want to rename your business or keep the same name as your sole proprietorship, you will need to ensure your desired business name is available in your state. Because LLCs are state-registered businesses, your business name must be state-approved.
It will also need to have the words "limited liability company" or "LLC" in the business title (typically at the end).
File the articles of incorporation (also called the articles of organization)
The articles of incorporation are documents that need to be filed with the state and should include the following information:
- Your business name
- Your business purpose
- The LLC's address where relevant documentation will be sent
- The management and membership organization
- Appropriate signatures
Create an LLC operating agreement
LLC operating agreements are documents that designate how many individuals own the LLC and their percentage of ownership. The LLC operating agreement is legally binding and organizes how the LLC will be managed and which individuals have control over what elements of the company.
Get a new employer identification number (EIN)
When registering your LLC, you will need a new employer identification number (EIN), as your business will operate differently than it did as a sole proprietorship. This is an essential step of registering your LLC, as this is the EIN you will use to operate under the IRS, including:
Obtain all necessary permits and licenses
Again, because you are changing the structure of your business, you will be required to re-apply for all relevant business permits and licenses as your limited liability company.
Although these steps seem relatively straightforward, ensuring that each portion of this process is done correctly and compliantly can be tricky and time-consuming. To be sure that you do not retain any personal liability, inadvertently commit tax fraud, or operate your business non-compliantly, you may want to consider hiring a professional with the relevant experience to help you through this process.
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