Transitioning a sole proprietorship to LLC is a good decision for many businesses. By making this conversion, you will be legally separating yourself from your businesses, giving you access to personal liability protections.

Overview of Converting a Sole Proprietorship

Deciding to incorporate is one of the biggest decisions that a small-business owner must face. Before making this choice, it's important to understand why a sole proprietor might convert their business to an LLC or corporation, as well as the pros and cons of each business structure. Most businesses start out as sole proprietorships. Usually, this is because the business launches with no firm plan in place.

In some circumstances, small business owners choose sole proprietorships because they're intimidated by the incorporation process. In other cases, the owner might feel there are not enough risks involved with their business to warrant the protections provided by incorporation. However, it's easy to get into a situation where you are held liable. For example, imagine you are a software developer that releases a piece of your software as shareware.

If a flaw in your software allows users data to be corrupted by a virus, it's possible you are held liable for this lost or damaged data. Similarly, if you sell homemade food products at a farmers market, you are held liable if a customer inflicted with food poisoning blames your product. Before you start your business, it's important that you make sure you're protected from personal liability.

What Are Sole Proprietorships?

Sole proprietorships are businesses that have one owner. These companies do not pay corporate taxes. Instead, business income tax appears on the individual return of the owner. While operating a sole proprietorship does increase your personal liability, there are multiple advantages to this business structure:

  • Having to handle less paperwork.
  • Tax returns for these businesses are very simple.
  • Your company is not subject to as many regulations as other entities.

However, if your business loses a lawsuit, you alone will have to suffer the consequences.

What Are Corporations?

A corporation is a type of business entity that is legally distinct from its owners. Forming a corporation will separate your personal assets and your business assets. A corporation can have a single owner or it can have multiple owners. If you're thinking about transitioning your small business to a corporation, you should think about choosing an S corporation, which provides impressive tax benefits.

S corporations are usually not taxed at the corporate level, and are instead, taxed on dividends. Choosing to form a C corporation means you will have to pay corporate taxes, but you will also gain the ability to appoint a board of directors and issue company stock.

LLC Basics

Limited liability companies are very different from other business entities. LLCs provide similarly limited liability protections to those enjoyed by corporations. Members of an LLC also have the option of receiving their share of company profits without having to pay corporate taxes in some states. With an LLC, you will also have multiple options for how you can distribute profits.

Incorporation Advantages

The primary advantage of incorporating your sole proprietorship is being able to shield your personal assets from debts and lawsuits related to your business. If your company is ever sued or needs to declare bankruptcy, you won't need to worry about your personal property being seized. Both corporations and LLCs provide these liability protections. This means that incorporating or forming an LLC is a good choice if there is a high level of risk associated with your businesses.

However, as you might expect, there are certain situations where you are held liable regardless of these protections. To make sure you are fully secure, you may want to invest in business liability insurance.

Forming a corporation can also help you save an impressive amount of money on your taxes. This is particularly advantageous if your business is very profitable.

When to Convert Your Sole Proprietorship

It's common for business owners to want to know what the best time is to transition their sole proprietorship to an LLC. Essentially, if you have personal assets that you fear are at risk from your business, you should convert your sole proprietorship as soon as you can. If you're nearing the year's end, however, you may want to delay your transition to January. Holding off until the beginning of the new year will prevent you from having to file two tax returns.

If you need help your sole proprietorship to LLC transition, you can post your legal needs on UpCounsel's marketplace. UpCounsel accepts only the top 5 percent of lawyers to its site. Lawyers on UpCounsel come from law schools such as Harvard Law and Yale Law and average 14 years of legal experience, including work with or on behalf of companies like Google, Menlo Ventures, and Airbnb.