Why small businesses may want to change to an LLC structure from sole proprietorship. Here are some basic steps for forming one.
There are 28 million small businesses in the United States, according to the the Small Business Administration.
More than 70 percent of these businesses are sole proprietors, basically an unincorporated business run by an individual and without employees.
Sole proprietorship makes sense for anyone starting a business. It’s simple and involves little hassle to set up. Plus, it makes tax filing easier. But there are reasons why a sole proprietorship might consider changing to a Limited Liability Company (LLC) structure.
The problem with a sole proprietorship is there is no distinction between the individual and the business. For freelancers who work for hire, that’s not much of an issue.
But if you sell a product or service, you’ll want to consider separating and protecting your personal assets from your business assets. If a sole proprietorship is successfully sued, the individual’s house, bank accounts, car, boat, or any other assets may be attached.
If an LLC is successfully sued, only business assets are at risk. The business owner’s personal property is off limits.
You might think you as a sole proprietor are just too small to worry about any of that. Think again. As LegalZoom’s Ann McDonald points out, “Imagine you write software and distribute it as shareware, you might think that is as low risk as it gets, right?
However, imagine that you inadvertently distribute a virus that destroys data on people's hard drives. Now you may be liable for their lost data. Selling homemade jam at a farmer's market? Seems harmless enough until someone gets food poisoning and blames your preserves.”
An LLC retains the simplicity of the sole proprietorship, while minimizing personal legal exposure without the recordkeeping complexities, expenses, and tax issues of a corporate structure.
Also, if you are taking on partners with an ownership interest, an LLC may be the best option.
Here’s how you set up an LLC.
Name Your Business
You might think you can just use your name for your business, i.e., “Jane’s Business Services.” But if there are other Janes using the same name in your state, you can’t.
Your business name must be unique in the state your company is based. You can Google any potential names, but check with the Secretary of State office for your state (here’s a list).
Some states have a searchable database; alternatively, some online legal filing services may provide a free basic search for you. According to the SBA, in addition to your business name being different from any existing LLC in your state, it must also:
- Indicate “LLC,” i.e., Jane’s Business Services, LLC
- Not include certain words that may be restricted by state regulations, e.g., bank or insurance.
- Not violate any trademarks (conduct a search using the Trademark Electronic Search System)
Related Article: What Is the Best City to Launch a Startup?
Some non-legal considerations include:
- Does the name reflect what your business does?
- If you’re not a graphic designer, get one to develop a suitable logo. This is your “face” to your customers and you don’t want anything that looks less than professional.
- Keep it relatively simple and avoid anything with long sets of initials or numbers, or anything that could make it hard to remember.
File Articles of Organization
This is just a short form to file the name of your company, its members (owners) and contact information.
You may also be asked to provide other details such as the purpose of the business. Rules vary by state, as well as the filing fee, which can be anywhere from $30 to $200.
Write an Operating Agreement
While not legally required in many states, it’s a good to write an LLC operating agreement that details management and ownership responsibilities of the company.
As The Wall Street Journal points out, “Having such an agreement can help protect the LLC structure if it’s challenged in court and prevents you from having to default to state operating rules."
It also eliminates the potential of misunderstanding and disputes when agreements aren’t written out.
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Register With IRS
You need a new EIN (Employee Identification Number); you can’t use an EIN of the old sole proprietorship. You can apply here.
Get a New Business Bank Account
One of the main reasons to set up an LLC is to separate personal and company assets. Which is why you need to open up a bank account in the name of the business LLC.
If you used the same name for your old sole proprietorship you need to close that account to avoid any confusion between the two.
Obtain Any Necessary Licenses and Permits
These vary by state and locality. Refer to the Small Business Administration for specific federal and state licenses and permits.
Maintain Your LLC
Your state may require you to maintain your LLC status on a periodic, usually yearly, basis. If you don’t, as Small Business Trends notes, “You could end up losing your personal liability protection. [I]t’s a very simple form [requiring only] a nominal fee.”