Written by: Carolyn Young
Carolyn Young has over 25 years of experience in business in various roles, including bank management, marketing management, and business education.
Reviewed by: Sarah Ruddle
For over 15 years, Sarah Ruddle has been a noteworthy leader in the business and nonprofit world.
Updated on July 18, 2024
If you’re in business as a sole proprietorship, you may consider changing to a limited liability company (LLC) because of the many benefits, such as personal liability protection.
An LLC is a separate entity from its owners; therefore, the members are not personally liable for the business’s financial obligations. This makes a huge difference, and this guide will help you get there.
Let’s discuss the specific benefits of an LLC.
LLCs are easier and less expensive to form than a corporation. Unlike corporations, LLCs are not required to have a board of directors or hold annual meetings. LLCs do, in most states, have to file annual reports. Corporations are more complicated.
In an LLC, the members do not have to answer to anyone. They ultimately control the company and can structure the management in any way they choose. In a corporation, on the other hand, managers answer to the board of directors, which has overriding decision-making power.
In LLCs and corporations, owners are considered separate entities from the business, so both structures offer personal liability protection. However, in a few instances, owners do have personal liability. For example, if an owner personally guarantees a bank loan, which is common, they’re liable for that debt.
In a sole proprietorship, on the other hand, the business owner and the business are considered the same, so the owner is personally responsible for all obligations of the business.
As mentioned above, LLCs are pass-through entities, which means income passes through to the member or members. If the LLC has only one member, it’s taxed as a sole proprietorship. If the LLC has more than one member, it’s taxed as a partnership.
However, LLCs are unique because they can elect to be taxed as a corporation if the members decide it makes financial sense. This is done by filing an election form with the IRS. In addition, you can choose to be taxed as a C-Corp or an S-Corp.
For corporations, the business income is taxed at the current rate for corporations (21% as of late 2022), which is lower than the usual individual taxpayer rate. But remember that corporation shareholders must also pay taxes on their distributions.
However, members are subject to self-employment tax in an LLC taxed by default as a sole proprietorship or partnership. Once such LLC switches to being taxed as a corporation, self-employment taxes no longer apply.
Similarly, self-employment taxes do not apply to members with S-Corp status, which is the main advantage of electing S-Corp status.
With S-Corp status, members are generally paid as company employees, which means more accounting and payroll expenses. Therefore, S-Corp status is only beneficial when the self-employment tax savings exceed those additional expenses.
No matter the entity type, most businesses split profits based on owners’ capital contributions. Corporations pay dividends based on the ownership percentage of the shareholders.
With an LLC, on the other hand, owners can specify in the operating agreement any profit-sharing plan they choose. As a result, one member can take a share of profits greater than their ownership interest, while other owners take less. This may be based on the fact that one member is more involved in day-to-day operations.
If you have a sole proprietorship, your name is the legal business name legally. However, an LLC allows you to choose your business name, lending greater legitimacy.
You simply need to form an LLC to change from a sole proprietorship to an LLC. Here are the steps to do so.
Since, with a sole proprietorship, your business name is your name, you’ll need to choose a name for your LLC.
Your business name is your business identity and the first impression people will have of your company, so take care with this step of the LLC formation process.
Even so, naming your business can be challenging. You need a name that’s unique and easy to remember and conveys what your business does. You also need it to be SEO-friendly so that it can easily be found on Google. To choose a name, you can try a few different methods:
Once you have a few business name ideas, you’ll want to ensure they’re available. First, do a business name search on your state’s relevant website, usually the Secretary of State’s website. You’ll also need to check your state’s LLC naming regulations to ensure you comply.
Next, you’ll need to make sure the name is not trademarked. Then, check with the US Patent and Trademark Office to ensure the name is available nationally.
You should also check to see if the domain name is available, which you can do on a site like GoDaddy. For example, you’ll want a .com domain name rather than .org or .co to give your business domain more credibility.
Once available, you can reserve the name with your state using its name reservation form.
Most states require that you appoint a registered agent for your LLC. A registered agent is a person or company authorized to accept and respond to official correspondence on behalf of your business, such as legal, tax, or financial documents.
A registered agent ensures your business stays in compliance with state laws. In addition, the registered agent’s job is to ensure no important notices or documents are missed.
