When you’re first starting out with your business—whether you’re going it alone in the form of freelance work or as a side project you devote hours to outside of your regular 9-to-5—changing the organizational structure of your business may not be at the top of your to-do list. A sole proprietorship can be a perfect fit in terms of business registration and tax considerations when your business is in these early stages. But what about when your burgeoning business starts picking up steam, expanding its customer base and even adding employees? Then you’re going to want to seriously consider leveling up from a sole prop to another business structure, and a common transition for businesses operating in the US is from sole proprietorship to LLC, or limited liability corporation.
What’s the Difference Between a Sole Proprietorship and an LLC?
Before deciding to transition between doing business as a sole proprietorship to forming an LLC, it’s important to get a handle on the differences between these two structures. The main difference between the two essentially comes down to how much legal separation there is between the personal (you as the business owner and any business partner(s) you may have) and the business itself. Why should you be concerned with separating business from personal, you may ask? It's a question of legal liability—whether or not you’re putting yourself or your business partner(s) in a position of being legally responsible for debts and liabilities incurred by, or legal action brought against, the business.
When you’re the owner of a sole proprietorship, you’re not legally required to keep your business and personal finances separate (although this is a good general rule to follow, not only for tax purposes but also for building business credit). This is not the case with a limited liability company, where personal assets and the company’s assets cannot be mixed. (The mixing of these two types of assets is known as “piercing the corporate veil”.) Legally speaking, this firm separation of business and personal assets means that you as the business owner are protected by limited liability. When you’re operating as a sole prop, you are completely liable and your personal assets can be seized to settle debts in the event of something like a bankruptcy.
First Steps Toward Forming an LLC
Once you’ve decided to make the plunge and transition your business to an LLC, there are certain legal and tax-related boxes that you’ll need to check off. Right off the bat, you will want to seek out some legal guidance to help you through the many parts of this process. (Take note that, as always, this post is not to be construed as legal or financial advice!) Hiring a legal professional, perhaps one with specialized knowledge, will allow you to navigate the whole process a lot more smoothly.
A lawyer can also function as your registered agent, meaning they are the main point of contact between the LLC and legal authorities. (Or you can be your own registered agent, if you wish.) Filing your company's articles of organization (an official document that includes information like your business name and address and a list of members) and registering with the IRS for tax purposes are other areas where a legal advisor can help.
The checklist of items you need to take care of to complete your transition to an LLC is a pretty long one, so make sure you give each one the attention it deserves. Once your initial paperwork is filed, you'll want to make sure all relevant business licenses are in place. (Refer to the Small Business Association Licences and Permits Tool to get started.)
Getting the right business insurance policies in place for your business structure is another important area to consider, whether you're updating your current coverage or applying for the first time. (If your company is becoming an LLC, business insurance should definitely be on the table, even if you hadn't been too concerned with it as a sole prop.) Opening up a new bank account in the name of your LLC (or updating the information on file for your current business bank account) is another next step. To avoid any missed payments, make sure you advise your clients of your new business name, and update the banking information for any automatic withdrawals.
Armed with this checklist, you're in a good position to start moving forward with your transition to an LLC. Curious about the different organizational structures your business can take on beyond the sole prop and LLC? Check out our post on organizing your business in the US.