If you’re like most entrepreneurs in America, you likely started your business as a sole proprietorship. It’s the fastest, easiest and most popular way to start your own business, but it also carries more risk. 

Converting your sole prop business to a Limited Liability Company (LLC) or other business entity can provide valuable tax benefits and help you protect your personal finances. 

Here’s how to convert from a sole proprietorship to an LLC. 

Is It Time To Change Your Business Structure To An LLC?

Ideally you’ll want to form a business entity when you create your new business. But in reality, small business owners may not want to invest the cost of setting up a separate legal entity when they are cash strapped or unsure whether their business will take off. 

Signs it may be time to start an LLC include:

• You take on additional risk, for example, by taking on larger jobs, driving a company vehicle, or entering customer homes. 
• You cannot get business insurance for your sole proprietorship.
• You want to hire employees, and minimize risks when you do. 
• You need financing; there are more financing options for corporations and LLCs.
• Your business is making money and you want to explore strategies to reduce taxes. 
• You want to take on investors or business partners. 

Just don’t wait too long to make the switch. If your business is sued before you form your LLC, it will be too late to then form an LLC to protect your assets. 

Reasons To Convert A Sole Proprietorship To An LLC 

There are numerous advantages to an LLC or other business entity over a sole proprietorship. Among them: 

Asset Protection

One of the main reasons for forming a legal entity is to protect your personal assets from the activities of your business. If you properly form and maintain your LLC, you can effectively separate your business and personal finances, and avoid personal liability for all or most business debts. 

Create More Tax Flexibility

A sole proprietorship is a pass-through entity. For income tax purposes, income and expenses from the business are reported on Schedule C which is attached to the taxpayer’s personal tax return. 

An LLC has more flexibility when it comes to taxes. By default, income and expenses from a single-member LLC will pass through to the LLC owner’s tax return (like a sole prop), but the LLC can elect to be taxed as a corporation. A domestic LLC with at least two members is classified as a partnership, unless it elects to be taxed as a corporation. 

Some LLC owners find that choosing to be classified as an S corporation can save money on self-employment taxes. Talk with a tax advisor quickly when you form your LLC to determine the best way to approach business taxes for your LLC.  

Hire New Employees

Both sole proprietors and LLCs can hire an unlimited number of employees. If you plan to hire employees, make sure you obtain an Employer Identification Number (EIN), which you can get for free from the IRS if you haven’t already. 

The advantage of hiring employees as an LLC is limited liability. If your sole proprietorship hires an employee who gets injured at work, your personal assets could be at risk if that employee sues you. With a properly maintained LLC, that liability is limited. 

Better Business Financing Options

If your business will get small business loans at some point— whether that’s a line of credit or a working capital loan— you’ll have more options if your business is an LLC or corporation. That’s because some small business lenders do not lend to sole proprietorships. 

While most small businesses credit cards are available to both sole proprietors and LLCs, there are a few issuers that will not allow sole proprietors to qualify. 

Sole Proprietorship Vs LLC: Pros And Cons

Of course there are pros and cons of converting your sole proprietorship to an LLC. 

How To Change Sole Proprietorship To LLC

When it’s time to change from a sole proprietorship, you’re going to take the same steps as any business starting an LLC. You don’t really “convert” it; instead you form an LLC and wind down the sole proprietorship. 

Ensure Your Business Name Is Available

You may decide to create continuity by using a business name similar to your LLC. However, your LLC name won’t be exactly the same, because the business name for the LLC must indicate it is an LLC by using L.L.C., LLC, Ltd. Liability Company or a similar variation in the name. 

(State laws vary, so be sure to check the requirements before you choose your LLC name. If you are using a business formation service, it can help you understand the requirements.)

Tip: You may want to file a fictitious business name (also known as “doing business as”, DBA or trade name) for the prior business name if you plan to continue to use it. There will be an additional fee for this service. 

You must choose a business name that is not being used by another business in your state. You also want to check registered trademarks to make sure your business name doesn’t infringe on the trademark of another business.

Your Secretary of State or Department of Corporations (or similar agency) will likely offer an online search tool so you can check other registered business names in your state. In addition, you can search USPTO.gov for federal trademarks. 

File Articles Of Organization

You’ll file the Articles of Organization with the state in which you form your LLC and pay a filing fee to the state. If you form your LLC in a state different from the one you operate in, you may need to also file as a foreign corporation in your state and pay that fee as well. (If you form an LLC in New York there is also a publication requirement.)  

You’ll need to name a registered agent to accept official documents (including legal notices) on behalf of the LLC. While you can serve as your own registered agent you must have a physical address in your state and be available to receive legal notices during normal business hours. 

Create an Operating Agreement

You’ll also need to adopt an LLC Operating Agreement. It spells out the rights and duties, as well as liabilities and obligations of the members (of the LLC). While you won’t file it with the state, you could lose the protection of the LLC if you fail to adopt an Operating Agreement. 

Get a New EIN 

A new LLC must get an Employer Identification Number (EIN) which serves as the taxpayer identification number for the LLC, much like your Social Security number does for your personal taxes. You can get a free EIN from the IRS. Unfortunately if you had an EIN for your sole prop you cannot use it for your LLC. 

Get Business Licenses

Whether your business is a sole proprietorship or LLC, you may need state and/or local business licenses, as well as occupational licenses or professional licenses. When you convert your sole proprietorship to an LLC, check with the licensing authority to learn how to switch your registration to your new entity. (You may need to cancel the old one and register again as the LLC.) 

Apply For A Business Bank Account

While it’s helpful for a sole proprietorship to have a business bank account, for an LLC a separate business checking account is a must. Commingling business and personal accounts may jeopardize the liability protection of an LLC. 

Build Credit For Your LLC

Building business credit can also be helpful for your LLC when it comes to getting small business financing. You can build business credit through vendor accounts, business credit cards and other types of business loans that report to commercial credit agencies. Learn how to build business credit here.

The Bottom Line: Sole Prop to LLC

Converting your sole proprietorship to an LLC can be a key step in your small business journey. Don’t wait to consider it, as taking the time to set up the right business structure can pay off significantly in the long run.