In most states, a member of the LLC can be the registered agent, or you can choose an individual that meets your state requirements. Generally, the requirements are that the registered agent:
Some states have more specific requirements, so check the rules in your state.
Many business owners hire a registered agent service to ensure all important documents are received and addressed promptly. A registered agent service also offers convenience.
If you choose to be your registered agent, you’ll have to be available at your registered agent’s address during regular business hours. However, a registered agent service will allow you the flexibility to run and grow your business wherever you need to be.
Members or managers can manage LLCs. In a member-managed LLC, members handle all management duties. In a manager-managed LLC, non-member employees oversee operations and management duties.
Note that with a manager-managed LLC, a member can be a manager, but only in cooperation with another manager who is not a member.
Member-managed LLCs generally work best for LLCs with few members, all of whom can take an active role in day-to-day operations. Conversely, manager-managed LLCs are best for LLCs with multiple members, some of whom want to be “silent” or passive members and not involved in day-to-day operations.
Most LLCs are member-managed, as they are small businesses that cannot afford a management team.
Some states require that when you register your LLC with the state, you declare whether your LLC will be member- or manager-managed, so be aware that you may need to make this decision before you file.
In most states, the document you need to file to make your LLC official is the articles of organization. In some states, it’s called a certificate of organization or formation.
Generally, you can file the document online, usually on the Secretary of State’s website. The document requires your business name, address, registered agent information, and sometimes member or manager information.
Fees vary by state and range from $40 to $500. Depending on the state, your LLC should be approved within a few weeks of filing. Some entrepreneurs use an LLC formation service like ZenBusiness to handle this step. It saves time and ensures the process is done correctly.
As mentioned above, LLCs are pass-through entities, which means income passes through to the member or members. If the LLC has only one member, it’s taxed as a sole proprietorship. If the LLC has more than one member, it’s taxed as a partnership.
However, LLCs are unique because they can elect to be taxed as a corporation if the members decide it makes financial sense. This is done by filing an election form with the IRS. In addition, you can choose to be taxed as a C-Corp or an S-Corp.
C-Corp status means income is taxed at the current rate for corporations (21% as of late 2022), which is lower than the usual individual taxpayer rate. However, consider C-Corp shareholders – who, in the case of an LLC, are members – must also pay taxes on their distribution—called double taxation.
However, members are subject to self-employment tax in an LLC taxed by default as a sole proprietorship or partnership. Once such LLC switches to being taxed as a corporation, self-employment taxes no longer apply.
Similarly, self-employment taxes do not apply to members with S-Corp status, which is the main advantage of electing S-Corp status.
With S-Corp status, members are generally paid as company employees, which means more accounting and payroll expenses. Therefore, S-Corp status is only beneficial when the self-employment tax savings exceed those additional expenses.
Most states do not require an operating agreement, but it’s a very important document. It defines the ownership percentages of members and how profits and losses are distributed. Those are the most important elements of the operating agreement, but it should also include the following:
You can find operating agreement templates here, but it’s best to have them drawn up or reviewed by an attorney. The language of an operating agreement is crucial and can often help determine how member disputes will be resolved.
The IRS uses an EIN to identify your company, just as a Social Security number does for individuals. It’s used for tax filing purposes. An EIN is required if your LLC has more than one member or if you are hiring employees. Obtaining an EIN simply requires applying on the IRS website.
The IRS rules for obtaining an EIN are as follows:
All EIN applications (mail, fax, electronic) must disclose the name and Taxpayer Identification Number (SSN, ITIN, or EIN) of the true principal officer, general partner, grantor, owner, or trustor. This individual or entity, which the IRS will call the ‘responsible party,’ controls, manages, or directs the applicant entity and the disposition of its funds and assets. Unless the applicant is a government entity, the responsible party must be an individual (i.e., a natural person), not an entity.
When you have an LLC, it’s important to keep your business and personal finances separate for accounting and tax purposes. Co-mingling your business and personal funds can threaten your liability protection since the line between business and personal assets will not be clear.
Most banks offer business bank accounts, so check with your local bank. You’ll need your EIN and a copy of your articles of organization. Your bank may require other documents as well.
Most states require that you file an annual or biennial report with the state to verify you’re still doing business. These can generally be filed online. A small fee usually applies and varies by state.
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