Most freelancers start their work as sole proprietors, but at some point, they might want to learn how to change sole proprietorship to LLC. Their client pool is growing, the business is more widespread - so, a change is due at this point.
But can you change from a sole proprietorship into LLC? How difficult would it be to do that? Are there any steps that you'll have to take with the IRS? Read on, and you'll find the answers to your questions.
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Can a Sole Proprietor Be Under an LLC?
This depends on a variety of factors, such as the nature of your business as well as the state that you are active in. For instance, certain states will not allow certain types of licensed practitioners (i.e., lawyers) to set up an LLC. They'll need to set it up as a different type of business altogether.
Other states may allow sole proprietors to become LLCs even with these conditions - but there might be certain limitations. For instance, their personal property may not be protected from malpractice claims or bankruptcy, and they may experience personal losses from it.
So, it is important to check with the laws of your state. In most cases, there should be no reason why a sole proprietor can't change the nature of their business. Basically, they will be formalizing their business, filing paperwork just like they would be starting their LLC from scratch.
Why Should I Change from Sole Proprietorship to LLC?
One of the main benefits of opening an LLC versus staying a sole proprietor is that it gives you limited liability protection. When you are a sole proprietor, all your personal assets are tied to your business. Therefore, if your business goes bankrupt or you face a lawsuit, they have every right to seize your personal assets (i.e., your car, your house) to pay your debt.
This is not the case with an LLC. With the offered limited liability protection, your personal assets are not subjected to being seized. Your business and personal assets are held separately. So, in case something goes wrong with your business, at least your personal property will be safe. A sole proprietor isn't required to have a business bank account.
With LLCs, there is also a much lower chance for your business and personal finances to get mixed up. You'll have a new bank account, so when tax time comes, you will know exactly which expenses are connected to your business. It will also be helpful in terms of limited liability.
Last but not least, when you change your sole proprietorship to an LLC, you will be gaining more credibility. LLCs are ranked higher on the business scale, so the chances are that your potential clients will have a better impression of you.
How Hard Is It to Change from Sole Proprietorship to an LLC?
Generally speaking, changing from a sole proprietorship to an LLC is nothing different from starting the LLC from scratch. You will have to file the same paperwork as someone who is having their first attempt at running the business.
The only difference is that, depending on the state that you are in, you may have to close your old sole proprietorships and the associated business bank accounts. If you don't, there will be confusion, as you will be personally liable for two businesses - one of which is no longer in use. This action may take some extra time from your hands.
When Should I Turn My Sole Proprietorship Into an LLC?
Usually, when the time comes to change from your sole proprietorship to a single-member LLC, you will see a couple of signs. Here are the moments that tell you it's time to make the switch from a sole proprietorship to an LLC:
You Want Personal Liability Protection
As the sole owner, you are personally liable for everything that goes wrong with your business. If you love a lawsuit, the court can seize your personal assets such as your bank account, your home, your car, and everything you own.
However, by setting up a new LLC in place of your sole proprietorship, you receive personal liability protection. In these circumstances, they will only be able to access your LLC bank account.
Your Tax Burden Is Getting Too High
For a sole proprietorship, the self-employment tax and other income taxes might become slightly vexing. However, if you open an LLC, some of those tax burdens may be lowered.
You Are Planning to Get Business Funding
Sole proprietorships typically have issues when it comes to business funding. This is because most creditors are reticent to lend to this type of business owner.
However, as the owner of an LLC, you will seem more professional - ergo, you will be more likely to get that credit or loan that you needed.
You Want More Credibility
Customers are always looking for professionalism, so they are more likely to hire someone who has a formal business entity. Starting a separate legal entity under the LLC label might bring more clients.
Changing from sole proprietorship takes a few steps that you have to be careful about (even deciding on incorporating or LLC). Here are some tips and considerations that you should keep in mind:
Professional Assistance Is Helpful
Setting up an LLC can have quite a few hoops and complications, and getting lost in the paperwork is a great possibility. This is why you might want to first look into some legal professionals to help you through the process.
Cancel the Sole Proprietorship
This may depend on the state that you are in, but in most circumstances, you need to cancel your registered sole proprietorship if you want to open an LLC. This is usually the case when you want to operate under the same business name. Check with your state regulations and see exactly where you fit in.
Choose the Name
As a sole proprietor, you would have your own name as the name of the business. However, with an LLC, you need a business name that ends with Limited Liability Company (or LLC). You may choose your own name to begin with, or you may decide on a different company name.
Choose a Registered Agent
Each LLC will need a registered agent that will act as the main point of communication between your business and the authorities.
You can choose to be your own registered agent, or you may have someone else do the job for you. In most cases, it's your attorney - and if you don't have one already, you can always hire someone from a law firm.
File Your Certificate of Incorporation
When setting up an LLC, there are certain pieces of paperwork that you will have to file. For starters, you have your Certificate of Incorporation or Formation, which you will need to file with your Secretary of State. You will need to pay a filing fee for this as well.
Draft Your Operating Agreement
When you are setting up your LLC, you also have to draft an LLC operating agreement. This will outline just how well you plan on running your LLC. It is a long-term technical business plan for your LLC.
Register Your LLC with the IRS
As a business owner, the IRS sees your work like any sort of corporation. You get profit from your business, and hence, you need to pay taxes. Applying for an EIN (Employer Identification Number) is one important step in registering with the IRS.
Pay Your Tax Obligations
After registering and filing all of your legal documents, you need to pay all of your tax obligations. Several tax types are concerned here, such as your annual minimum tax, your filing procedures and your additional taxes. Different states will have different tax obligations, so make sure that you are aware of what yours are.
These licenses may differ based on the state or city. Depending on the type of business that you are running, you may need to get a zoning permit as well.
Contact Your Insurance Company
When changing from a sole proprietorship to a limited liability company, you need to contact your insurance company. Depending on the changes that you are making, you may have to buy a different business insurance company. Even if you don't need to change your policy, they'll still need to put your new information down.
Update Bank Information
Most sole proprietors will just use their personal bank accounts to make and receive payments, not bothering to set up a separate bank account. However, when you open an limited liability company, you will need a new LLC business bank account and business credit card - these must be intended solely for your LLC. If you also used a separate business account for your old business, make sure that you close the old one (after your last payments go through).
The Bottom Line
Changing from a sole proprietorship to LLC is relatively easy, as long as you follow the steps. You might want to hire an attorney for some of the technicalities, but for the most part, it should be just like starting a new business from scratch.