Create an LLC

3 advantages of converting your sole proprietorship to an LLC

For small business owners, a limited liability company (LLC) may offer more advantages than a sole proprietorship. Learn 3 quick benefits of converting your sole proprietorship to an LLC.

Jump to:
section

Table of Contents

Sole proprietorship is the most common form of business in the U.S., accounting for 73.1% of all businesses1. In fact, most companies usually start out as sole proprietorships before incorporating into a different structure, such as a limited liability company (LLC). But is converting sole proprietorship to LLC a good idea? And at what point in time should you consider this switch up?

First off, what is a limited liability company? As the name suggests, an LLC is a type of business that grants its owner(s) limited liability against company debts and liabilities. In other words, creditors cannot seize your personal assets in an attempt to recover business liabilities. It’s different from a sole proprietorship because the latter is an unincorporated form of business. As such, the business and its owner are one, which means creditors can legally use a sole proprietor’s personal property and assets to settle business debts.

While each state has its own set of requirements for forming a limited liability company, your business can generally take the structure of an S-corp or C-corp, depending on how you want to be taxed.

3 advantages of converting your sole proprietorship to an LLC

The three main advantages of LLC over sole proprietorship are limited liability, tax flexibility and access to more funding options. Below is a look at each of these benefits.

Limited liability

A limited liability company is a legal entity on its own, separate from the owner. As such, the company is held accountable for its contracts, agreements and debts. As the owner, you cannot be personally liable for these contracts and debts solely by virtue of owning the company.

This liability protection is usually important when you have employees. Without it, their actions may expose your personal assets and property. Besides, the protection that comes with an LLC can prove instrumental if you own a high-risk business. Even if it defaults on debts, your personal possessions will remain safe.

Tax flexibility

Converting sole proprietorship to LLC allows you to choose whether you want your company to be taxed as a single-member LLC, partnership, S-corporation, or C-corporation. Many people often go with S-corp because it offers numerous tax benefits.

With a sole proprietorship, you have to pay the 15.3% social security tax that’s usually charged on net income. That’s not the case with an S-corp. Instead, you only have to pay self-employment tax on the wages you pay yourself. Thus, you can opt to pay yourself a smaller salary and put the rest towards a Simple IRA and Roth IRA – both of which are tax-deferred – to maximize your retirement funds.

Funding options

If you run your business as a sole proprietorship, you are likely to find it difficult accessing loans from banks and other financial institutions. This is usually down to credibility concerns. And even if you get approved for credit, it will typically come with higher interest rates and unfriendly lending terms owing to the risky nature of sole proprietorships. Similarly, investors very rarely put their funds into these types of businesses because of their risk factor and they have no personal asset protection2.

The only option left is equity financing, which is not entirely a good route to take because you will have to give up some ownership interest and restructure the business entirely. It cannot be a sole proprietorship once you admit a new owner.

A practical way to overcome these challenges is incorporating your business into an LLC. In addition to being more credible, limited liability companies are safer to lenders, which often incentivizes them to offer credit. Plus, LLC stocks are generally more versatile. So, you can give an equity investor a small percentage of shares in exchange for financing.

Disadvantages of an LLC

Despite the stated advantages of LLC over sole proprietorship, this form of business is not completely free of drawbacks. Here are some disadvantages of an LLC:

  • Cost: in addition to state formation fees, limited liability companies are also subject to ongoing fees like franchise taxes and annual report fees.
  • Continuity concerns: In the case of a single-member LLC, your company will have to be dissolved if you pass away.

If I have a sole proprietorship, when should I form an LLC?

Ideally, converting sole proprietorship to LLC should happen as soon as possible in order to protect your personal assets. It also makes sense to convert your business structure to accommodate a new partner. Obviously, you can’t operate a sole proprietorship when there are two or more owners. A limited liability partnership (LLP) is an option, but even that doesn’t offer the same liability protection as an LLC because you’ll only be protected against your partner’s liabilities, not business liabilities.

Besides liability protection, you can look at switching up to a limited liability company if you often struggle to get funding as a sole proprietor, and also if you want more options when filing and paying taxes.

That said, if it’s already close to the end of the year, consider waiting until the start of the following year before converting sole proprietorship to LLC. There’s a simple reason behind that. If, in any particular year, your business operated as both a sole proprietorship and LLC, you will have to file two different tax returns – one for each structure that you operated under during the year.

References

  1. Kyle Pomerleau. “An Overview of Pass-through Businesses in the United States.” Tax Foundation, 21 Jan 2015, https://taxfoundation.org/overview-pass-through-businesses-united-states/
  2. Christopher Carter. “Sole Proprietorship Problems.” Houston Chronicle, 23 May 2022, https://smallbusiness.chron.com/sole-proprietorship-problems-4441.html

5 Steps To Form Your LLC

1
Choose an available business name
2
Designate a registered agent
3
File all your state-required paperwork (Articles of Organization, operating agreement, etc.)
4
Get a federal tax ID (EIN) number
5
Make sure to pay all mandatory annual fees and state fees
Or, skip the above steps and let Nearside do it for you!
Form Your LLC Today
Free report and guide
How COVID-19 Impacted Incomes of the Self-Employed Workforce
How did the pandemic impact the income of  gig workers and entrepreneurs? Download to learn more.
Get The Report

More From

Frequently asked questions

No items found.

References