Understanding Sole Proprietorship Conversion: A Comprehensive Guide

When founding a business, how you structure your company can have a serious impact on your future performance, as each type of business entity has its own distinct advantages and disadvantages. Not only the entity type but who, if anyone, is your initial employees and contractors. Many of these formation docs and variables are created in the short term without the long-term vision of the potential growth of the business. Sometimes the circumstances surrounding a business change and it becomes necessary to transition from one format to another or for the cap table to undergo a material change. For instance, while many companies are well-served by functioning as a sole proprietorship, there comes a time when it makes more sense to convert into an LLC. It is important to recognize the benefits and limitations of operating as a sole proprietor, in either form or function, as this makes it easier to know when it is appropriate to make the transition to what the 2.0 version of your business looks like.

What is a Sole Proprietorship??

The entity form of a sole proprietorship is a private, unincorporated business owned by a single person. Since it is unincorporated, the owner of the business and the business entity are considered one and the same, with no legal distinction made between the two. This differs from how an LLC operates, where the owners of a business and the business itself are technically separate. Notably, a sole proprietorship is the simplest business structure, as there is very little administration and relatively few costs involved at launch. You don’t need to register a separate legal entity before launching either, making it quicker to get started. It also grants business owners complete control over their company, as they do not have to compete with other owners. Many small businesses get their start as a sole proprietorship, as their scope is often limited enough that a single person can reasonably manage the business on their own.?

However, there are also several disadvantages with the sole proprietorship structure, which often become more exacerbated as a company grows larger. One of the biggest problems with a sole proprietorship is that it lacks many of the protections that other business entities have to offer: with an LLC, a business owner’s personal finances are separate from their business finances, so in the event of an overwhelming financial obligation, the business is held responsible, not the individual owners. However, since the business and the business owner are considered one entity in a sole proprietorship, any business debts or other liabilities go directly to the business owners themselves, even if they are not directly responsible for them.?

Why It Might Be Time For a Change?

Although a sole proprietorship is simpler to form and allows for a great deal of flexibility, there are several reasons to consider transitioning to an LLC. There are obvious financial benefits: you’re better able to protect your personal assets and have fewer taxes to pay while running an LLC than being self-employed. You can also more easily expand your business and hire more workers: while sole proprietorships can hire employees, this comes with specific employment and tax laws that need to be followed. Converting to an LLC often makes it easier to account for employee compensation and taxes.?

One might also want to consider transitioning away from sole proprietorship if they want to form an outside partnership or seek out capital. Bringing on a partner automatically changes a sole proprietorship to a general partnership in the eyes of the IRS, so transitioning is non-negotiable under these circumstances. Additionally, sole proprietors have limited options for raising outside capital, whereas other types of businesses can work with institutional capital partners to expand their operations. Of course, not every potential partner is created equal: one should look for a partner who is committed, capable of funding, and has a good track record. They should also consider what value gaps they have and how well their potential partners can fill them. Still, if you’re looking to build out your business, it might be time to move on from sole proprietorship.

There are six key steps when converting from a sole proprietorship to an LLC:

1. Confirm your business name, ensuring that it is available in the state where you plan to file. Do a business name search on the website of the agency responsible for business filings, typically the secretary of state.
2. File the articles of organization with the relevant state agency and pay the filing fee. The process requires basic information about the LLC, including the name, address, purpose of the LLC, name/address of the registered agent, and management structure.
3. Create an LLC Operating Agreement, which specifies the details of the management and ownership of the LLC, along with the rights and obligations of its members. This can include voting rights, distribution of profits and losses, retirement and exit process and non-compete provisions for the LLC members.
4. File a Form SS-4 with the IRS to obtain a new Employer Identification Number (EIN). The EIN is a nine-digit number the IRS assigns to businesses for tax filing and reporting purposes. Even if you have one for your sole proprietorship, you will need a new one when forming an LLC.?
5. Apply for a new bank account. Since personal and LLC assets are separate, you will need to open a new bank account specifically for the LLC. You must also be cautious not to mix personal and business finances, as this can lead to problems down the road.?
6. Apply for any relevant business licenses and permits. Many states have unique business requirements and certain industries have specific licenses you need to operate a business. An attorney or LLC service can assist with this process.?

Making the Right Choice For Your Business

Not every business needs to be an LLC: if you’re operating under a smaller scope, a sole proprietorship might suit your specific needs. What’s important is understanding where you want to take your business and choices need to be made to get there. For many, converting from a sole proprietorship to an LLC or a partnership can be an important step toward achieving new levels of growth. Though it requires one to give up the flexibility of being the sole proprietor, it opens up opportunities to expand one’s strategic vision, allowing access to new avenues for success.?