Have you been operating as a sole proprietor for a while but are itching to take things to the next level? It may make sense to convert your business to a limited liability company (LLC).
The process is relatively simple, but you need to do a little legwork, complete the required paperwork and cover the costs to set up an LLC.
In this article, we’ll look at signs it may be time to switch and what you need to do to make it official.
Signs you're ready to convert your sole proprietorship to an LLC
Not all businesses need to change their operating structure. But remaining a sole proprietor isn't suitable for everyone and every business situation.
Here are three signs converting to an LLC may be a good option.
1. You're ready to hire employees
If you've reached a point where you can no longer manage your workload independently and are ready to hire employees, it may be time to switch.
While you can still hire employees as a sole proprietor, having employees opens the door to new business liabilities. For example, they could get hurt or injured on the job or make professional mistakes on behalf of your company.
When you set up a business as a sole proprietor, there's no separation between your personal and business finances. That means your personal assets could be at risk if someone sues you for negligence in your business.
When you form an LLC, your business becomes a legally distinct entity; you are not the same as your business. Forming an LLC isn't a magic bullet, but it does help protect your business and personal assets.
2. You want more protection
Sole proprietorships are the simplest and least expensive business structure to set up. They’re good for low-risk, lower-profit businesses. But they also provide the least amount of financial protection.
As you grow and your risk increases, you’ll have more to lose if something goes wrong. Because a sole proprietorship doesn’t separate your personal and business finances, your assets — such as your savings, home, car and privacy — become exposed to creditors or lawsuits.
Forming an LLC allows business owners to grow their business and take on more risk.
3. You want to seek funding to grow
There’s no separate business entity when you’re a sole proprietor — and that’s risky for lenders. You’re more likely to qualify for a loan from a bank or credit union if your business is an LLC.
But if you’re seeking funding from venture capitalists or angel investors, converting to an LLC likely won’t help. Setting up your business as a corporation would be a better bet.
6 steps to switch from a sole proprietorship to an LLC
The process of converting a sole proprietorship to an LLC varies by state. But in general, this is what you can expect.
1. Cancel your DBA if you have one
When operating as a sole proprietor, you can submit a "doing business as" (DBA) statement, also known as a fictitious business name statement, to run your company under a name that's different from your legal name.
If you filed a DBA when you started as a sole proprietor, you need to cancel it.
2. Choose a business name
You'll need a new name for your business, which must be one no other LLC in your state has.
Depending on where you live, you may be able to check business name availability through the secretary of state's office. If not, check with the business bureau or agency responsible for registering businesses in your state.
It’s also a good idea to conduct a trademark and copyright search to make sure you’re not infringing on anyone else’s rights.
3. Complete the paperwork
Once you've decided on a name for your new business entity, it's time to complete and file the necessary paperwork. Here's what you'll need.
Articles of organization
Articles of organization are the main document you’ll need to make your LLC official. Don’t confuse them with an article of incorporation document, which is for forming a corporation.
The articles of organization is a document that includes:
- The business’s name and address
- The business owner's name and address
- A description of the business
- The application date
- The name of the business’s resident agent
The resident agent is responsible for receiving official correspondence related to the LLC.
The business’s owner is the registered agent of single-member LLCs. If your LLC has more than one member, you'll need to decide who will act as the registered agent.
After completing the articles of organization, you must file them and pay the appropriate filing fee, which varies by state.
Create an LLC operating agreement
An operating agreement includes information about:
- The ownership status and voting rights of each LLC member
- The financial contributions made by each member of the company
- How you will share profits and losses
- How the company can add and remove members
- When and how the LLC may be dissolved
You can probably skip this step if you’re a single-member LLC. But if your company has more than one member, it may be worth creating an operating agreement to make sure everyone's on the same page. Some states require it, so it’s best to check with a lawyer.
Apply for an EIN
An EIN, or employer identification number, is a tax ID number for your business. You can get one for free from the IRS. The IRS requires LLCs with employees and those that must file certain excise tax forms to obtain an EIN.
Some single-member LLCs aren't required to get one. However, having an EIN makes it easier to separate your personal and business finances.
If you already have an EIN for your sole proprietorship, check with a tax or legal professional to find out if you must apply for a new one. In general, you need a new EIN when changing your business structure, but there may be exceptions.
4. Set up a business bank account
One of the benefits of setting up an LLC is the financial protection it affords your business. To reap the full benefit of this protection, you must keep your personal and business finances separate.
That’s why it’s important to set up a bank account and credit card that you only use for your business. If you already had separate accounts for your business, update the name on them to reflect the LLC.
5. Update your insurance coverage
If you're converting your business from a sole proprietorship to an LLC, chances are you've experienced some significant changes. As a result, you may need to add or remove coverages, increase or decrease policy limits or change your deductibles.
Regardless of whether you change to business insurance for LLCs, you need to put the policies in your LLC's name to ensure you're covered if you need to file a claim.
6. Update your licenses and client contracts
When you started your business, you may have needed licenses and permits to operate legally.
If you have licenses or permits for your business that are in your name and not your LLC's name, you may need to update them or apply for new ones.
Contact the appropriate authorities in your state, city or town for additional information.
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