Make It Official: How and When to Convert Your Sole Proprietorship to an LLC

Let’s set the stage: You’ve been self-employed for a while, and you’re a pro at doing your small business taxes by now. You hustled and worked hard last year — business has been booming. As you fill out your tax return for the year, you start to realize that Schedule C is looking a bit more crowded than you’re used to. Is it time for a change?

Eventually, self-employed taxpayers might find themselves outgrowing their roles as small-scale sole proprietors and decide they’re ready to graduate to something a little more official, like a limited liability company (LLC). But how do you know you’re ready to make the switch?

Here are some signs you might be ready to create an LLC and what steps you should take once you’ve decided to make the leap.

When to switch from sole proprietor to LLC

When thinking about turning your business into an LLC, ask yourself one simple question: Are things getting serious?

And by “serious,” we mean:

• Is your business growing?
• Are you earning, or do you plan to earn more profits?
• Are you considering hiring some employees to help you?
• Are you thinking about adding more owners?

If you answered “yes” to any of the above, it might be time to commit to something a little more official.

Benefits of creating an LLC

If you think tacking “LLC” to the end of your business name sounds scarily official, don’t panic. It’s not nearly as complicated as it sounds, and the benefits of an LLC are invaluable for your personal protection and peace of mind.

Here’s what you get when you upgrade your sole proprietorship to an LLC:

• Liability protection: Business growth, financially or physically, inevitably comes with more liability. By converting to an LLC, you are protecting your personal assets like your car, house, and savings from any potential claims against your business.
• Simple tax process: As a sole proprietor, you’ve become accustomed to reporting your business income and expenses on your individual tax return with Schedule C. That doesn’t have to change when you convert to a single-member LLC. Using the same form, you can continue to report your business assets on your personal return. Easy peasy!
• No double taxation: While you can elect to have your LLC taxed as a corporation, many small business owners instead opt to remain classified as a sole proprietorship or partnership for tax purposes. This way, your business remains a pass-through entity, and you avoid the double taxation corporations must deal with. Since you’re still being taxed as a pass-through entity, you might be able to deduct losses against other income as well.
• Credibility: Having the letters “LLC” attached to your business title makes you sound more official to potential customers. Your business will be seen as more reliable, trustworthy, and less of a risk by becoming a formal LLC.

How to convert your sole proprietorship into an LLC

So, you’re convinced that making the switch to an LLC is right for you. But where do you start? Here are the basic steps you’ll need to follow.

Step 1: Give your business a name.

Creating a formal business structure often means you need to change your business name. Usually, you need to incorporate some version of “LLC” in your business title, but each state has its own rules when it comes to naming your small business. Some states even allow you to pay a fee to “reserve” your business name for a set amount of days in advance.

Your business is your baby and giving it a name can be more challenging than it sounds. If you’re having a hard time thinking of something, try out this business name generator for some fun ideas.

Step 2: Nominate a registered agent.

When you form an LLC in your state, you will often be required to choose a registered agent. Your registered agent is a person or business entity who will act as the middleman between your business and the state, handling all your official correspondence, tax notices, and legal documents. You can be your own registered agent if you choose, or you can use a professional registered agent service.

Step 3: File your LLC Articles of Organization.

Now it’s time to file your Articles of Organization (sometimes called Certificate of Formation or Certificate of Organization). This formation document establishes your LLC as an official business in your state.

Your state may have a standard form for you to use, which you can file online or by mail. The form is typically simple to fill out — specifics vary by state, but you’ll generally need to include your company’s name, address, the name of your registered agent, and your signature.

Note that you state will charge you a filing fee to register your LLC. Again, the amount varies by state and ranges from $40-$500.

Step 4: Create an LLC Operating Agreement.

You’re almost there! Next, you’ll want to create an operating agreement. Most states don’t officially require you to have one of these, but it’s a good idea to create one anyway, especially if you are adding any owners.

As a single-member LLC, your operating agreement will help set your business apart as a separate legal entity from your personal assets. In the case of multi-member LLCs, the operating agreement will also detail the rights and roles of each owner. This document will help you deal with any potential conflicts or ownership transfers down the road.

Step 5: Get an EIN for your business.

If you are planning on hiring employees or opening a business bank account, you will need to obtain an Employer Identification Number (EIN). Think of an EIN as a Social Security number for your business — it’s a number the IRS uses to identify your business entity. Since LLCs operate as corporations or partnerships, the IRS requires the LLC to have an employer identification number. You can apply for an EIN online via the IRS website here.

It’s time to limit your liability

When things start getting serious as a sole proprietor, it could be time to make your business official. Creating an LLC is a logical next step for sole proprietors who want to create a formal business structure separate from their personal assets while avoiding the complexities and the “it’s complicated” hurdles that often come with corporations.

This article is for informational purposes only and not legal or financial advice.