Many small businesses get their start as a sole proprietorship. After all, it’s the default business structure. If you’re a single business owner and never filed any official formation paperwork with the state, then you’re operating as a sole proprietorship.
There comes a time when a sole proprietor wants to formalize the business. Perhaps you realized that your side hobby is now a legitimate and blossoming business. Perhaps you realized that operating as a sole proprietorship puts your personal savings and assets at risk should your business incur any debt or be sued. Or maybe you want to take on a new client who requires you to operate as an LLC or corporation.
No matter the reason, the bottom line is it’s affordable and relatively simple to create a Limited Liability Company (LLC). And, there won’t be many changes in the way you operate your business. On the plus side, the LLC puts separation between your business and your personal assets and you’ll have more flexibility in how your business is taxed. You may even change your perception of your business and feel more motivation to see it grow.
If you’re interested in forming an LLC, here’s the general process. Note that specifics will vary by state, but these six steps will give you a general idea of what to expect.
Moving From Sole Proprietor to LLC
1. Research to Make Sure Your Business Name is Available in Your State
Let’s say that Jane wants to form an LLC for her business, Jane’s Candies. She needs to make sure that there already isn’t another business called “Jane’s Candies” registered in her state. To check the availability of a name, you can contact your state’s secretary of state office (some states offer an online searchable database). Another option is to have an online legal filing service do the search for you – and many sites will offer this basic search for free.
2. File Articles of Incorporation with Your State Government Office
The next step is to file specific paperwork, often known as Articles of Organization, with your state office. The document is straightforward and you’ll be required to provide information like:
- The name and address of your LLC
- Your LLC’s purpose. You typically won’t need to be specific here, and can even give a general answer like “The purpose of the Limited Liability Company is to engage in any lawful activity for which a Limited Liability Company may be organized in this state.”
- The name and address of your registered agent (this is the person designated to receive official papers for the LLC).
- An indication of your management: will your LLC be member-managed or manager-managed?
3. Create an LLC Operating Agreement
While the LLC is a great choice for those business owners looking for increased personal protection with less formality, there still is some paperwork involved. Some states require LLCs to create an operating agreement. This document is an official contract that spells out the management and ownership of the LLC. It can outline details like how much of the company each member owns, everyone’s voting rights; how profits and losses should be distributed among the members; and what happens when someone wants to leave the business.
The operating agreement can just be a few pages, and you can find some samples on the Web. Even if your state does not require an operating agreement, it can be an important document to help clarify verbal agreements and prevent misunderstandings.
4. Register with the IRS
When you form an LLC, you’ll need to apply for a new EIN (Employer Identification Number) with the IRS. This is most likely true even if you already had an EIN as a sole proprietorship. You can apply for an EIN here. The EIN is used for opening business bank accounts, filing taxes, handling payroll, and obtaining business credit.
5. Apply for a New Bank Account
If you had a business bank account for your sole proprietorship, you’ll need to close that account and open a new one in the LLC’s name (and with your new EIN number). Now that you’re an LLC, you’ll need to maintain a sharp separation between your business and personal finances. This will help shield your personal assets from the business – and has the added benefit of streamlining your business’ records for tax reporting.
6. Apply for Business Licenses and Permits
Don’t forget about any of the licenses and permits that are required to legally run your business – such as a professional license, reseller’s permit, or health department permit. Some states require that you reapply for a license when your business structure changes. You can contact your local office or a site like BusinessLicenses.com to find out about your specific licensing requirements.
That’s it. With those six basic steps, you’ve now formalized your business activities into a formal business structure.
If you’re wondering what comes next…you can opt to be taxed as an individual and still fill out the Schedule C and Schedule SE like you did as a sole proprietor. Or check with your CPA/tax advisor to see if there’s a better tax strategy, since you now have more options as an LLC than you did as a sole prop.
Lastly, you’ll need to maintain your LLC, or you could end up losing your personal liability protection. Check to see what your state’s maintenance requirements are, as you’ll typically be required to file an Annual Report (it’s a very simple form) and pay a nominal fee.
Best of luck on your business venture, and congratulations on taking this important step toward creating a solid foundation for your new business.
LLC Computer Photo via Shutterstock